Analyzing Likely Tax Cuts in 2003: Can Bush Kickstart the Economy?Published: December 18, 2002 in Knowledge@Wharton
When Congress returns from the holiday break, President Bush is expected to unveil his plan for using tax cuts to stimulate the economy. But would the proposals under discussion provide the kind of short-term economic boost the White House says the country needs?
In fact, not everyone agrees that the country does need a short-term jolt. “I do not believe, at this particular juncture, that we need more fiscal stimulus,” says Wharton finance professor Jeremy Siegel. “I think the monetary stimulus from the Fed is going to be working, and that is what we are going to see stimulate the economy next year.”
The president is sure to promote his plan as a remedy to current economic problems, but most elements now under discussion would have little immediate effect, many experts say, adding that the Bush proposals are not so much a new strategy as a continuation of the old one, driven by his long-term growth and tax-cut philosophy.
And the president’s new economic team appears to have been selected more for its talents at salesmanship than to signal a new economic direction.
The nominee for Treasury Secretary, John W. Snow, chairman and CEO of CSX Corp., the railroad holding company, apparently has similar views to the man he would replace, Paul O’Neill. But while O’Neill was caustic, Snow is smooth. “Snow [seems to have] good credentials and looks like he could be a very effective spokesman for the tax rationalization measures Bush wants to push,” Siegel says.
The new economic team is expected to propose about $300 million in tax cuts spread over 10 years. While details are not final, it is likely the president will propose a reduction in the current “double taxation” of corporate dividends, a rebate or tax cut for low- and middle-income workers and quicker depreciation for businesses that spend money on new equipment. Bush also is pressing to speed up the income-tax rate reductions already scheduled for the next few years and to make permanent the cuts approved in 2001 and set to expire after 2010.
Critics are already complaining that tax cuts are likely to aggravate the newly reborn federal budget deficit. In order to borrow to make ends meet, the government would sell Treasury bonds, soaking up investor dollars that otherwise might go to corporate America in the form of stock and bond investments. Moreover, to attract investors, the government might have to offer yields higher than today’s, causing other long-term interest rates to rise. That could make it more expensive for companies to borrow, which would undercut economic growth.
That’s the deficit-hawk theory, at any rate. At present, however, the deficit is quite small, and many economists argue it has long been considered acceptable for government to borrow, spend and cut taxes to pull the economy out of a downturn.
“I don’t think the deficit is anything close to being a problem yet,” says Wharton finance professor Andrew Metrick. “It’s very small relative to other countries in the world and very small relative to historical standards in the United States. I think we are in a recession and in a wartime economy, and it’s appropriate to borrow from the future … Later, when we’re in peacetime, we’ll pay it back.”
“The most important long-run factor influencing the deficit is economic growth,” Siegel says. “We should be targeting, long-run, those factors that stimulate growth if we want to solve the deficit problem.” Tax reduction, he adds, can stimulate growth over the long term, though it is not likely to have as big an effect in the short run as monetary policies such as the Fed rate cuts.
While recovery from last year’s recession has been sluggish, the economy is hardly a disaster. Most experts expect modest 3% growth in 2003. Inflation and interest rates are very low. And even though unemployment has risen, the current level of 6% is modest by historical standards. Wall Street analysts have forecast 12% earnings growth from Standard & Poor’s 500 companies next year, and many think stocks can easily rise by 8 to 10%, close to the annual average for the past century, though that still would leave the major indexes well below their 2000 highs.
Of course, a protracted war in Iraq could pull the rug out and plunge the country back into recession, and oil prices have recently moved to a worrisome level above $30 per gallon. Consumer confidence is well below the levels of two years ago, though it has recently improved, and the stock market has racked up three consecutive years of declines for the first time in 60 years. Growth was poor in October and November.
For several years, rising home prices and low mortgage rates have spurred a refinancing boom that has provided consumers with the spending money that has propped up the economy. But mortgage rates have been so low for so long that the refinancing boom may soon end, closing the new-cash spigot. Meanwhile, business spending has shown little sign of perking up, despite the Federal Reserve’s 12 interest-rate cuts, knocking the Fed Funds rate to the lowest level in four decades – 1.25%.
Many economists argue that business investment is weak, not because money is hard to come by but because companies are still working off excess capacity built up in the late ‘90s. This is why the Fed effort to stimulate the economy through monetary policy, the rate cuts, has not yielded faster results; cheap money is available, but businesses don’t need it.
For political reasons, the administration is likely to emphasize the short-term effects of its economic plan, but most of the measures are more likely to pay off over the long term.
Most reports say Bush is likely to propose a reduction in the “double taxation” of corporate dividends. Currently, companies pay corporate income tax on profits distributed in dividends, and shareholders pay personal income tax on the dividends they receive.
