Kevin A. Hassett

The large tax reduction passed by Congress last spring will have a significant impact on the economy. However, there is substantial debate surrounding what the overall effects might be in light of the economy's recent decline. Policymakers in Congress and the White House wonder whether they should approve additional measures that would stimulate the economy and, if so, what form they should take.

On October 12, William Gale of the Brookings Institution, Kevin A. Hassett of AEI, and Donald Kiefer of the Treasury Department gathered to discuss that question. Kiefer, the director of the Office of Tax Analysis, laid the groundwork for an exchange between Gale and Hassett by outlining the provisions of President Bush's tax reduction passed earlier this year. Many aspects of the new law have not gone into effect yet, he noted, and a number of provisions are slated to "sunset," or cease, in a matter of years, both of which are factors that lawmakers should take into account when considering additional stimulus packages. 

What We Need Now 

The U.S. economy was already faltering when the September 11 terrorist attacks disrupted its workings, said Gale. The attacks may even have pushed the United States into a recession. The budget outlook, which was relatively auspicious at the beginning of the year, has deteriorated due to Bush's tax cuts and the weakening economy. The long-term outlook, however, remains strong. In light of such circumstances, Gale continued, what we need now are policies that stimulate the economy in the short run while limiting the impact on long-run revenue. We have recently poured significant amounts of short-term stimulus into the economy in the form of rebate checks, new spending, the airline bailout, and monetary policy. Further stimulus, if necessary, can come from temporary rebates to individuals or temporary subsidies for new investments by firms. Rebates should be targeted to low- and middle-class households, which would spend a larger fraction of them than would wealthier individuals. Providing tax credits for new investments during the near future would stimulate the economy by encouraging increased investment, rather than providing a windfall for previous investment.

Such measures, Gale added, avoid exacerbating the nation's long-term fiscal challenges. Expensive long-term packages would strain the budget and raise interest rates, which would restrain business and housing investment in addition to interest-sensitive consumption.

Increasing Demand

In many cases, responded Hassett, short-term cuts do not work. Most people will spend only a portion of a short-term tax cut, because they hope to increase their permanent consumption by saving the remainder.

Short-term measures like the one suggested by Gale avoid that problem by targeting people with low incomes. That portion of the population is the exception to the rule, said Hassett, since low-income households are almost by definition short on disposable income and will spend practically all of their rebates immediately. Congress is currently considering a one-month holiday for the payroll tax or a refund of payroll taxes to people with low incomes. Hassett believed that such measures would result in an immediate increase in demand.

He was more ambivalent about targeting new investments for temporary tax credits. If such credits were enacted, the United States would likely experience a significant effect on investment demand, but would also have significant deadweight loss associated with the credits. They would provide a big subsidy to investments that are easy to adjust quickly but would give short shrift to other investments that are harder to adjust. 

Interest Rates 

Finally, Hassett disagreed with Gale's concerns about the effects of long-term cuts on interest rates. Gale argued that such cuts would lead to budget deficits and, as a result, increased borrowing by the federal government. That borrowing would then result in higher interest rates. But Hassett has found little scientific evidence in modern studies to confirm that small changes in government debt would lead to significant changes in interest rates. He reminded the audience that the U.S. debt, which is approximately $3 trillion, is only a tiny fraction of the total amount of debt issued by Western nations whose debt is similar enough to ours to be a reasonable substitute for it. That may explain the negligible effect on rates.