The economy may not be recovering as strongly as some would like. But it is healthy enough at the moment that the Bush administration does not need to accelerate existing tax cuts or push for new cuts to stimulate economic activity, according to professors of finance and public policy at Wharton. They also say that the reemergence of federal budget deficits is reason enough to forego thinking about tax cuts.
In wide-ranging interviews, in which they discussed what they think the administration s economic agenda should be for the next two years, faculty members also said that heightened terrorist activity and an invasion of Iraq hold the potential to unsettle the U.S. economy and swell government spending. But they noted that if a war with Iraq ended quickly, and if terrorism were held to a minimum, the economy would probably be much improved in time for the 2004 election campaign.
I m not enthusiastic about accelerating the income-tax cuts, says finance professor Jeremy Siegel. They won t do much to spur the economy. In any event, he adds, My feeling is that President Bush won t get the tax cuts he wants because of Democratic opposition.
Siegel says the current recovery is proceeding at a healthy pace compared to the last time the country emerged from recession. We had a sluggish recovery from the last recession 10 years ago, and this recovery is stronger than that, he explains. Some economists feel that lagging job growth indicates a weak recovery, but Siegel notes that job creation is slow only because productivity is particularly strong.
Siegel estimates that when the government issues a revised figure for the nation s gross domestic product (GDP) in the third quarter, it will show that the economy is growing at an annual rate of 4%. That figure is to be released in late November.
I m pretty dubious about this tax-cut business, says Gerald Faulhaber, professor of business and public policy and management. I think we went overboard on tax cuts. We ended up with surpluses at the end of the Clinton era as a result of the long boom we had. Bush came in to cut taxes because that was part of his agenda. But now the boom is over and nobody is predicting surpluses. We have a war on terrorism and a possible war with Iraq. We ll probably have a long-term presence in Iraq [if a war is waged and won], all of which is expensive. And, at the same time, the elderly want a prescription plan. How are we going to pay for that? The notion of more tax cuts is reckless, to tell you the truth. If we want this stuff, we should pay for it. We shouldn t leave it to our grandchildren.
According to finance professor Nicholas Souleles, the administration will have to decide whether its goal is short-term stimulus or long-term growth because each goal requires different policy approaches. If the focus is on short-term stimulus, you could consider short-term spending or tax cuts, Souleles explains. But for purposes of long-term growth, you might not want to increase government spending because that could raise interest rates and so crowd out private-sector investment.
Targeted Tax Cuts
Souleles also says that lower-income households are likely to spend more of a given tax cut, so if the goal is to stimulate the economy, the administration could consider targeting tax cuts disproportionately to low-income people. In addition, people are likely to spend more of a tax cut if the cut is permanent. They figure they don t need to save that first tax cut because they know they re going to get more tax relief in the future. So in terms of a spending kick, permanent tax cuts should have a bigger effect. But permanent tax cuts could continue to crowd out long-term growth. There are trade-offs involved in decisions like these.
Adds finance professor Franklin Allen: The administration shouldn t run up a huge deficit. That should be their priority. Allen says the administration should take note of what has happened to Japan in the last decade. Japan was in a strong position fiscally but their asset bubble burst in the early 1990s. In the mid-1990s tax revenues went way down and that s when Japan started on this debt binge they re still on. When people say, The U.S. won t make the same mistake, that s when I get really worried. The administration s view is that the current budget deficit is a short-run problem and that the country can afford to borrow for a couple of years [until a faster-growing economy starts to produce more tax revenue]. I don t think it is a short-term problem. I d rather see us in fiscal balance than running up deficits.
The Bush tax-cut plan that was enacted last year, coupled with the collapse in stock prices and a recession, left the government with a deficit of $159 billion for fiscal year 2002, which ended Sept. 30. An even bigger deficit is expected for fiscal 2003. Looking further out, burgeoning deficits would make it harder for the government to deal with long-term problems related to Social Security and Medicare, according to the faculty members. Federal Reserve chairman Alan Greenspan recently warned that continuous large deficits would risk returning to an era of high interest rates, low levels of investment and slower growth of productivity.
One positive way to look at the deficit is that the shortfall for fiscal 2002 stood at 1.5% of GDP, much lower than the 5% and 6% levels of the mid-1980s. But if the government spends billions on a war in Iraq and on counter-terrorism efforts, that percentage could rise in a hurry.
Siegel predicts the United States is unlikely to enter another recession. He does say, however, that growth will slow down in the fourth quarter because consumers have already spent a lot of money this year on durable goods, which are products expected to last three years or more.
