“Seldom have so few gotten so much from so many.” That might be the motto of President Bush’s proposed tax cuts.

As the nation entered the new millennium, it faced three problems. First, the economy was slowly going into a recession, with a stock market bubble about to burst. Second, inequality was growing. While the Nineties had at last arrested the decline in income of those at the bottom of the income distribution, the fruits of that decade’s growth went disproportionately to the rich. Third, there were long-range problems, including Medicare and Social Security systems that were underfunded and an economy that had become addicted to living beyond its means, borrowing more than a billion dollars a day from abroad.

While Bush inherited these challenges, he started with one advantage that Clinton had not had. Bush senior had bequeathed to Clinton a serious deficit—8 percent of GDP, if one excludes the money that was supposed to be going into Social Security. But Clinton bequeathed to Bush junior large surpluses. These surpluses might have been used to shore up our Social Security and Medicare system. They might have provided badly needed new benefits, like long-term care and prescription drugs. They might have been used to repair America’s infrastructure, our aging highways, bridges, and airports. The burst of growth in the Nineties was based on new technologies and progress in science; and yet, even here, we underinvested, because of pressure to meet deficit targets.

As President Bush took office, he took advantage of the economic downturn to push for a tax cut, but it was a tax cut that was not designed to stimulate the economy—and it did not do so to any appreciable degree. Two years later, the economy is still languishing. The cost of Bush’s mistake has been enormous. In 2001 alone, we had a gap of some 3 percent between the economy’s potential and what it actually produced, which translates into a loss of $300 billion. And there is strong evidence that as success breeds success, failure breeds failure: if the economy’s output is lower today because of this mismanagement of national economic policy, it will be lower five, ten, twenty years from now, since some of the lost output would have been spent on investments that would have enhanced productivity.

 

Advertisement

 

The first order of business—then and now—should be a tax cut that stimulates the economy. All the better if we can have a stimulus that not only enhances growth but also addresses our long-term problems, including our growing inequality. In fact, it must have been hard for Bush to design a tax program that cost so much in revenue while at the same time doing so little to stimulate the economy.

 

Two arguments are being made to defend Bush. The first holds that he is not to be blamed for the country’s current economic difficulties: Who could have predicted that the downturn would have lasted so long? But many (myself included) did predict this, for an obvious reason. Underlying the economic downturn was huge overinvestment in high-tech and telecommunications companies, the sectors that had sustained the economy during the Nineties. It would be years before we worked off the excess capacity that resulted from such overinvestment. Meanwhile, it was unlikely that the lowering of interest rates by the Federal Reserve would have much effect; firms with excess capacity are not going to build still more excess capacity just because they can borrow more cheaply.

But there is a more fundamental answer to Bush’s defenders: the art of economic policymaking is knowing how to respond to uncertainty. America has one of the poorest unemployment insurance schemes among the advanced industrial countries, with more limited coverage, and benefits that are both shorter (only twenty-six weeks) and lower. Improving those benefits would have provided an automatic stabilizer at a time of economic slowdown—money would be spent only if the unemployment rate increased, especially the long-run unemployment rate, which doubled in Bush’s first two years.

Eventually, unemployment benefits were extended for another thirteen weeks, but only until the end of 2002. By then, the extended benefits of almost a million Americans had run out, and three quarters of a million more workers faced a cutoff of benefits after Congress initially failed to renew an extension. It was not just that the Bush administration and the Republican Congress had heightened the anxiety of almost two million workers during the Christmas holidays, but in doing so, the administration further undermined the strength of the economy. It was no accident that the Christmas shopping season of 2002 was a weak one. Unemployment benefits have at last been extended, but there is room to extend them further, much further.

A second argument that needs to be disposed of is one put forward by Bush himself: if the tax cuts were good enough to be passed in May 2001, it makes sense, so he has said, to accelerate them now. The duplicity in the argument should be obvious: by the same logic one could have argued that since the sunset provisions of the first Bush tax law, under which some of the key provisions, like the elimination of the estate tax, are to terminate in 2010, were good enough to be enacted in 2001, why not make them permanent? The reason for the terminal date was simple: the country could not afford to make the changes in the law permanent, even when we thought we had huge permanent surpluses. If we could not afford them then, do we really believe we can afford them now? Even if we ignore the unequal distribution of the benefits, many economists were not convinced that the tax cuts were a good thing even then.

