No Substitute
Short-term incentive effects must dovetail with permanent ones.

December 4, 2001, 8:00 a.m.

ver the years, supply-siders have understood that there is no substitute for the real thing. Near-term adjustments in interest rates or tax structures may in fact give the economy a kick in the growth direction. But unless there is real, long-term change, these "substitutions" only steal from the future.

We can see this clearly with interest rates. When interest rates are declining and are expected to continue to decline, people have an incentive to delay purchases of consumer durables and to delay home refinancing. However, once interest rates hit their bottom and are expected to increase, the floodgates open. Supply-siders argue that during periods of declining interest rates the economy should slow. Witness the current slowdown. And when rates have bottomed and are expected to rise, the economy is expected to pick up.

The methodology easily extends to other examples. The "Big Three" automakers are now offering zero-interest-rate promotions. It is reasonable to assume that carmakers are not going to offer negative interest rates. Hence, this is as low as it is going to get for car financing. Not surprisingly, consumers have jumped at the offer and cars are selling like hotcakes. The temporary "price reduction" has worked and inventory is being worked down, solving the carmakers' previous production mistakes.

However, if one looks a little more closely, all that actually is happening is that the automakers are stealing from future sales. In the near-term, shortly after the promotion ends, car sales are going to slow, perhaps significantly. That means future car production will unambiguously slow. This trade-off, or substitution, may be desirable now, but it only eats away at future production rates.

Substitution effects can also be witnessed on the tax front. The 1986 Tax Reform Act raised the capital-gains tax rate to 28% from 20%, and the prospect of higher tax rates on existing investments led to a flood of transactions in which investors realized huge amounts of capital gains. The increase in realization led to a surge in capital gains tax-revenue collections that flooded the coffers of both the federal and state government.

Interestingly, the geniuses at the State Tax Board in California failed to realize that the surge in revenues was a one-time event. Instead they projected higher tax revenues into the future and ramped up spending to match the projected higher revenues. We know what happened afterwards: rather than reduce the spending in recognition of the temporary nature of the revenue surge, Gov. Pete Wilson raised taxes and pushed California into a terrible recession. This incident illustrates how supply-side effects may lead to policy mistakes for those who ignore them. However, not all was bad. The incident demonstrated that changes in the incentive structure can have powerful short-term effects on the economy.

Another example of a temporary effect was produced in the early 1980s during the first Reagan tax-rate cut. Recall that the rate cuts were phased in and the top marginal rate on earned income of 50% was reduced gradually to 28%. Look at the after-tax rate of returns during the transitions. The first year the taxpayer in the highest tax bracket would keep $0.50 out of every dollar earned. After the tax cuts were fully implemented the taxpayer would keep $0.72.

In short, with the same pre-tax cash flow, any taxpayer that was able to shift income from the early years to the latter years would increase after-tax income by 44%. During that time people devised a variety of ways to shift income. One easy way was to overpay state and local taxes. The taxes would be written off against federal taxes at the higher rate. The refund would be taxed at the lower federal taxes the next year. Other people simply delayed income recognition by absence of work. During that time the U.S. experienced a recession and the economy did not show any signs of life until the bulk of the tax-rate cuts were in place.

These were the short-term effects of the rate cuts. But there have been some long-term effects, too. Lower tax rates increased incentives to work, produce, and save. It is not a coincidence that the U.S. resurgence coincided with the reduction in tax rates, the reduction in regulations, and the reduction in the inflation rate. The policy changes led to a permanent shift in the structure of incentives in the U.S. economy.

Bush in Deed
The election of George W. Bush offered the promise of a new round of incentive-increasing measures that would lead to a permanent reduction in the tax rates. However, there were some doubts as to whether the new administration was a true believer in the supply-sider credo. Bush talked a good game and still does. However, one has to judge deeds, not words.

The Bush proposal promised to lower tax rates, eliminate the death tax, and to reform Social Security. In some respects the president is keeping his word. However, one is correct to be somewhat disappointed by the phase-in and temporary nature of the program. While these are due to static revenue budget constraints and may reflect a political reality, they also reflect a lack of understanding or belief in short-term substitution effects.