The Federal Reserve, Siegel added, acted properly earlier this month when it lowered the federal funds rate one half of a percentage point, to 1.25%, to spur economic activity. Furthermore, it was right for the Fed to signal that it would take back that half point if the economy improves significantly. At the same time, the Fed has room to cut rates again if the economy does not respond the way the Fed thinks it should. I d rather see [a cut in interest rates] rather than a tax cut, Siegel notes.
The Deflation Debate
But Siegel thinks the half-point cut may be enough. I fully believe the Fed, in lowering interest rates and pushing liquidity in the markets, will have a positive effect on the economy next year. The fourth quarter is tough but I don t see that as a prelude to a collapse in consumer spending. The Fed could go to zero, but it wouldn t go there unless the economy really started faltering. Christmas spending would have to be disappointing and in January we d have to see slippage in other indicators.
Siegel forecasts that inflation will creep up to 2% or 3% in the next couple of years. He discounts fears of deflation in the United States, saying, No deflation is in the offing.
Allen and Faulhaber, though, suggest that deflation widespread, persistent declines in prices is a possibility in the United States. They note that Japan has been struggling unsuccessfully to boost economic growth since the early 1990s, even with interest rates at zero percent. We need to worry about deflation, Faulhaber says. The stock market is still somewhat overvalued and there s a mini-bubble in the property market. A further decline in stock and real estate prices would add fuel to the argument that deflation could be in the offing.
I worry more about deflation than most people, both in the United States and globally, adds Allen. Anyone who s shopped for a TV lately has noticed that prices have been falling. You can buy a really nice TV for $200 or $300. It is good that TVs cost less than they used to, he notes, but if prices keep sliding, people may hold off buying goods until prices fall still further. In a deflationary environment wages could decline and jobs could be cut, and consumers would have greater difficulty servicing their debt.
China is playing a role in keeping prices down for many mass-produced goods. This comes at a time when the world is experiencing excess industrial capacity. China can produce a lot of things cheaply, Allen says. That puts downward pressure on prices worldwide. It could well cause deflation.
Allen also worries about a collapse in housing prices. People say home prices on average in the U.S. haven t fallen since the 1930s, but I think we re closer to the 1930s than one would think.
Siegel, however, disagrees. Housing will remain strong. Housing prices are high and there are not a lot of bargains out there, but I don t see a crash in real estate. I do not think we are in a generalized bubble. Prices are not excessively high. There are pockets of regional speculation, but speculation [was more rampant] earlier this year than it is now. I think we re seeing a cooling off of the housing market.
There is one area where Siegel would like to see tax relief: elimination of the double taxation on dividends. Dividends are first taxed on the corporate level as earnings and then again when they are received by individual investors. Such a move would not only benefit investors but would help restore confidence in the financial markets in the wake of scandals in corporate America and on Wall Street.
Siegel believes that dividends should be deductible from the corporate income tax. Others believe it is better to give a tax break to individual investors. Either way, says Siegel, such a move would help bring back investor confidence. Giving companies an incentive to pay dividends will bear a lot of fruit in the coming years. We re one of the few countries in the world that has no tax break on dividends. That, combined with some other factors, has caused dividends to go out of style and has created a crisis of confidence on the part of investors.
In an op-ed piece in The Wall Street Journal in August, Siegel and two colleagues Wharton finance professor Andrew Metrick and Harvard finance professor Paul Gompers described one of the benefits of ending double taxation of dividends. If dividends were a deductible expense, firms would be strongly motivated to pay out all their profits as dividends, since retained earnings would be subject to the corporate tax, they wrote. Firms that did not pay dividends would be viewed unfavorably by investors who feared that the earnings are inflated and that the cash does not exist. The payment of cash dividends would therefore add significant credibility to management s earnings reports.
Since eliminating double taxation of would reduce the amount of revenue going to the U.S. Treasury, Siegel proposes that the administration support a trade-off of sorts: rewrite the law governing estate taxes in exchange for a dividend tax break. He says the government could exempt from tax the first $4 million or $5 million of the estate tax.
By the time 2004 rolls around, Siegel and Faulhaber say President Bush should not be saddled with a deteriorating economy as his father was when he lost a reelection bid to Bill Clinton as long as a war with Iraq and activity by Al Qaeda proceed in a way that does not have negative political and economic consequences.
I think he s going to have a recovering economy; he won t have a rip-roaring economy, says Siegel. The stock market is going to be firm, but it will take many years to get back to where we were in March of 2000 [when technology and dot-com stocks crashed]. We all know uncertainties are in the cards, like a war with Iraq that may overwhelm the economy. But at this particular juncture, I think he has a stronger recovery than his father did.
Adds Faulhaber: There are some danger signs around: the possibility of deflation and a housing bubble. And if an Iraqi war goes badly, that wouldn t help. But in a year or so we ll see a rise in the stock market and the economy. Generally speaking, I think it s going to be Bush s election to lose in 2004.