November 7, 2001 | WebMemo on Taxes
On November 6, 2001, Senate Majority Leader Thomas Daschle
(D-SD) reaffirmed his intention to introduce a two-component
economic stimulus package that would combine the plans of Senators
Max Baucus (D-MT) and Robert Byrd (D-WV). It now appears likely
that the upcoming Senate debate on economic stimulus legislation
will center around Senator Daschle's plan and a plan proposed by
Senator Charles Grassley (R-IA) that is strongly supported by
Although both plans are intended to ease the impact of the the
economic recession and improve the incentives to work, save, and
invest (the real catalysts for economic growth), there are
substantial fiscal policy differences between them. On the one side
are those, led by the President and Senator Grassley, who believe
that vigorous tax cuts combined with limited spending increases
will do the most to lift the economy out of its current slump. On
the other side are those, led by Senator Daschle, who believe that
substantial spending increases combined with limited, targeted tax
cuts will do the most to remedy the economic problems worsened by
the September 11 attacks.
This Report addresses the question of which approach-significant
tax cuts with limited spending or significant spending with limited
tax cuts-would do more to boost the economy. It evaluates both of
the Senate stimulus plans, using the same economic model, against
the same baseline, to determine which approach would produce the
best economic results over the next five years.
Analysts in the Heritage Foundation's Center for Data Analysis
(CDA) used the WEFA U.S. Macroeconomic Model, the Center's
Individual Income Tax Model, and work by the staff of the Joint
Committee on Taxation to address this question. Specifically, CDA
economists estimated the economic effects of the Bush-Grassley plan
and Daschle plan using the same model of the U.S. economy, one that
contains a two-quarter recession beginning in the third quarter of
2001 and ending during the first quarter of 2002. This analysis
Although both plans transfer income to low- and moderate-income taxpayers through rebates and both assist the unemployed, the fact that the economic outcomes produced under the Daschle plan fall far short of those produced under the Bush-Grassley plan raises serious questions about the utility of cash payments and increased government spending as the primary tools for boosting economic activity. The better approach would be to lower tax rates and the tax burden on labor and capital to improve incentives for workers and business owners, producing more jobs and generating higher incomes, which, in turn, translate into higher investment and consumer spending.
SUMMARY OF PLANS
CDA analysts evaluated two economic stimulus plans for this
Report: the plan proposed by Senator Charles Grassley and strongly
supported by President Bush, and the plan proposed by Senator
Majority Leader Thomas Daschle that would combine the plans of
Senators Max Baucus and Robert Byrd.
The Bush-Grassley plan consists of five elements: individual
income tax reductions, tax policy changes that reduce capital
costs, cash relief to low- and middle-income workers, extending and
expanding unemployment insurance, and expanding health insurance
coverage. The plan is expected to result in static federal revenue
reductions and spending increases totaling $248 billion over next
five years. Specifically, Senator Grassley and the President
The Daschle plan consists of five elements: cash relief to low- and middle-income workers, tax policy changes that reduce capital costs, extending and expanding unemployment insurance, expanding health insurance coverage, and significantly increasing spending for infrastructure and national security projects. The key contrast between the Bush-Grassley plan and the Daschle plan centers on the amount of tax relief vs. the amount of increased spending that each provides. Specifically, the Daschle plan would consist of:
Significant spending increases for agriculture, highway
projects, transportation security, border security, bioterrorism
prevention, and state and local anti-terrorism grants.
The Daschle plan would reduce federal tax revenue and increase spending by a total of $88 billion over the next five years.
COMPARISON OF ECONOMIC EFFECTS
There may be many good political reasons for Congress to pass an economic stimulus package, but there is one overriding economic reason: the intervention should improve the incentives to work, save, and invest--the real catalysts of economic growth. Fiscal policy changes that focus on these economic incentives will lay the foundation for stronger economic growth and reduce the depth and shorten its duration of the current slowdown. Indeed, the competing stimulus plans should be evaluated with respect to their effects on depth and duration of the recession as much as, or more than, with respect to any other criteria.
To determine how the two plans compare in terms of their effect
on the expected depth and duration of the current recession, CDA
analysts developed projections of the economic impact of each of
the plans. The chart below shows how each plan will affect the
change in employment between the beginning of the recession (the
end of the second quarter of 2001) and the time when total
employment returns to the level it would likely have attained had
their not been the recession of 2001 (i.e. the first quarter of
2004). This chart shows that, while both proposals lessen the depth
of job loss, only the Bush-Grassley plan significantly shortens the
time before employment regains the level it would have attained
without a recession. As Chart 1 shows, the Bush-Grassley plan
reduces the employment trough by nearly 33 percent and shortens the
length of the job slowdown by six months.
