Evans On The Economy -- How Bush's Tax Cut Will Really Work

Dec. 21, 2004
Look for action on the supply side; market growth is key to spending.

I have been in the economic forecasting business for quite some time -- 40 years, to be precise -- and I have never seen so many conflicting opinions as on the economic merits of President George W. Bush's latest tax cut. More curiously, I have not yet seen any accurate analysis of the tax cut. First, let me indulge in a little history. Many economists were surprised that the 2001 Bush tax cut did not provide as much stimulus to the economy as had tax cuts during the Kennedy-Johnson and Reagan years. In fact, most people did spend their tax cut. But they bought goods produced in other countries. In other words, consumption did rise -- check the figures -- but imports rose almost as much. Hence, there was virtually no gain in U.S. production. Hence, there was no pickup in capital spending. The so-called multiplier didn't multiply. Meantime, what were foreign producers doing with all the extra dollars? They couldn't eat the stuff, so they reinvested it. And because the world is on a de facto dollar standard, that meant the money flowed back into this country and into Treasury securities. In other words, it was a wash. The U.S. government reduced taxes and boosted the deficit; Americans bought more imports; foreign producers took the extra dollars and bought the extra Treasury securities. So on the demand side, there was virtually no impact from the cut. That bit of economic history doesn't seem to be so difficult to understand. Yet these days any commentary on the latest Bush tax cut seems to be hopelessly politicized. Either people believe that the latest Bush tax cut is a wonderful idea because Bush is one heckuva president, or they think it is a terrible idea because Bush stole the 2000 election and doesn't deserve to be in the White House. The fact -- virtually ignored -- is the latest round of tax cuts will likely have some positive effect on the supply side, not the demand side, of the economy.

  • Because the private sector spends money more efficiently than government, returning money to the people who earned it will cause productivity to rise faster, which eventually will boost capital spending and the standard of living.
  • Reducing high marginal tax rates will boost incentives to work harder and invest in things with a positive economic return.
  • Probably most importantly, reducing dividend tax rates will boost the stock market, which will then stimulate both consumer and capital spending. The last point is the most contentious, but at least in my view is the most obvious. A rise in capital gains tax rates after 1972 was followed by a massive stock market slump. The reversal of that increase in late 1978 led to a 40% gain the next two years. The rise in tax rates in early 1987 was a contributing factor to the market plunge later that year. And the cut in 1998 helped boost the market to record levels. Of course, I'm not saying that changes in the capital gains tax rates were the only factor affecting stock prices. I am saying they were an important contributing factor. According to my calculations, if the top dividend rate is at 15%, down from 38.5%, during the next two years, the stock market will rise by 10% to 20% more than otherwise would have been the case. That will add 0.5% to 1% to the growth rate each year for the next two years. And that -- not the demand-side effect -- will be what gets the U.S. economy moving again. Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.
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