As recent events have shown, there is a potential rift between the Administration and Republican leadership in the Senate. While it remains to be seen whether this rift will delay or derail tax reform, there is a more immediate rift that is developing within the reform debate itself. Divided are those seeking permanent large scale reforms to the Tax Code and those who are willing to settle for a short-term tax cut. The recent death of the Border Adjusted Tax (BAT) is evidence of this divide. The BAT was seen by some lawmakers as essential to completing the puzzle of deficit-neutral tax reform. Senate rules require deficit-neutrality to establish permanence for tax reform under budget reconciliation procedures, and key to that objective was the estimated trillion dollars in revenue that the BAT was to generate.
In the absence of alternative funding sources, the idea of a temporary tax cut has gained traction. The question that naturally follows a discussion on temporary cuts is whether they actually drive economic growth. Fortunately, in this instance we have some recent historical data to help answer that question: the Bush tax cuts.
The Bush tax cuts can be loosely classified as two cuts and two direct stimulus packages. The tax cuts were phased in beginning in 2001, accelerated in 2003, and made partially permanent in 2012. The tax stimulus checks were part of the 2001 tax cuts and were reprised in 2008. There were also business tax changes and reductions in the capital gains rates, but in this article we will limit our analysis to the resulting economic growth from the cuts and stimulus package, as well as the effects these provisions had on the deficit. We will also compare the effects of the tax cuts against those of the stimulus package to understand which is more efficient for stimulating growth. Although tax cuts and stimulus checks both increased the deficit and reduced the tax burden on individuals, each tended to affect income classes differently.
An Overview of the Bush Tax Cuts
One of the recurring arguments in favor of tax cuts is that high tax rates stifle growth. Theoretically, the mechanics of tax cuts can lead to increased growth, but data from the Bush tax cuts tells a slightly different story.
As part of an effort to stimulate the economy and promote economic growth, the Bush tax cuts created a new 10 percent bracket, reduced the top tax rate from 39.6 to 35 percent, and reduced the 28, 31, and 36 percent rates to 25, 28, and 33 percent, respectively. The result of these cuts has been examined thoroughly by many commentators and economists with the consensus that the cuts resulted in benefits to the wealthy that did not extend to the rest of the economy. And while there is some evidence that it was a policy decision to benefit the wealthy, this also resulted from the structure of the Tax Code. With a progressive Tax Code (a system under which tax rates rise as income increases), tax cuts will generally benefit the wealthy disproportionately as they tend to pay a greater portion of their income in taxes. Whether by design or as an incidental result of the Code’s progressive structure, it appears that the cuts led to greater income inequality. The share of income held by the top 1 percent of earners increased by approximately 5 percent between the enactment of the cuts and the recession of 2008.
It may be difficult, however, to tie the increase in the share of income held by the wealthy to economic growth. There was a similar increase in the share of income held by the wealthy from approximately 1994 to the collapse of the technology industry bubble in the early 2000s. However, GDP growth averaged a little more than 4 percent from 1994 through 2000, compared to 2.7 percent from 2001 through 2007. This came in the face of a tax increase in 1993, though some argue that reductions to capital gains rates in 1997 along with other reductions to the tax burden for some individuals and businesses were the real driver of growth at the time. Nevertheless, the Congressional Research Service (CRS) concluded in a study of the top tax rates from 1945 through 2010 that the data “suggests the reduction in the top tax rates have had little association with saving, investment, or productivity growth.” Instead, the CRS concluded that “the top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution.”
The Bush-Era Stimulus Packages
Tax cuts were not the only tax policy tool used to stimulate the economy in the first decade of the new millennium. The Bush administration also pursued an aggressive economic stimulus policy for individuals. The first of these occurred in 2001 and resulted in advance rebate checks of $300 to $600 that were disbursed to eligible taxpayers. One study showed that taxpayers used 20 to 40 percent of these rebates for direct spending—w ith lower income recipients spending on the high end of that range—within three months of receipt. These taxpayers were also found to have spent another third in the subsequent three-month period. The remainder was generally used to pay down debt or was saved. Other studies showed higher savings rates and smaller spikes in spending. Another study showed that the checks increased consumption by .8 percent in the first quarter in which the checks were received and .6 percent in the subsequent quarter. Thus, the legacy of this first stimulus effort is mixed, with no clear indication that there was a substantial boost.
In 2008, the Administration returned to the stimulus strategy with even bigger stimulus checks that reached $600 or $1,200, depending on marital status, and that increased by $300 for each dependent. This effort was generally seen as being more effective, with each stimulus dollar generating $1.19 in economic activity, versus $.59 in spending for each $1 of a tax cut. This is supported by studies demonstrating that the rate of spending for the stimulus funds was higher in 2008 than it was in 2001. In fact, the major criticisms of the 2008 stimulus package did not relate to the idea of the cuts, but rather the timing. The consensus was that the cuts came too late, because the 2008 recession had already hit the economy by the time many received their checks. Others argued that increasing unemployment benefits would have been a more effective stimulus. Interestingly, the direct payment was more effective than reducing the amount withheld from a taxpayer’s paycheck, which President Obama used during his first term in office. Analyses of this approach found that the reduced withholding only resulted in a 50 percent increase in spending when compared to the stimulus checks.
Thus, the more efficient approach to lowering the tax burden and stimulating growth appears to be sending stimulus payments directly to individuals as opposed to cutting rates. Each functions as a reduction in the tax burden, but the more visible nature of direct payments has a greater effect on individual spending habits and economic growth. This could be an important consideration as Congress transitions discussions from a permanent tax reform package to a temporary tax cut aimed at growing the economy.
For additional information on tax cuts and stimulus packages please contact your CBIZ tax professional.
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