Even though the projected 10-year budget surplus has reached a staggering $5.6 trillion, some lawmakers are publicly fretting that President Bush’s relatively modest $1.6 trillion tax cut is too big. These politicians, led by Sen. Evan Bayh, Indiana Democrat, want the tax cut to include a “trigger” provision that would automatically repeal or suspend tax relief if the surplus fell below some arbitrary level.
A tax cut trigger would be a big mistake for a number of reasons. Indeed, it is something of a surprise that Mr. Bayh would associate himself with this kind of proposal. He is supposed to be a “New Democrat,” and was rated as one of America’s most taxpayer-friendly governors by the Cato Institute while serving as Indiana’s chief executive. If this trigger proposal is any indication, however, he has changed his stripes since coming to Washington.
A trigger would undermine the economic rationale for reducing tax rates, and hence blunt the effect on future economic growth. The purpose of lower tax rates is to encourage productive economic behavior by improving incentives. But if workers, investors, and entrepreneurs are uncertain whether tax rate reductions will occur, this could dramatically reduce the “supply-side” impact of a tax rate reduction on the economy’s performance.
In large part because of this effect, conditional tax cuts could create a self-fulfilling prophecy. Lawmakers who oppose tax relief insist on a trigger because they are worried the economy will perform below expectations and that this will mean less debt reduction. Yet the very existence of the trigger will greatly dampen the stimulative effect of lower tax rates, thus making it more difficult to achieve the debt reduction goals that trigger advocates profess to support.
A conditional tax cut also could create perverse incentives on the spending side of the equation. Knowing that a tax cut would be suspended if the surplus did not reach a certain level or the debt did not fall by a specified amount, some politicians would have an even greater incentive to support more federal spending. In effect, those who favor bigger government could thwart tax relief.
The historical record. There are some lessons from the recent past that suggest tax cuts should be implemented as quickly as possible and without any conditions.
It is now widely recognized, for instance, that President Reagan’s across-the-board tax rate reductions were instrumental in rejuvenating America’s economy and ending the economic malaise of the 1970s. But the Reagan tax rate reductions were not as effective as they could have been in the first two years because of a slow phase-in period and a concern that Congress was going to suspend the final stage of the tax cuts.
This episode from 20 years ago has important lessons for today’s policy-makers. Lesson No. 1 is that the sooner tax rate reductions are put into place, the sooner the economic benefits begin to materialize. Unfortunately, this did not happen in the early 1980s. Because President Reagan had to make compromises with a hostile Congress, rate reductions actually were implemented over several years. There was a 5 percent reduction in tax rates on Oct. 1, 1981, a 10 percent reduction in taxrates on July 1, 1982, and a final 10 percent reduction on July 1, 1983.
This slow phase-in of the Reagan tax cuts was a mistake because it meant the economy did not receive a net tax cut until at least mid-1982 and perhaps not until January 1983. The tiny rate reduction that occurred at the end of 1981, for example, was offset by inflation-induced bracket creep. (The Reagan tax cut did have an indexing provision to protect taxpayers from being thrown into higher tax brackets by inflation, but this provision did not go into effect until the mid-1980s.)
There was a bigger tax rate reduction in 1982, but this tax cut also was substantially offset by tax increases. Not only was there more bracket creep, but there was a big payroll tax rate increase as well (a legacy of the 1977 Social Security bailout legislation).
This episode is instructive because President Reagan’s opponents argued that the economy’s weak performance in 1981 and 1982 somehow proved that tax rate reductions did not boost economic performance conveniently ignoring the fact that the economy did not receive a net tax cut during much of that two-year period. Nonetheless, the argument was superficially effective, and opponents of the Reagan tax rate reductions used this misconception to argue that the final stage of the tax cut scheduled to go into effect on July 1, 1983 should be postponed or repealed.
Fortunately, President Reagan held firm and rejected calls to suspend the final stage of the tax cut. This was important since any sign of weakness likely would have caused uncertainty for investors and entrepreneurs, and therefore may have delayed the economy’s rebound even further.
The Bush White House, quite properly, already has rejected Mr. Bayh’s misguided proposal. Delaying tax cuts is a bad idea. Making tax cuts conditional on other events is an even worse idea. Triggers of any kind will undermine the economic benefit of tax rate reductions.
Daniel J. Mitchell is the McKenna senior fellow in political economy at the Heritage Foundation.