One way to justify the phase-in of tax rate cuts is to assume that short-run substitution effects are not that important and only the long-run incentives matter. However, that does not square with the 1986-87 capital-gains experience or the automakers recent experience. Substitution effects seem to be important. If one believes that the long-run effects are what matter, then why make the death-tax reduction a temporary one?

Perhaps the justification for this Bush initiative is that political pressures will not let Congress reinstate a 55% death tax from a zero tax rate. Under that scenario, after 11 years, we would have a permanently lower personal income-tax rate and no death tax. If this is the case, we would enjoy all the long-run benefits, even if we feel that the implementation costs are unnecessarily high.

Armed with this analysis we can now focus on the current economic situation. Economists and the administration have proposed a number of temporary measures to aid the economy. In the analysis of these we need to focus on two effects. The first is whether the policy changes would have a short-term effect and, second, whether that effect is permanent. That is, whether it permanently improves the incentive structure of the economy.

One of the president's proposals is to accelerate the implementation of the personal income-tax rate reductions. In terms of incentive effects, this measure is a winner. A reduction in the top personal income tax rate to say 35% from 39.6% would increase after-tax take home pay to $0.65 on the dollar from just over $0.60. That's a 7.6% increase in the after-tax rate of return. So, Americans would have a 7.6% increase in their incentive to work and produce beginning January 1, 2002. In the meantime, they would have a 7.6% incentive to delay income recognition. Given the short period between now and the end of the year, the annualized rate is phenomenal and growing. One can expect people to slow production until the beginning of next year.

The proposed 30% increased depreciation is a good deal, too. Expensing is the optimal and desirable policy. Thus, anything that moves us closer to the expensing ideal is a move in the right direction.

Here's how to look at the issue: Under current law, companies are allowed to depreciate 100% of their capital expenditures. Under a 35% corporate income-tax rate, a company would be able to shield $35 worth of profits for every $100 in revenue. However, under current law, the depreciation must take place over several years. Hence, the net present value of the tax shield will be less than $35. Thus, advancing the depreciation schedule gets us closer to the $35 shield.

Consider the case of a 30% advancement in the depreciation schedule. On a $100 investment, a company will now be able to shield an additional $10.50 this year. However, it will lose $10.50 worth of tax shield in future years. At a zero interest rate, companies would be indifferent. However, with positive interest rates they are clearly better off by the proposal. How much better depends on the level of interest rates and the length of the depreciation schedule. We know that the higher the interest rate and the longer the depreciation schedule, the greater the benefits from the additional 35% depreciation. An additional point to make is that in order for the tax shield to be of any value, a company has to have positive earnings to write the depreciation off.

The Bush administration proposal could be a good one if written and implemented correctly. However, the proposal seems to suffer from a bland form of supply-side economics. It is trying to be too cute.

By enacting a temporary provision it forces people to increase their expenditures in the short-term. This, they would argue, helps get us out of the recession. But there are a few problems with this logic. One is that if the measure is just altering the timing of economic activity, it will have no permanent effect on the economy — all we are doing is stealing from the future.

Look Long
The only way to justify these measures would be if somehow the famous Keynesian multiplier existed and (for once) it actually worked. The argument would be that the increased purchases of capital equipment would lead to a multiplier effect that would lift us out of the recession. This seems consistent with some of the comments made by the president's economic advisors as well as the president himself — particularly Bush's line that we are all supply-siders and Keynesians now. But if there is no multiplier the only way that we can have a long-term benefit is by lowering the effective cost of capital permanently by making the higher accelerated depreciation permanent.

Another example of a temporary solution to stimulate the economy is the proposed sales-tax holiday. It is a fine measure if the objective is to raise tax revenues in the short-run. It may also be a fine measure if one believed in the multiplier effect. However, if one remains true to his supply-side roots, the temporary measure would only steal from the future without permanently increasing incentives to work, save, and produce. That's simply not what supply-side economics is all about.

Short-term incentive effects to stimulate the economy are fine as long as they dovetail with permanent incentive effects. The president should apply the arguments used to advance the personal income-tax rate cuts, to accelerate the depreciation schedule permanently, and to eliminate the death tax.