Tax-Cut Talk

President Bush is calling on Congress to quickly pass his $1.6 trillion tax-cut plan to forestall an economic decline. "A warning light is flashing on the dashboard of our economy, and we just can't drive on and hope for the best," the President warned. Business earnings have turned weak and may remain weak for months to come. The stock market is struggling to maintain its footing and unemployment is beginning to rise again.

The President's plea for a tax reduction obviously springs from the assumption that a tax cut is an appropriate means for averting the dreaded decline. He proposes no massive boosts in government spending, no new protection of American industry from foreign competition, no tighter government control over commerce and industry, as several U.S. Presidents have done in the past. Instead, he favors a gradual reduction of some taxes.

Taxation is no simple fiscal matter. It presents problems of shifting, diffusion, and incidence, the difficulties of which challenge even the ablest economist. Every tax change, whether up or down, sets into motion a chain of reactions that affect industrial production, prices, wages, employment, modes of living, and so on. Most legislators who are no economists are unaware of the numerous economic effects of the taxes they impose. They are guided by public opinion, which is molded by the media, which in turn are led by thought leaders pointing the way.

Throughout the world, Keynesian theories have become the most influential formulation of economic thought in a century, appealing to both practical politicians and mathematical economists. The former readily embrace it because it calls for large-scale political economic planning; the latter relish it because it meets all the requirements of rigorous mathematical thought.

Colored by Keynesian concepts, public opinion expects government to be a balancing agent. Whenever the economy sinks into depression and unemployment government must come to the rescue. In stagnation and decline the Federal Reserve System must "stimulate," "bolster" and "revive" the economy, and the United States Treasury must maintain "aggregate demand" through infusions of public and private spending. Keynesian economists argue that business spending is rather impulsive, dynamic and volatile, while consumer spending is rather regular, stable and passive. Consumption is moving along a stable function, adjusting readily to the macro-environment that is managed by government. Most administrations from Roosevelt to Clinton have been guided by Keynesian thought and doctrines. The George W. Bush Administration can be expected to follow in their footsteps.

The $1.6 trillion tax plan must be seen in this light. It provides generous, across-the-board tax cuts for individuals but little direct relief for corporations. It proposes to double the current $500-per-child tax credit to $1,000, to reduce the marriage penalty by allowing a couple to subtract 10 percent of the earnings of the lower-paid spouse before figuring their taxes, to repeal the estate tax by 2009 and to allow charitable deductions for taxpayers who do not itemize their deductions.

It is significant that the tax plan makes no mention whatever of any need for a reduction in government spending. It is designed primarily to stimulate consumer spending and boost aggregate demand. It is true that the Bush budget proposal deletes all one-year project expenditures, the so-called pork- barrel expenses amounting to some $15 billion annually. But such deletions defy political reality as Congress is bound to appropriate money for new projects every year: funds for bridges, community libraries, etc. Recommended by powerful members of the House and Senate Appropriations Committees, such projects constitute favors which every Administration must grant to the members for their consideration of its own projects. The deletion which is made without any public justification or defense, therefore, must be seen as a mere accounting device that will be corrected as quietly as it was made.

The Bush tax plan seeks to stimulate spending in order to avert a dreaded decline. Yet, even if spending were the proper means to the desired end, it is unlikely that it will be crowned with success. The income tax cuts are to take place gradually from 2002 to 2006, starting in the coming Fiscal Year with a reduction of some $21 billion or just 0.2% of gross national product. Such an amount obviously would have no meaningful impact on the present economic downturn. Even if the reduction were to be made retroactive to the beginning of this calendar year or the beginning of the current Fiscal Year, it would hardly be felt in the $10 trillion economy. Failure to bring about the desired stimulation would strengthen the quest not only for ever bigger tax cuts but also an early return to deficit spending.

Many supporters of the Bush tax plan castigate the President for basing his tax-cut proposal on the Keynesian spending rationale. They argue in favor of an income tax reduction on grounds of supply-side considerations. The President should build his proposals on the need for continuous growth of the supply of goods and labor rather than approaching economic policy through such macro-economic concerns as gross national product. Ever since the 1980s many conservative defenders of the market order have favored and labored for tax cuts with the intention of increasing the incentive to work and produce goods and services. Supply-side economics was the heart of the economic program of Ronald Reagan's presidency, during which tax rates were cut substantially. High marginal tax rates and onerous regulations, supply-siders hold, discourage private investment and economic expansion. Tax reductions stimulate them, which will benefit all members of society.

