Tax Cuts May Be Just What the Slumping Economy Needs

Suddenly the idea of a tax cut is becoming respectable as worries mount about the U.S. economy. The darkening outlook has prompted debate about how a sizable tax reduction would affect growth and how quickly one could be put into effect.

President-elect George W. Bush insisted during his visit to Washington this week that a tax cut is needed to avert an economic downturn. And the Federal Reserve Board said Tuesday that an economic slowdown now threatens the long U.S. economic expansion.

Economists look to the Fed to lower interest rates early in the new year, especially if unemployment rises. But some economists say lower interest rates may not have a dramatic effect on an economy suffering from an erosion in consumer and investor confidence.

So a growing number of economists and some members of Congress now say a quick, limited tax cut is just what the economy needs. Tax cuts have worked in the past, they say--notably during the Reagan administration in 1981 and again in 1986.

If unemployment spreads after the New Year, “the new administration and Congress should have little difficulty in agreeing on an early and sizable income tax cut--say, $100 billion a year,” said economist Albert M. Wojnilower of Monitor Clipper Partners, a New York-based investment firm, and a veteran predictor of interest rates.

There remains plenty of opposition to the tax cut idea. Congressional Democrats normally would want to use the federal budget surplus for spending programs to help the working poor.

One big problem is that tax cut legislation seldom passes quickly--and might not come soon enough to head off a recession in 2001.

But tax expert Lawrence Stone of the Los Angeles law firm Irell & Manella said there is a way to get money quickly into people’s hands to spur the economy.

“They can reduce withholding rates and make the reduction retroactive to Jan. 1, even as they continue to debate just how they want to structure a tax cut,” Stone said.

If the economy is careening into recession, Bush could get a tax cut passed by the summer--although not a giant, complex tax package.

Support for tax cuts has arisen amid increasing signs of an economic slowdown. Retail sales are anemic this holiday season and automobile sales fell 2.2% in November. Companies are curbing investments in new plants and equipment and they have begun to cut costs by laying off employees.

“The economy is decelerating, and the world economy may be heading into recession,” said economist William Rhodes of Williams Capital Group, an investment research firm.

The Federal Reserve should cut interest rates in January, and “a fiscal response may also be necessary,” said economist Edward Yardeni of Deutsche Bank Alex. Brown, an investment firm.

Bush’s proposed tax program would lower rates to four new brackets: a top rate of 33% of taxable income, down from 39.5% currently; a 25% basic rate for middle-class taxpayers, down from today’s 28% and 31%; a 15% rate; and a new 10% rate.

For lower-income wage earners, the effect would be to cut taxes by roughly one-third, giving taxpayers more spending money or cash to pay their debts or to save. “Lower-income people have to spend every cent. They don’t have savings beyond their stake in Social Security,” said Stone, who served in the Treasury Department in the administration of President Johnson.

But a major effect of the tax cut, which Bush in his campaign estimated at $460 billion over five years, would be to give a big reduction to the wealthiest taxpayers. That’s inevitable as the top 1% of income earners pay 33% of all income taxes, argues Lawrence Lindsey, Bush’s chief economic advisor. Couples earning more than $200,000 a year are in the top 1%. Their tax cut benefit would be proportionately large.

Still, a big tax cut for the rich will be a hard sell politically, and it is where compromises on tax legislation are most likely to occur, analysts say.

Yet it is upper-income taxpayers who need the tax cut at present, Wojnilower said. A tax cut “would cushion the loss of wealth among upper-income spenders suffering stock price disappointments,” Wojnilower explained in an address Tuesday to Capital Group, a Los Angeles investment firm. If wealthy taxpayers trim their spending, or cut back on investments in business, that has economic consequences.

President Reagan targeted upper-income taxpayers and businesses in his first tax cut in 1981. That Reagan program lowered the top rate for individuals from 70% to 50% and instituted investment tax credits and accelerated depreciation for business and investors. The consequence was an immediate boom in real estate investment. The stock market took off in 1982 in the bull market that has extended to the present.

Reagan also raised defense spending dramatically, which spurred the economy and led to budget deficits, said Lindsey, who published a 1990 study of the Reagan economic programs titled “The Growth Experiment.”

In 1986, a Reagan tax reform package took away business tax credits and accelerated depreciation but lowered corporate tax rates to 33% from 46%. And it lowered the basic personal income tax rate to 28%, a level not seen since before World War II.

Since then, tax rates have crept back up, and as incomes have risen, particularly from stock options, the alternative minimum tax has applied to more taxpayers. In addition, some deductions, credits and exemptions have been phased out for high-income taxpayers. The AMT is a parallel tax system with fewer deductions designed to collect some taxes from individuals with multiple deductions.

The average rate of taxes actually paid by Americans today is 15.5%, economist Rhodes said. With Social Security and Medicare taxes added, the average rate goes higher than 20%. The 15.5% average is the highest rate of actual federal taxes paid since the aftermath of World War II, Rhodes added. Given the growing support for some form of tax cut, that average is likely to change in the next year or two.

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TAX-REDUCTION SUPPORT: A growing number of economists say a quick, limited income tax cut is just what the U.S. needs. C1