The Benefits of Tax Cuts and Alternatives to Stimulus Spending

Seven steps Congress should take to end the recession and jumpstart the economy

What if someone told you the key to physical health was gorging on fatty foods and lounging on the couch all day? You’d probably write them off faster than if Bernie Madoff asked for a second chance at investing your money.

Why then should taxpayers accept a gorge and spend-like-crazy plan when it comes to the country’s economic health?

The road out of this recession is one that creates sustained economic growth, not short-term spending increases. It’s the difference between eating healthy with daily exercise and drinking a Red Bull: one offers a lifetime of benefits, the other causes a burst of energy and then a crash.

A healthy recovery plan consists primarily of tax cuts, with a mix of reduced barriers to investment, appropriate regulation, and the right monetary policy. But just like the value of exercise would be negated by poor eating habits, you can’t cut taxes and spend too. Fiscal stimulus might be politically advantageous, but a sweeping array of tax cuts, targeted to reach all sectors of the market, would do far more to restore the economy to long-term health.

The myth that stimulus spending works is based on the theory that increased demand for products, encouraged by government spending, will promote increased production and thus spur economic growth. Yet, stimulus spending misdirects resources, fails to increase aggregate consumption, only creates temporary jobs, and adds to the national debt.

Harvard economics professor Gregory Mankiw, who served as chairman of President George W. Bush’s Council of Economic Advisers, offers the following example: if you hire your neighbor for $100 to dig a hole in your backyard, and he hires you to do the same in his yard, then government statisticians will report that the economy has created two jobs and increased GDP by $200. But it is unlikely that, having wasted all that time digging, anyone is really better off.

President Barack Obama’s aides have said the new administration is only interested in ideas that can be historically and empirically proven to work. Well, the historical and empirical data proves that the fastest way out of economic downturns is letting individuals and businesses keep more of their money, creating more incentives to produce.

The U.S. economy stagnated during the 1970s but was revived from its intense inflation, unemployment, and recession by the pro-growth policies of the Reagan era, not stimulus spending. Tax cuts and appropriate monetary policy improved the economy after spending increases under former Presidents Ford and Carter had failed.

More recently, when the economy was struggling post-9/11, President George W. Bush proposed rate reductions in capital gains and dividends to encourage business growth. The tax cuts took effect immediately and within a few months the economy began to see recovery. Unemployment declined steadily and the economy grew by an average of 4 percent through 2006. Unfortunately, President Bush also spent more than any previous administration and endorsed coercive housing and regulatory policies that attributed to the housing bubbles creation and collapse, which sent the economy into a tailspin. As beneficial as tax cuts are on the one hand, the government can shoot itself in the foot by trying to dictate economic activity with the other hand.

Compare that to the New Deal response to the Great Depression. Intense government control of prices, massive spending on inconsequential public works projects, and heavy regulation of industry kept the economy pinned down. Unemployment grew year after year, despite the holes that the government had people digging and refilling.

According to a recent University of California, San Diego study, government spending is only likely to increase gross domestic product (GDP) $1.4 dollars for every dollar spent. Conversely, a recent study by Christina Romer, chairwoman of President Obama’s Council of Economic Advisors, found that tax cuts are likely to raise GDP by $3 for every dollar spent.

The Senate, now debating how much of the proposed stimulus package should go to spending projects and how much should be tax cuts, should consider several options that would promote a healthy economic lifestyle and not just offer the short-term value of energy drinks:

1. An across the board tax cut on both income and business taxes

The House Republican Study Committee has suggested an alternative to the “Making Work Pay” tax credit: reducing the lowest individual tax rates 5% across the board would create an average savings of $500 for those in the 10% tax bracket and nearly $1200 for those in the 15% tax bracket.

The South Korean government has chosen tax cuts to ignite its economy, cutting virtually all tax rates by 2%. A similar action by the U.S. would help individuals and businesses.

2. Cut FICA payroll taxes

An alternative to a broad income tax cut would be cutting FICA taxes, the bulk of the payroll tax, which would help employees and employers. Reducing FICA taxes from 12.4 percent to 6 percent would reduce both the employee paid tax and the employer match by 3.2 percent, increasing take-home pay and leaving companies more money to create jobs or reinvest in production. Cutting payroll taxes also circumvents government bureaucracy because the IRS doesn’t have to process income tax adjustments or issue credit checks.

There are downsides to the FICA cut however. Social Security is already in financial trouble, and cutting its revenue stream would require a complete revamping of the social safety net system (a good, though complicated thing to do).

3. Special tax cuts for small businesses

Since small businesses, defined as those employing fewer than 500 people, employ nearly half of all working Americans, reducing their tax obligations would allow them more money for capital investment and new hires. In 2005, small businesses created 78.9 percent of all new jobs in America. House Republicans have suggested allowing small businesses to take a tax deduction equal to 20 percent of their income.

4. Reducing corporate taxes to be globally competitive

Cutting the top corporate tax rate from 35 percent to 25 percent or lower would put the United States on par with the European Union when it comes to tax levels. Europe has been cutting business and capital gains taxes for years to our comparative disadvantage. Ireland has slashed their corporate taxes in half to 12 percent, Austria is at 20 percent, and England is at 28 percent. Among industrialized nations, only Japan has higher business taxes than the United States. To attract more business capital, the American tax code must be competitive with the rest of the world.

5. A tax holiday on all Wall Street investment returns

The federal government could waive taxes on future earnings from investments in stocks, commodities, etc., if they were made between now and any particular end date. A tax holiday of this kind could be structured in different ways, but the outcome would be restoring some confidence and vigor in investment prospects, thawing more credit and letting the market restore itself. Capital gain taxes could also be temporarily or permanently reduced in tandem with this holiday.

6. Tax cuts on anything related to infrastructure investment

If infrastructure investment is critical for America’s future, the government should encourage private investment in roads, bridges and schools. The government could waive or reduce taxes on profits made from private equity that is put into building roads, bridges, broadband access and schools. Companies that are hired to do the infrastructure work could also be allowed to operate like non-profits: for instance letting construction firms buy materials tax-free. There are billions of private equity dollars waiting to invest in infrastructure. The fewer barriers there are to this type of investment the faster capital markets will thaw.

7. Making it easier to access money in retirement accounts

There are currently a lot of fees associated with withdrawing funds from tax-sheltered 401(k)s and other retirement accounts. Allowing people to manage their own finances and have access to all of their money in a recession is critical to building consumer confidence. Letting people withdraw money from retirement accounts – tax and penalty free for a year – would be a good way to boost consumer confidence.

There are other ideas on the table too, such as permanently repealing the alternative minimum tax and encouraging infrastructure investment through the expansion of private activity bonds. Rationalizing financial sector regulations such as mark-to-market capital requirements and exclusivity rights in bankruptcy proceedings would not only increase stability, and thus confidence in the current market, but it would protect against future troubles.

Tax cuts will not bring immediate improvement. However, if appropriately used, they will help the economy much faster than stimulus by paving the way for long-term, sustained growth.