June 7, 2005 | WebMemo on Taxes
Why is the 2003 tax cut working so much better than the 2001 tax cut? Why is the economy performing better, for instance, and why are tax revenues growing faster than projected today compared to what happened after the 2001 tax legislation? The answer is that not all tax cuts are created equal. Tax cuts based on the Keynesian notion of putting money in people's pockets in the form of rebates and credits do not work-and these are the tax cuts that dominated the tax legislation approved in May 2001. Supply-side tax cuts, by contrast, do improve economic performance because they reduce tax rates on work, saving, and investment. And since lower tax rates on productive behavior dominated the May 2003 legislation, it is hardly surprising that the economy has responded positively.
As the following comparison indicates, the 2001 and 2003 tax cuts yielded significantly different results:
To be sure, tax policy is only one of many government policies that impact economic growth. Moreover, exogenous factors such as the terrorist attack in 2001 influence economic performance. So it would be wrong to attribute all of the good news since May 2003 to the supply-side tax cut, just as it would be incorrect to blame the Keynesian tax cut for all the job losses and economic weakness between May 2001 and May 2003. Furthermore, not every provision of the 2001 tax cut was economically misguided and not every component of the 2003 tax cut was based on sound economic policy.
To reiterate, it is not enough merely to cut taxes. Tax reductions only benefit the economy if the "price" of engaging in productive behavior is reduced. Keynesians argue that rebates and credits boost growth by injecting purchasing power in the economy, but this simplistic analysis fails to realize that government withdraws an equal amount of purchasing power from the economy when it borrows money to finance the rebates and credits.
An examination of the major provisions of the two tax bills underscores the difference between Keynesian tax cuts and supply-side tax cuts. The 2001 tax cut, for example, included many provisions that had no positive impact on economic performance because of poor design. Other tax provisions in 2001 were based on supply-side principles, but implementation was postponed-which meant a concomitant delay in the pro-growth impact. A review of the major provisions in the 2001 bill illustrates the problem:
The 2003 tax cut was not perfect, but most of the major components were based on supply-side principles. And because the legislation focused on good tax policy, it generated much better economic results. A review of the major provisions in the 2003 bill illustrates the link between good policy and good results:
Some politicians argue that taxes should be higher, but if they really want more money in Washington, they should argue for more tax cuts like the ones adopted in 2003. Tax revenues have risen much faster than inflation since the 2003 tax cut was enacted. The results for 2005 have been especially impressive. Revenues to date for the current fiscal year are up more than 13 percent compared to the previous period.
This does not mean that tax cuts "pay for themselves," but it does mean that the right kind of tax policy-lower tax rates on work, saving, and investment-will lead to faster economic growth. And faster economic growth means more income for the government to tax. In other words, the best way to generate tax revenue is to expand the "tax base."
But the purpose of good tax policy is not to give politicians more money to waste. Pro-growth tax cuts should be implemented to boost economic performance and expand individual opportunity. Indeed, to the extent that pro-growth tax cuts generate more income and a larger tax base, any additional revenue should be used to finance further reforms to bring America closer to a simple and fair flat tax.
Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.
 Bureau of Labor
Statistics, "Bureau of Labor Statistics Data: Employment, Hours,
and Earnings from the Current Employment Statistics survey
(National)," June 7, 2005, at