Siegel favors eliminating the corporate tax bill because that would “level the playing field” between dividend payments and interest payments. Companies now get tax deductions for interest paid on debts such as corporate bonds they have issued to raise money. This is one reason, says Siegel, that too many companies have taken on too much debt.
If companies could deduct dividend payments in the same way, they would be more inclined to raise money by issuing new blocks of stock, removing some of the pressure to build up debt, he argues, adding that a dividend tax break also would give companies an incentive to pay out more of their profits as dividends, putting money into investors’ hands.
Currently, most companies emphasize delivering profits to investors in the form of rising share prices. To do this, they use profits to reinvest in the company or to buy back shares, thus increasing the value of the remaining shares. If dividend payments were deductible, managers who wanted to retain profits would have to make a stronger case to shareholders than they do now, and there would be less room for the kind of accounting shenanigans that have been in the news in the past year or so, Siegel argues. “It also would cause a pretty strong upward movement in stock prices, because after-tax profits of corporations would definitely rise.”
According to Siegel, it would be best to eliminate the tax that corporations pay on dividend money while retaining the income tax that individuals pay. This way, dividend payments would be treated the same as interest payments companies make to corporate bond holders.
Shareholders would benefit nonetheless, he says, because companies’ larger after-tax profits would result in larger dividend payments and stock-price gains.
But critics are likely to argue it’s unfair to cut corporate taxes and not individual taxes, so the administration may propose a reduction in the tax rates individuals pay on dividends, Siegel suggests. The dividend rate could be cut to half of the income tax rate, or it could be set to match the long-term capital gains rate, which is 20% for most investors.
Encouraging greater use of dividends also would weaken the incentives that have contributed to some of the other problems witnessed in the past year, Metrick notes. After the Enron collapse destroyed the retirement savings of many of the company’s employees, it became clear that too many companies are requiring or encouraging employees to hold their company stock in 401(k)s and other defined-contribution plans.
“A lot of the reason that companies put employees into company stock in their 401(k) plans – which is very bad, in my view – is that they get a tax deduction for the dividends they pay to stock in their 401(k) plans,” he says. If such a deduction were available on all dividend payments, there would be no particular benefit to packing company shares into defined-contribution plans.
In addition, a new tax policy encouraging broader use of dividends would make executive stock options less attractive, Metrick points out. In order to fully share in stock returns, executives would have to own real shares, since options holders do not receive dividend payments. This would better align executive interests with shareholders’.
Bush also is expected to propose a change that would allow companies to take the entire tax deduction for capital expenses in the year in which they are incurred, rather than spreading the deductions over many years, as is currently required.
Kent Smetters, professor of insurance and risk management at Wharton, notes that when tax rates, deductions, rules for write-offs and all other factors are considered, corporate tax rates are higher in the United States than in many European countries. Smetters was deputy assistant secretary for economic policy in the Treasury department from June 2001 through September 2002.
“I think there is some real logic to trying to bring down those rates,” he says, adding that lower marginal rates would help prevent U.S. companies from relocating overseas. “By and large, the smartest thing to do is to increase the expensing provision.”
In effect, he points out, any profits reinvested in a company then would become tax-free. “It would apply to new investment, so it would give lots of incentive to create new investment.”
According to Smetters, a more generous expensing provision should give companies reason to stay in the U.S., a benefit not just for business owners but low and middle-income workers as well. The administration may propose this as a temporary measure to spark business investment in the short term. But Smetters says that he would do it permanently to avert the difficulty of verifying whether a capital investment complied with a temporary rule. Also, a temporary incentive could drive companies to make premature investments that would actually hurt them in the long run.
To get support from Democrats, Republicans may offer something targeted to the less affluent, such as a rebate like the $300 and $600 checks distributed in 2001.
But even if one assumes the economy does need short-term stimulus, there’s no guarantee rebates of this type will work, says Nicholas S. Souleles, finance professor at Wharton. While the hope is that taxpayers would spend rebates, they may choose to save them, notes Souleles, who has studied peoples’ use of tax refunds.
Within a few months of receiving ordinary tax refunds each spring, taxpayers tend to spend from one-third to two-thirds of the money, he adds. Research has also showed that taxpayers tended to save the $300 rebates they received in the late summer and early fall of 2001. The less affluent the recipient, the more likely he or she will spend a rebate. “If you want to maximize the short-term [economic] kick of a tax cut, you might want to target it to people who are liquidity-constrained,” he says.
People are more likely to save their refunds and rebates if they are pessimistic about the future, and they are more likely to save if the rebate is a one-time-only check. If it is part of a long-term cut they expect to enjoy for many years, they tend to spend it, he says. Hence, the best way to get taxpayers to spend rebates to stimulate the economy would be to target the poor, to make tax cuts permanent and to convince recipients they don’t need to hoard the money to use in bad times. Notes Souleles: “People will respond differently to the same tax cut, depending on their situations.”