President George W. Bush apparently is in the fortunate position of finding support for his tax-cut proposal in both popular systems of economic thought — in Keynesian dogma and supply-side doctrine. Depending on economic conditions in the coming months, he can move from one to the other. If the American economy should weaken, he can point to gross national product, plead for compensatory spending and argue as a Keynesian. If it should hold its own, he can plead for continuous economic growth and hold with the supply-siders. With such ideological support, he need not fear much political opposition to his tax-cut plan.

The President nevertheless must brace himself for bitter opposition from a few political leaders who seek popular support and acclaim by appealing to a common and ignoble attribute, to envy. It is more irreconcilable than hatred and more potent and durable than the discredited Marxian ideology which discoursed about class conflict and class war. The party of envy is lamenting "the working class has about as much chance of getting tax relief under this bill as we do winning the sweepstakes." A prominent United States Senator is leading it, quipping, "The Bush tax cut would give millionaires enough money to buy a Lexus luxury car, while a typical working person only gets enough for a muffler." Not to be outdone, a Washington editor is calling the tax cut proposal "a reverse Robin Hood bill."

Like all other tax-cut formulas prescribed in the past, the $1.6 trillion tax plan is ill-designed to correct the maladjustments caused by the issue of fiat money and credit. The additional consumer spending, which the tax reduction seeks to encourage, and more government spending on old and new projects are unlikely to correct the distortions of a ten-trillion-dollar economy. To promote consumption, which is gratifying, is not to advance readjustment, which is rather painful, inflicting losses on business and causing unemployment. Surely, a new burst of spending and credit expansion may sustain the distortions and temporarily prevent the readjustment. But it merely delays the inevitable and actually makes matters worse. Similarly, to reduce the marginal income tax spread of 15% -39.6% to 10% - 33% may reduce the pains of recession, but it does not correct maladjustments that are causing it.

A few economists judge the tax package according to basic principles of economics. They look upon all forms of political intervention according to their effect on social peace and the productivity of human effort. Taxation and regulation, they assert, perceptibly divert production from the lines chosen by consumers in an unhampered market order. They view tax reductions as an appropriate way of redirecting production to consumer preference and restoring the supremacy of consumer judgment. But they also are aware that a tax reduction without a simultaneous spending reduction unfortunately does not restore the consumer supremacy; it merely leads to a reshuffling of the burden of government from the shoulders of taxpayers to the loan market.

The tax-cut plan does not propose to reshuffle but places a budget surplus on the table. The Congressional Budget Office (CBO) anticipates a ten-year surplus of some $5.6 trillion through 2011. About $2.5 trillion thereof are expected to flow from payroll taxes and belong to Social Security's trust funds. $400 million are earmarked for Medicare trust funds, which leaves a Treasury surplus of some $2.7 trillion. Most of this surplus is expected to accrue later in the decade — provided the revenue continues to flow and grow at present rates.

The Congressional Budget Office's projections of a genuine surplus, resting on the assumption of uninterrupted boom conditions with bursting revenues, are rather unrealistic. After many years of boom fever we must brace for an economic readjustment which would soon diminish the revenue and erase the Treasury surplus. A painful recession and slow recovery would turn it into a budget deficit, as all recessions have done in the past. A recession surely would tempt the new administration to spend the annual Social Security surplus, as the Clinton Administration did unhesitatingly in 1998, 1999, and 2000. It is the reserve accumulated for the not-so-distant day when "baby boomers" start drawing retirement checks. To spend it now is to incur new debt to the Social Security Administration, to pay interest on it, and to incur more market debt when the Administration needs the funds in the future. And once again, the Treasury would have to choose between raising some taxes or shifting the burden to the loan market.

If the budget surpluses consist only of Social Security surpluses, they belong to the contributors to the trust funds. At least, that is a moral conclusion which most individuals draw in their relationship with others. If they were free to choose, they would individualize and privatize the trust accounts, which would end the surpluses and convert the national debt now owed to the Social Security Administration to one held by the members.

