History proves the lasting value of tax cuts

The three US rate cuts of the postwar period were not panaceas but each stimulated growth and tax receipts.

In the next few weeks, opponents of President George W. Bush's economic policy will take shipment of fresh ammunition in the form of government forecasts. The Congressional Budget Office is expected to announce that growth rates, tax revenues and the federal surplus will all be smaller than was promised in spring.

What comes next is as predictable as August heat on the east coast. Tax cut opponents will target their material to undermine the president's just-passed tax cut and its chief author, Larry Lindsey, the White House economic adviser. The economic slowdown, they will argue, proves what they have said all along: that tax cuts are not the engines of growth the president called them but risky divergences from budget orthodoxy that will generate dangerous budget shortfalls. They will insist that there are dangers even in relatively small cuts such as the one implemented this year, which reduces rates by only a few percentage points, and over a 10-year period. In short, history demands a reversal.

This is a false conclusion. America's rate cut exercises - there have been three important ones in the postwar period - did not instantly solve all of its economic problems. But in the long run they served to fuel both economic growth and tax receipts.

The principal chronicler of those earlier tax cuts has been Mr Lindsey himself. Twelve years ago, while a Harvard professor, he wrote a book on their effects called The Growth Experiment (Basic Books). Mr Lindsey was, even then, an avid tax-cutter and Republican adviser. A study of his book illuminates both the value of the Bush programme and its limitations.

Consider the first great tax reform, proposed by President John F. Kennedy in the early 1960s, as growth slowed. Income tax rates were at a record high. To restore individual incentives, the Kennedy plan pulled them down dramatically - the top rate went to 70 per cent of income from 91. In 1963, the president said that "tax reduction and tax reform overshadow all other problems" - quite a statement considering that the Soviet bear also loomed.

As today, the opposition cried "fiscal folly". In tones reminiscent of Tom Daschle, today's Senate majority leader, Harry Byrd, chairman of the Senate finance committee, slammed Kennedy as "the first president deliberately to ask for a tax reduction that would add to the deficit". The president's plan languished in committee. After Kennedy's tragic death, Washington finally passed the legislation, more out of loyalty than conviction.

Yet rather than decline, as standard maths would suggest, tax receipts increased by 2.5 per cent in 1965. So did the economy, growing at a robust 5.8 per cent. Such numbers represented an all-out victory for the "tax cuts for growth" camp.

More problematic was Ronald Reagan's tax cut of 1981. That plan also promised stronger growth and a "positive revenue effect" from cuts. Ridicule again followed. "It is not credible that the more Reagan cuts taxes the sooner we reach budget balance," said Paul Samuelson, the economist. This time, critics succeeded in paring the act down, in much the fashion that Mr Bush's plan was recently reduced. Pressure over budgets forced the law's authors to reduce their rate cuts and to phase the change in slowly.

The short-term result of the compromises was to diminish the incentive effects of the cut. Citizens deferred income today so that they could pay taxes at tomorrow's rates, yielding the disappointing receipts and slower growth the critics had warned of. This is also very likely happening again today owing to a slow phase-in. The tax cut could not, as Mr Lindsey noted, prevent recession.

In short, the modest 1981 plan was followed by a commensurately modest result, which in turn gave fodder to critics. The act's benefits, most notably a crucial indexing to inflation of the income brackets for different tax rates, became visible only after the public formed its mixed opinion of the law.

In 1986, by contrast, the Reagan administration managed with the help of a Democratic Congress to pull rates down dramatically - the top rate went to a historic low of 28 per cent. Strong economic growth, as Mr Lindsey points out, followed this change, giving America a 15-year-long economic stimulus by rendering it a global tax haven. While America's pre-eminence in recent years is now seen as having been inevitable, its decline was at the time widely predicted.

Nor, according to Mr Lindsey, was the rate cut to blame for the widening of the deficit that followed. Higher federal spending caused most of that. With the aid of a National Bureau of Economic Research model, The Growth Experiment shows that 70 per cent of the deficit increase was owing to new outlays. Only 30 per cent of it stemmed from tax cuts.

In the long run, growth offset the deficit, as Mr Lindsey forecast it would. His book even contains a chapter with the prescient title "The Great Surplus of 1999". "We have learnt," concluded Mr Lindsey magisterially, that in the long run "almost any tax cut will reduce revenue by less than static revenue assumptions suggest". At the time, he must have hoped he was toppling budget orthodoxy for good.

How does it feel to find himself on the front lines fighting the same old arguments about the "cost of tax cuts" today? "It's somewhat ironic for a historian of tax cuts to find himself an actor in a tax battle," he said last Thursday. "But history shows that tax cuts are good for the economy."

One lesson to be drawn from Mr Lindsey's study is that slow, small tax cuts like the current one are harder to defend than fast, big ones. On Thursday, Democratic lawmakers suggested that tax increases should start to come next year. Experience suggests the opposite: 2002 may be an opportunity to add to the work begun with this year's cut.

© Copyright 2001 Financial Times

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