Gradually Phasing in Tax Cuts Has Held Down Economic Growth

The announcement that real gross domestic product grew at a 4.2 percent rate in the first quarter is good news. But one cannot help but feel that we should be doing better. Real GDP normally grows much more rapidly in the early stages of economic expansions following a recession. One possible culprit for the less-than-hoped-for growth may be the phasing-in of key elements of the 2001 tax cut. The way tax policy affects individual decision-making is complex. Some tax changes mainly affect the average tax rate - taxes as a share of income. Others affect the marginal tax rate - the tax on each additional dollar earned. Because average and marginal rates affect people differently, when both are changed simultaneously, it is sometimes hard to figure out their economic effects. For example, an increase in average tax rates with no change in marginal rates theoretically could increase labor supply. That is because workers will have to work more to make up the income lost to higher taxes. Conversely, a reduction in average tax rates might lower labor supply because workers need not work as much to have the same after-tax income. Economists call this the income effect. Changes in marginal tax rates are less ambiguous. If average tax rates are unchanged and marginal rates are increased, people clearly will have less incentive to earn taxable income because they will keep less of each additional dollar they make. They will work and save less and put more effort into saving taxes. All other things being equal, a reduction in marginal tax rates with average rates unchanged will always lead to increased output. Economists call this the substitution effect. Another complicating factor is timing. We saw this in 1992, when there was a bulge in income realizations late in the year as people anticipated higher taxes after the election of Bill Clinton. Hillary Clinton's law firm, for example, distributed bonuses in 1992 that otherwise would not have been paid until 1993. While the number of people who have this much flexibility in the timing of their income this way is small, the same principle applies to all income earners. In the aggregate, the impact can be large. Back in the early 1980s, economist Arthur Laffer predicted that phasing-in the Reagan tax cut would severely reduce its impact. Enacted in 1981, it was not fully effective until 1984. Although the tax cut was supposedly 10 percent per year for 1981, 1982 and 1983, because of prorating there was really no tax cut in 1981. As of 1982, the cumulative tax cut was 10 percent, rising to 18 percent in 1983 and 23 percent in 1984. Therefore, Laffer concluded that the full growth effects of the tax cut would not start until 1983 and not be fully effective until 1984. Said Laffer, "Common sense tells us that people don't shop at a store the week before the store has a widely advertised discount sale. Prospects of lower tax rates in future years created incentives for individuals and businesses to reduce their income during 1981 and 1982 when tax rates were high, in order to realize that income in 1983 and 1984 when tax rates would be lower." Sure enough, there was a huge increase in growth in 1983. Real GDP jumped from minus 1.9 percent in 1982 to plus 4.5 percent in 1983 and 7.2 percent in 1984. While other factors obviously played a role, the phasing-in of the Reagan tax cut undoubtedly delayed its impact. Putting these factors together, we see that the 2001 tax cut was poorly designed to stimulate growth in the short run. Average tax rates were reduced by increasing the child credit and sending out tax rebates, while marginal rates were largely unchanged. The main marginal rate reductions were phased-in, with many still not having taken effect. Economic theory says that this should cause growth to fall. A new study from economists Christopher House and Matthew Shapiro, both of the University of Michigan, confirms this theoretical prediction. "The immediate effect of the 2001 phased-in tax cuts," they found, "was to reduce output and employment." GDP in 2002 was 0.4 percent less than what could have been achieved with a smaller but more immediate tax cut. Messrs. House and Shapiro also look at the 2003 tax cut and find that it was much more effective precisely because more of it took effect immediately. "Just as the phased-in nature of the 2001 tax law may have delayed production and employment, the immediate tax relief included in the 2003 law may have contributed towards the increased pace of economic activity in the second half of 2003," they conclude. We may owe the slowness of the economic recovery to those who thought that phasing-in the 2001 tax cut was the "responsible" thing to do.