What Works

The economy has been in recession for over a year, and it’s likely to continue contracting through the first half of 2009 — and possibly beyond. Clearly, policymakers need to pursue stimulus policies that work.

The centerpiece of an effective stimulus policy should involve two elements:

1. Extend the 2001 and 2003 tax reductions for as long as possible — certainly through at least 2013 — to prevent a tax increase. Better yet, make the reductions permanent.

2. Reduce tax rates on individuals, small businesses and corporations through 2013 by lowering the top rates by 10 percentage points and reducing rates by similar amounts for other taxpayers.

Our analysis, using a mainstream model of the U.S. economy, shows that these policies (relative to current law) would:

* Soften the recession in 2009 and speed the economic recovery through 2010 and beyond.

* Increase employment by a half million jobs in 2009 and by a million jobs in 2010, and create 3.6 million jobs from 2009 through 2012.

* Reduce federal tax receipts over five years by roughly $670 billion.

By contrast, the types of tax proposals mentioned as part of the Obama stimulus would have almost no effect on the economy — and the proposed increase in spending would have no effect on it whatsoever.

Much of official Washington is focused on a big stimulus plan based predominantly on increased spending. Whatever the merits of this spending on other policy grounds, it would not stimulate the economy in the near term. The American economy doesn’t rise and fall with the level of aggregate demand or deficit spending.

Further, government can’t simply pump up total demand through deficit spending. The deficit for the next two years is already projected to exceed $2 trillion. If deficit spending were an effective stimulus, the economy should already be poised to take off.

Yet the economy is contracting despite these unprecedented deficits. Why? Because government spending in excess of tax revenues will be financed by borrowing from the private sector. That deprives the private sector of a like amount of purchasing power. Government spending goes up, private spending goes down — changing the composition of demand but not the total. Worse, the amount of federal debt that must be issued to finance the projected deficits, plus the stimulus, may be enough to drive up interest rates significantly, thereby de-stimulating the economy.

Focusing on total demand in the economy is like focusing on the sound of one hand clapping. The other hand is supply, and that’s where the economic action really is.

There are normal processes that launch a recovery and drive an economy. These involve individuals and businesses responding to opportunities and incentives. When they respond, these individuals and businesses produce more goods and services, which increases production, demand and income. An effective stimulus policy recognizes these economic processes and seeks to accelerate them.

Lower marginal tax rates stimulate the economy because they create incentives for individuals and businesses to work, invest, take risks and seize opportunities.

Step One: Extend the 2001 and 2003 Tax Cuts at Least through 2013

The economy faces a massive tax hike in 2011 when the tax relief enacted in 2001 and 2003 expires. President-elect Obama has suggested he would prevent most of this tax hike but not the increase in top marginal tax rates, the increase in the dividend and capital gains tax rates, and the return of the death tax — the most important tax relief. Even a Keynesian should acknowledge it’s difficult for the economy to gain its footing when it faces the threat of a punitive tax hike.

There will be time enough to debate the progressivity of tax policy when the economy recovers fully. The focus now must be on speeding the recovery itself, and extending current policy in its entirety is the first step. It is, however, a policy of avoiding harm, and so it is only a necessary first step.

Step Two: Reduce Marginal Tax Rates for Individuals and Businesses

We should reduce the top tax rates on individuals, small businesses and corporations by 10 percentage points through 2013, and reduce other income tax rates by similar amounts.

President-elect Obama and Congress may want to consider additional tax elements, such as expanding bonus depreciation for small businesses. But these additional elements cannot match rate reductions as sound and effective tax policy.

Economic recovery is achieved by the economy itself, but Washington can accelerate that process. The best way to do that is to improve the incentives that drive economic activity — and that means reducing tax rates on work, saving, investment, risk taking and entrepreneurial activity.