Both plans affect economic activity but the Bush-Grassley plan, which contains significant tax relief and limited spending, produces uniformly better economic results than a plan based on substantial spending increases combined with limited tax cuts. For example, in FY 2002:
Moreover, as the attached table shows, the differences in the effects of the two plans will be even more pronounced in future years. The Bush-Grassley stimulus package creates more jobs, provides more income to families and does a better job expanding economic activity than the Daschle plan. These differences become more dramatic as the pro-growth elements of the Bush-Grassley plan take hold. On average, from FY 2002 to FY 2006:
The two economic stimulus plans analyzed in this Report clearly
reflect the two major views of government's role in economic
planning. On the one hand, the Bush-Grassley approach primarily
relies on changes in the tax rates on capital and labor to boost
economic performance. By lowering tax rates and the tax burden on
investment and capital assets, this supply-side plan provides
incentives for business owners and workers, producing more jobs and
generating higher incomes, which translate, in turn, into greater
investment and consumer spending.
On the other hand, Senator Daschle's demand-side approach principally relies on cash transfers to displaced workers and distressed businesses to stimulate economic activity. While this plan produces some increase in employment and income and is better than doing nothing, it fails to substantially increase the fundamental incentives for stronger economic activity. In fact, the Senator's plan never creates the large consumer response that would be needed in order for a demand-side, expenditure-based stimulus proposal to produce the job and income increases that are generated by supply-side proposals. While both plans transfer income to low- and moderate-income taxpayers through rebates and both assist the unemployed, the fact that the economic outcomes produced under the Daschle plan fall far short of those produced under the Bush-Grassley plan raises serious questions about the utility of cash payments and increased government spending as the primary tools for boosting economic activity.
William W. Beach is Director of the Center for Data Analysis at The Heritage Foundation; D. Mark Wilson is a Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation; Rea S. Hederman is Manager of Operations for, and Ralph Rector is a Research Fellow in, the Center for Data Analysis at The Heritage Foundation.
APPENDIX A: METHODOLOGY
Heritage Foundation economists in the Center for Data Analysis
(CDA) followed a two-step procedure in analyzing the budgetary and
economic effects of the two stimulus plans evaluated by this
Static fiscal year revenue estimates for tax rate changes were computed using the CDA Individual Income Tax Micro-simulation model. This model estimates the change in tax liability for a national sample of over 100,000 tax filers. The sample contains tax return data from the Public Use Tax File that is produced by the IRS. In addition, the sample contains demographic and other information from the Census Bureau's Current Population Survey. Economic data from the CBO August 2001 forecast were used to project the sample data forward to 2011.
The WEFA model contains a number of variables that are used to
simulate proposed policy changes. The following sections describe
how the CDA static estimates were introduced into the WEFA model to
estimate the dynamic economic and budget results.
Average Effective Personal Income Tax Rate.
The WEFA model contains a variable that measures the total amount of all federal taxes on individual income as a percentage of the nominal personal income tax base. Heritage economists adjusted this average effective tax rate downward for each of the forecast years to reflect the static revenue decrease estimates.
Average Effective Corporate Tax Rate.
The WEFA model contains a variable that measures the total amount of federal corporate tax revenue as a percentage of nominal corporate profits. Heritage economists adjusted this average effective tax rate downward for each of the forecast years to reflect the static revenue decrease estimates.
Labor Force Participation and Average Weekly Hours.
Small adjustments were made in the model's exogenous labor force participation rate and in the number of hours worked to account for the dynamic effects of accelerating the marginal income tax rate reductions.
Business Sector Price Index.
The business sector price index was reduced to reflect the lower tax rates on business income that would be reported on personal income tax forms.
Corporate AAA Bond Rate.
The corporate AAA bond rate was reduced to reflect the lower tax rates on business (capital) income in the three plans.
The WEFA model contains variables that measure the amount of federal transfers to persons. Heritage economists increased these amounts to reflect the tax rebates, unemployment insurance benefits, and any other transfers to persons in the three plans.
Government Grants to States.
The WEFA model contains variables that measure theamount of federal grants to states. Heritage economists increased these amounts to reflect any increased spending on medical insurance and other state grants in the three plans.
The WEFA model contains variables that measure the amount of federal defense and non-defense spending. Heritage economists increased these amounts to reflect any increased spending in the three plans.
The model assumes that the Federal Reserve Board will react to this policy change as it has historically. This assumption was embodied in the Heritage model simulation by including the stochastic equation in the WEFA model for monetary reserves.