- The Washington Times - Sunday, May 2, 2004

The growth in real gross domestic product at a 4.2 percent rate in the first quarter is good news. But one cannot help but feel we should be doing better.

Real GDP normally grows much more rapidly in the early stages of economic expansions after a recession. One possible culprit in the less-than-hoped-for growth may be the phasing-in of key elements of the 2001 tax cut.

The way tax policy effects individual decision-making is complex. Some tax changes mainly effect the average tax rate — taxes as a share of income. Others effect the marginal tax rate — the tax on each additional dollar earned.

Because average and marginal rates effect people differently, when both are changed simultaneously, it is sometimes hard to figure out their economic effects. For example, an increase in average tax rates with no change in marginal rates theoretically could increase labor supply. That is because workers will have to work more to make up the income lost to higher taxes.

Conversely, a reduction in average tax rates might lower labor supply because workers need not work as much to have the same after-tax income. Economists call this the income effect.



Changes in marginal tax rates are less ambiguous. If average tax rates are unchanged and marginal rates are increased, people clearly will have less incentive to earn taxable income because they will keep less of each additional dollar they make. They will work and save less and try harder to save taxes.

All other things being equal, a reduction in marginal tax rates with average rates unchanged will always increase output. Economists call this the substitution effect.

Another complicating factor is timing. We saw this in 1992, when income realizations bulged late in the year as people anticipated higher taxes after the election of Bill Clinton. Hillary Clinton’s law firm, for example, distributed bonuses in 1992 that otherwise would not have been paid until 1993.

While only a small number of people have this much flexibility in timing their income this way, the same principle applies to all income earners. In the aggregate, the impact can be large.

Back in the early 1980s, economist Arthur Laffer predicted phasing-in the Reagan tax cut would severely reduce its impact. Enacted in 1981, it was not fully effective until 1984.

The tax cut was supposedly 10 percent yearly for 1981, 1982 and 1983. But because of prorating, there was really no tax cut in 1981. As of 1982, the cumulative tax cut was 10 percent, rising to 18 percent in 1983 and 23 percent in 1984.

Therefore, Mr. Laffer concluded the full growth effects of the tax cut would not start until 1983 and not become fully effective until 1984. Mr. Laffer said: “Common sense tells us that people don’t shop at a store the week before the store has a widely advertised discount sale. Prospects of lower tax rates in future years created incentives for individuals and businesses to reduce their income during 1981 and 1982 when tax rates were high, in order to realize that income in 1983 and 1984 when tax rates would be lower.”

Sure enough, there was a huge increase in growth in 1983. Real GDP jumped from minus 1.9 percent in 1982 to plus 4.5 percent in 1983 and 7.2 percent in 1984.

While other factors obviously played a role, the phasing-in of the Reagan tax cut undoubtedly delayed its impact.

Putting these factors together, we see that the 2001 tax cut was poorly designed to stimulate short-run growth. Average tax rates were reduced by increasing the child credit and sending out tax rebates, while marginal rates were largely unchanged. The main marginal rate reductions were phased-in, with many still not having taken effect.

Economic theory says this should cause growth to fall. A new study from economists Christopher House and Matthew Shapiro, both of the University of Michigan, confirms this theoretical prediction. “The immediate effect of the 2001 phased-in tax cuts,” they found, “was to reduce output and employment.” GDP in 2002 was 0.4 percent less than what could have been achieved with a smaller but quicker tax cut.

Messrs. House and Shapiro also look at the 2003 tax cut and find it was much more effective precisely because more of it was effective immediately. “Just as the phased-in nature of the 2001 tax law may have delayed production and employment, the immediate tax relief included in the 2003 law may have contributed toward the increased pace of economic activity in the second half of 2003,” they conclude.

We may owe the economic recovery’s slowness to those who thought phasing-in the 2001 tax cut was the “responsible” thing to do.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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