December 4, 2001

December 4, 2001 | Commentary on Taxes

Stimulus Straphanger

Politicians are considering tax relief to help a sputtering economy, but not all tax cuts are created equal. There is a vast difference between "supply-side" tax cuts and "Keynesian" tax cuts. Supply-side tax policy focuses on how to reduce marginal tax rates in order to increase incentives to work, save, and invest. Keynesian tax policy, by contrast, simply seeks to put money in peoples' pockets in hopes that more consumer spending will stimulate growth.

These two approaches lead to radically different tax cuts. Supply-siders want to permanently reduce tax rates, particularly the top personal income tax rates that have such an adverse impact on investors, entrepreneurs and small business owners. Keynesians are just the opposite. They generally favor temporary tax cuts, and they want them skewed to those with low incomes who might be more likely to spend the money as quickly as possible.

Historical evidence should have ended this debate years ago. Ronald Reagan's across-the-board tax rate reductions, for instance, triggered a record economic expansion. Similar tax rate reductions also generated strong growth in the 1920s and 1960s.

The track record for Keynesian tax cuts, to be charitable, is not nearly as strong. The so-called tax rebate distributed earlier this year was based on Keynesian theory, and it was a total flop. The economy continued to stumble and unemployment rose. But this should not have come as a surprise. A similar tax rebate enacted during the Ford presidency also failed to improve economic performance.

Unfortunately, this historical record seems to have no impact on the policy debate in Washington. Some lawmakers, using Keynesian analysis, are talking about temporary tax "holidays." One proposal is for the states to have a 10-day sales tax holiday, with Uncle Sam reimbursing them for lost tax revenue. The other idea is to suspend the Social Security payroll tax for one month.

Both of these proposals are misguided. The notion that tax cuts should be designed to quickly put more money in peoples' pockets, in hopes that they will spend more money and jump-start the economy, is snake-oil economics.

Indeed, it is based on the same nonsensical theory that Bill Clinton used when he was trying to enact his pork-filled stimulus bill in 1993. From a Keynesian perspective, tax cuts and new spending have similar effects.

The Keynesian view is greatly misguided because it fails to consider both sides of the fiscal equation. More specifically, it does not recognize that government cannot give a consumer a dollar - either in the form of new spending or a tax rebate - without first taking that dollar from someone else.

In the case of tax rebates and tax holidays, every dollar that is used for that approach means one less dollar that is used to pay down debt. This means that money that would have wound up in the pockets of bondholders is now in the pockets of selected taxpayers. There is no increase in total spending power. The same is true for new government spending. Every dollar of additional government spending necessarily means one less dollar for bondholders to spend.

In any event, the Keynesian preoccupation with consumer spending makes no sense. Economic growth occurs when there is an increase in national income. This is why efforts to alter the use of income - by encouraging people to spend instead of save - are so futile. And since less saving translates into less investment spending, the Keynesian approach is flawed from both a theoretical and practical perspective.

The only way to increase national income is to encourage more work, saving, investment, risk-taking and entrepreneurship. This is why supply-side economics has a successful track record. When tax rates are reduced, people have more incentive to be productive and create wealth. And when this leads to additional income, this enables them to spend more and save more.

Advocates of faster economic growth should insist upon a stimulus package that works. This means all personal income tax rates should be reduced, and those lower tax rates should take effect immediately. With the possible exception of capital gains tax relief, across-the-board tax rate reductions are the strongest tonic for an ailing economy. It is particularly important to reduce the top tax rate, since this is the levy that imposes the greatest disincentive on investors, entrepreneurs and small business owners.

A stimulus bill that fails to include a significant reduction in all tax rates might be worse than doing nothing. A package comprised of new spending and gimmicks like tax holidays will not enhance economic growth. Indeed, such proposals will increase the risk of recession and unemployment next year. Adding insult to injury, those that blocked supply-side tax cuts then would point to the economy's poor performance and argue that this was "proof" that pro-growth tax cuts do not work. This is why President Bush should veto a phony stimulus package that does not include a reduction in all tax rates.

Daniel J. Mitchell is the McKenna senior fellow in political economy at The Heritage Foundation.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Related Issues: Taxes

Originally appeared in the Washington Times