The Bush tax plan does not distinguish between Treasury and trust-fund surpluses. It calls for reduction of the marginal income tax rates. As all tax changes have discernible effects on the behavior of taxpayers, a tax reduction can be expected to reduce the distorting and disincentive effects of present rates. It would not only allow people to keep and spend more of the money they have earned but also affect their behavior. A taxpayer now earning $50,000 a year faces a 28% federal income tax, a 15.3% payroll tax, and additional federal excise taxes on gasoline, telephone, and many other products. In addition he must pay various state and local taxes, which leave him less than 50 cents of each extra dollar of income. There are few individuals whose behavior is not affected by such costs. Economists call them the deadweight of taxation. The most glaring examples of its visible effects are the popular preference of fringe benefits over additional cash income and the growing number of Americans living in retirement. No one can possibly estimate the magnitude of this deadweight on American productivity and prosperity.

Any reduction in the income tax rate would reduce this deadweight. But it would not necessarily reduce the great complexity of the tax law, which adds hidden compliance costs even for low-income taxpayers. In fact, the income tax is so complicated that many people are incapable of filing their own tax returns. Threats of penalties aggravate the complications, such as penalties for untimely withdrawal of savings, mistakes in estimated tax, late filing, late payment, negligence, and frivolity. Making false statements and failure to file are prosecuted criminally. Scared and intimidated many people seek the assistance of tax attorneys and accountants who must cope with some 700 forms, some with special-interest loopholes, others with traps designed to expose unsuspecting taxpayers. The complexity reveals the handiwork of legislators who seek to guide, steer, and micro-manage the economy. Diligent IRS agents are their willing executors.

Some tax changes now being considered would even increase the complexity and boost the compliance costs. The proposed income tax reduction would drive many millions of Americans into a cumbersome parallel system: the alternative minimum tax. It is even harder to understand than the traditional system. Marriage tax relief, which would allow couples to subtract 10 percent of the earnings of the lower-paid spouse, would add complexity. Non-itemized charitable deductions would complicate many tax returns and their audits. New rules on the carryover basis of estates would add confusion and controversy. Unfortunately, the Bush tax plan is oblivious to compliance costs and the urgent need for long-term tax reform. Even if all its proposals were to become law, it would not improve the burdensome system.

American business is forced to labor under difficult conditions in an anti-business tax system. "Passive activity" is taxed at higher rates than "active activity," and "passive losses" differing from "active losses" are disallowed. And after all business taxes have been paid, the estate tax seizes up to 55 percent of all assets when the owner passes away. Owners of corporate stock pay taxes twice, once as corporate profits and then again as personal income. Finally, businesses must cope with complex pension rules, capital gains rules and expense allocation rules, inventory capitalization rules and economic performance rules, all of which impose huge compliance costs. Unfortunately, the tax-cut plan does not propose to reduce these costs.

Politics, as a practice, has always been the systematic organization of the benefits and burdens of government. Every party seeks to reshuffle the benefits and reassign the burdens in a never- ending political struggle. Every faction seeks to maximize its benefits and minimize its exactions. To forego a benefit for the sake of some tax reduction is rather unpopular because the special benefit usually exceeds the individual tax abatement.

We know where we are, but do not know where we soon will be. Recession is not the worst scenario the Bush Administration is bound to face. It is well-nigh certain that it will encounter a financial crisis in which the U.S. dollar will be tested. For two decades the United States has run large trade deficits, now amounting to some $450 billion a year, that were financed by foreign investors. As long as American interest rates are substantially higher than comparative foreign rates and the American economy keeps on growing and the stock market remains bullish, the inflow of foreign funds is likely to continue. But with interest rates falling, the economy stagnating and stock prices plummeting, it is likely that foreign dollar holders will not invest the requisite funds that are necessary to cover the deficits. They may even withdraw some of their funds, which would cause the U.S. dollar to fall in world money markets.

An international money crisis would place the Federal Reserve System between the proverbial "rock and a hard place." If it chooses to fight the stagnation by expanding money and credit, it may trigger a world-wide "flight from the dollar" and damage it irreparably. If it decides to defend the dollar by raising interest rates, it would aggravate the economic stagnation and usher in a painful recession. Whatever the Fed may choose, it will find itself on the horns of a fateful dilemma.

The Bush Administration undoubtedly believes that it has the power to shape the future. Surely, its policies will affect future conditions, as the policies of every administration mean to do; but we may learn anew that inexorable laws and principles dictate the effects of all policies and prevail in the end.