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November
15, 2002, 8:30 a.m. |
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ashington's balance of power has changed decisively in favor of the Republican
party and, in particular, George W. Bush. By gaining control of both houses
the Republicans control the political and economic agenda — which
now includes accellerating the Bush tax-rate cuts of 2001 and also making
them permanent.
This is a positive development for the economy. If the tax-rate cuts are enacted next year and are made retroactive, the impact on the economy's incentive structure will be immediate. Yet, in spite of the obvious economic benefits, the tax-cut battle ahead will not be an easy one.
A counterattack, in fact, is already mounting.
The static thinkers are going after the GOP plan, arguing that there is little evidence the tax cuts will have a stimulative effect. The arguments against enhancing the tax-rate cuts go as follows:
1. Two University of Michigan economists studied household behavior during and after last year's tax rebate. Their findings are that households did not spend much of the windfall.
2. Some now argue that consumers are in an asset-rebuilding mode — therefore, the bulk of a tax cut will be saved and not spent. The implication here is that a tax cut will not have much of a stimulative effect on the economy.
Nobel laureates Milton Friedman and Franco Modigliani have already debunked such theorizing. In simplified form, the Modigliani theory postulates that over a lifetime, the present value of consumption equals the present value of all income earned. Friedman, in turn, postulates that individuals consume a constant fraction of their permanent income. Under some general conditions, the two theories are equivalent.
So let's apply them to two takes on tax relief: one-time rebate checks and permanent rate cuts.
When an individual receives a $300 tax-rebate check, at best his net worth increases by $300. Assuming a 5% interest rate on government bonds and a 40% marginal tax rate, the $300 generates an additional $9 worth of "permanent" after-tax income. Thus, according to the Modigliani and/or Friedman consumption theories, a taxpayer's consumption increases at most by $9, and he saves the rest of the refund. The consumption theories explain quite easily why the bulk of last year's tax refund was saved and not spent by consumers.
Now consider the case of a "permanent" increase of $300 — that is, a taxpayer now receives that $300 every single year. At the 5% rate, in Modigliani's terms the taxpayer's net worth increases by $6,000. In Friedman terms the taxpayer's permanent income rises by $300. So, assuming a 40% marginal tax rate, the after-tax income will rise by $180 and the taxpayer will now be able to spend an additional $180 per year. Economists like Martin Feldstein are using this impeccable logic to argue for making the Bush tax cut permanent.
And here's some more fuel for the pro-tax-cut fire: Supply-siders today argue that a tax-rate cut increases the after-tax rate of return. The incentive effect of the higher rate of return results in a short-run increase in investment and a net increase in aggregate demand for goods and services. In other words, the higher rate of return through savings and investment will ultimately lead to higher permanent income, leading in turn to higher long-run consumption.
The static consumption arguments against accelerating the Bush tax cuts and making them permanent are weak at best. The new GOP Congress can stand its ground with the full support of sound economic theory.