But since then, we have two more pieces of information. We know that the tax cuts were ineffective in stimulating the economy. Why should we believe that accelerating them even faster will do much more for the economy? The tax cuts were oversold as a stimulus; and now we know they failed.

Secondly, in May 2001 we thought we had a surplus, not counting the money that was supposed to go into the Social Security trust fund, of some $3 trillion over the next ten years. During the Clinton administration, we thought that the surplus would protect Social Security and Medicare, finance needed investments, and help pay down the national debt.

In an astonishing feat of fiscal mismanagement, the Bush administration managed to squander that surplus, converting it into a $2 trillion deficit. Some of this was not entirely Bush’s fault. Even with the best of fiscal management there was a good chance the projected surplus wasn’t ever likely to be realized. But that’s exactly the point. Bush spent money that we did not have. It was reckless to do so. When I was chairman of the Council of Economic Advisers, I saw how those budget projections are made; I know how fragile they are. They rest on a set of hard-to-believe assumptions. Slight changes—such as a slightly slower growth rate than anticipated—can have big consequences. Bigger changes could have even bigger consequences, for example the bursting of the stock market bubble that had led to huge increases in capital gains tax revenue. The projections were too good to be believed and it should not have been surprising that they turned out to be wrong.

 

Now that we know our true fiscal situation more accurately—it is likely worse than the $2 trillion deficit “officially” being projected—it is even more reckless to continue on a tax-cutting spree. But Bush’s new economic proposals seemingly put aside all budgetary restraints. The new budget envisages a turnaround in the fiscal situation for the period between 2002 and 2011, from a huge ten-year surplus to an even bigger ten-year deficit—a difference of some $7 trillion. The administration thus anticipates huge deficits, even years after the economy recovers from the recession. For the year 2008 alone (even with misguided economic policy the economy will surely recover by then!) it expects a $190 billion deficit.¹

We know how to create a powerful and effective tax stimulus. What is needed is to give money through the tax system to those who will spend it and spend it quickly: the unemployed, the cities and states that are starving for funds, and lower-income workers. A strong stimulus would also be an equitable stimulus: the money, by and large, goes to the poorest Americans, those who have benefited least from the growth of the last quarter century. Giving money to cities and states will prevent cutbacks in educational and health expenditures, which can hit the poor particularly hard.

We also know how to get more benefit per dollar of tax relief. An investment tax credit, for instance, could be incremental, going only to corporations and individuals that increase their investments. When I was at the Council of Economic Advisers, we thought of a variety of other “low-cost” stimuli—for instance, allowing firms that invest more to “carry back” profits and losses from previous years, so that they can get a credit or refund on taxes previously paid. Such a stimulus even increases overall economic efficiency. (By contrast, the Bush proposal restricts carry-back provisions to firms that want to qualify for tax-free dividends.)

By now, it is well known how Bush’s tax package favors the rich, but the degree to which it does so is not well appreciated. While 50 percent of all tax filers would receive $100 or less, and two thirds $500 or less, Bush himself, according to Bloomberg News, would have saved $44,500 on his 2001 tax returns, and Cheney $326,555. According to an estimate in the Financial Times, John Snow, Bush’s secretary of the Treasury, would save some $600,000. The calculations of the Brookings Institution Tax Policy Center show that more than half of the benefits of exempting corporate dividends from the individual income tax would flow to the top 5 percent of the population. All the taxpayers in that group earn more than $140,000 and they have an average income of $350,000. The 226,000 richest tax filers, those with incomes over $1 million, will receive a benefit roughly equal in size to the 120 million tax filers with incomes below $100,000.²

The inequity arises not just from the fact that the rich own most of the country’s dividend-paying stocks, but also from the fact that average working Americans hold stocks largely in pension funds, IRAs, and other forms of investment that are already tax-exempt. For the average American, corporate earnings are not being double-taxed. The problem is that too often such earnings are not even subject to a single tax as more and more American corporations have learned how to avoid paying corpo-rate income taxes. Today, using these techniques, the average American corporation pays a far lower proportion of its profits in federal income taxes than was the case in the past, and at a lower rate than the one prescribed by the tax statutes. (For many rich Americans, moreover, even capital gains in taxable accounts entirely escape taxation, by means of a provision in the tax law called “step up of basis at death.” In effect, when a person dies, the appreciation in a stock he holds goes untaxed.)