On Economic Cures
Given that the economy seems to be slowing, the policy heads are furrowing their brows over which would be better -- lower tax rates or lower interest rates. Well, it turns out that both would be best, though neither is likely to run the economy on a dime.</br></br>-- Taxes. Will lower marginal tax rates spur growth? Sure. Low taxes are associated with rapid growth the world around. The Reagan tax cuts, once fully implemented in 1983, ended "malaise" and started a boom that persisted through 2000, except for a nine-month dip in 1990 and tepid growth as the economy digested the 1990 and 1993 tax increases. We would not now be experiencing growth close to zero, as Alan Greenspan described it in his testimony last week, if we had passed a tax cut last year, when opponents warned that it would "overheat the economy," whatever that may mean.</br></br>And there, in timing, is precisely the rub in using tax changes as countercyclical policy. Given the political delay in crafting tax legislation, tax cuts will arrive at the right time only through blind luck. What's more, taxpayers watching the political tides anticipate tax changes, often in perverse ways. Recall, for example, what happened with the investment tax credit. Expected passage of the credit brought business investment to a halt while the players waited for it to go into effect, just as an anticipated suspension called forth a burst of activity before the suspension was enacted. Both reactions merely aggravated the economic situation the tax credits were meant to remedy.</br></br>It's better to think of tax policy in structural terms, designing it to produce incentives for growth in the long run. In these terms, cutting marginal tax rates is a no-brainer for one reason -- taxes are way too high. Not only did Mr. Clinton's tax increase create de jure brackets of 15-28-31-36-39.6%, but the disallowance of certain deductions and his phase-outs of exemptions make the de facto brackets even higher. In high-tax states like New York and browned-out California, the top combined federal-local marginal rate approaches 50%, a level loaded with disincentives and distortions.</br></br>These higher marginal rates are especially punishing because real bracket creep -- what happens as wages and salaries increase with economic and productivity growth -- pushes more people into higher brackets. As a result federal tax revenue as a percentage of the economy is remarkably fat, at levels last seen in World War II. And the evidence that taxes are way too high is hanging out there for all to see in the form of budget surpluses.