The Daily Interview: The Downside of the Tax-Cut Deal

The proposed $1.35 trillion tax cut that President Bush and Congressional leaders agreed to Wednesday has many investors cheering.

Kenneth Thomas Lecturer, Wharton Business School

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But Kenneth Thomas, a lecturer at Wharton Business School, thinks that there is a downside to the cut, which is to be distributed over the next 11 years and would include a $100 billion tax rebate this year.

Thomas warns that the tax cut could indirectly lead to higher interest rates, adversely impact our trade deficit and potentially, even lead to another government deficit.

TSC: How significant is the proposed tax cut, and how beneficial do you believe it will be for the stock market and the economy?

Thomas: It's actually very significant considering the magnitude. Whenever you make a cut at these levels, it has an impact on the economy. But I, and a number of other economists, have questions about whether this tax cut will distribute wealth equitably to all classes. That's been an overarching question.

On October 11, 2000, I, along with over 300 economists, including eight Nobel Laureates, signed a petition opposing the large-scale tax cuts proposed by President Bush on other grounds besides its wealth distribution impact. First, a sustained budget surplus, should it materialize, could be used for other purposes besides a tax cut, such as investments in economically and socially desirable projects, endowing Social Security, or even paying down the national debt. Second, the costs of the tax cuts and planned increases in government expenditures, under various economic assumptions, could exhaust the projected surplus outside of Social Security and Medicare. Third, if sustained projected surpluses fail to materialize, the tax cuts could potentially even lead to another government deficit.

The other issue that's equally important with the possibility of a return to a budget deficit is the adverse impact on interest rates that this might have. The last time we had tax cuts of a large magnitude was during the Reagan years. Everyone associates the Reagan years with great memories, but my students associate the name Reagan with deficits and increases in government expenditures.

We've worked so hard and so long to get the deficit under control, and we do not want to do anything that could endanger that.

TSC: But this proposal is only calling for a 5% increase in government spending.

Thomas: That's correct, but ... remember the main reason we had the deficit reduced was because of the expanding economy. With an expanding economy, government expenditures automatically fall because there is less going to welfare benefits and unemployment, and taxes rise because there are more tax receipts due to more income.

You have to remember that everything is not equal here. With the economy slowing down right now, we are going into a situation where we are going to have more unemployment and welfare benefits being paid out, and of course, less tax revenue because people are making less money. Some people even believe there is the potential for a recession.

TSC: But won't the tax cut and the $100 billion in rebates due out this year boost the economy and avoid the continued downturn that you seem to think will still be imminent? Some economists calculate that if even half of that $100 billion is spent, it could boost GDP growth by a full percentage point, and many are still predicting a rebound in the second half of this year, which a tax cut would play nicely into.

Thomas: First, policy lags may be quite long. Any stimulus usually has a 12- to 16-month or even longer lag. Even though tax cuts have been the linchpin of Bush's economic policy, I am just not as excited about it as many people are. That's the bottom line.

Second, in a $10 trillion dollar economy, with two-thirds of that being generated by the consumer, a $100 billion rebate is relatively small.

Third, there is considerable uncertainty as to the direction of our economy. Also, economists are far from unanimous on the economic impact of the proposed rebates. Economics is still the "dismal science."

TSC: How do you see the tax cut negatively impacting the trade deficit and interest rates?

Thomas: I find most persuasive the argument by MIT professors Modigliani and Solow in their April 9, 2001 New York Times op-ed piece that the tax cuts would make our perilous trade imbalance even worse, as well as potentially cause higher interest rates. They argue that tax cuts, rather than increasing needed national saving, will increase consumption, with the likelihood of inflationary pressure and higher rates.

There is also the problem of the crowding-out effect. To finance tax cuts or government expenditures, the government may go into the bond market. The increased supply of bonds, other things equal, will cause interest rates to rise. That often crowds out domestic investment and, also, by resulting in a stronger dollar -- again other things being equal -- lowers exports and has an indirect, negative impact on the trade deficit.

I want to again emphasize what I see as the main drawback, namely the disparate wealth impact. The tax cuts are clearly going to be to the advantage of the wealthier, as opposed to those with low or moderate income.

TSC: So, what do you think will lift the economy, and what should the government do instead?

Thomas: Customer confidence, more than anything. This rate cut and rebate will be somewhat positive for that. But I just don't have the degree of enthusiasm that other people do.