How tax cuts will, and won't, aid economy

Impact from lower interest rates and big tax reductions wouldn't be felt for months.

A recent cartoon shows President Clinton and his dog, Buddy, standing at the White House door. "I've turned off the lights," the president says. "I've turned off the oven. I've turned off the economy. I guess I'm ready to go."

Of course, a president can't really pull the plug on the economy, and now a new president may find that there's no light-switch-quick "on" button, either.

In fact, while falling interest rates and rising expectations of a tax cut could be having some psychological and financial effects, economists generally say it still takes months for policy changes to take a measurable hold.

True, the Federal Reserve can reverse course like a jack rabbit. Last month, it cut interest rates twice, switching from tightness toward ease in two policy discussions. That ripples outward quickly, trimming rates for businesses and consumers.

Similarly, President Bush wants to fire a second big antirecession gun. This week, he presented a 10-year, $1.6 trillion tax cut as "an important part of helping our country's economic recovery." While the tax cut will likely take some months to materialize, it, too, can put money in people's pockets.

And the promise of an economic revival ahead seems, for now, to have stabilized the stock market - at a time when the risk of plunging share values could deepen the economy's slowdown.

Despite all this, economists warn that it takes time for either monetary or fiscal policy to cause a measurable change in the pace of the aircraft-carrier-size American economy.

Easier money, at best, takes six to nine months to stimulate economic activity.

"Monetary policy works with unpredictable and lengthy lags," says Victor Zarnowitz, an expert on the business cycle at the Conference Board, a business research group in New York.

Just maybe, he adds, the rapid spread of information with the Internet and 24-hour news media will shorten the lag.

January's swift reversal

The Fed's one percentage point rate cut in January was the biggest one-month shift during Fed Chairman Alan Greenspan's entire 13 years in office.

Many Fed watchers expect a further rate cut - perhaps half a percentage point - at or before the next meeting of Fed policymakers March 20.

Nonetheless, it could be late summer before lower short-term rates counter the Fed's 1.25 percentage point hike in rates between June 1999 and May 2000.

"It's almost impossible to reverse immediately the damage done to the economy in those months," says Robert Scott, an economist at the Economic Policy Institute in Washington. "The Fed has done enough damage to push us into recession."

The Fed had to reduce interest rates more than 5 percentage points, after inflation, to trim unemployment from its 7.6 percent peak at the time of the last recession in 1990-91, notes Mr. Scott. It will take "at least 1.75 to 3 percentage points" to reduce or eliminate the risk of recession now.

"There is no reason not to cut rates very sharply and quickly," he says. "There is no risk for inflation to recur."

Tax cuts as growth engine

The second major tool for battling a recession is tax and spending policy. Many economists argue that because Congress and the White House can negotiate many months over tax cuts, and it can be even more months before households and businesses respond, fiscal policy is not a workable method.

However, the uselessness of tax cuts is a "myth," says Allen Sinai, chief economist for Decision Economics in Waltham, Mass. "Once personal-income-tax withholding schedules are changed, funds are provided immediately and directly to households to spend or save."

President Bush said Monday his tax cut should be retroactive - bringing the total to $2.2 trillion - which would help make it more effective quickly. And the administration has the power to trim withholding rates without congressional approval.

If Congress and the administration get a tax cut program in place by late August, made retroactive to Jan. 1, and implement a new withholding schedule July 1, the Bush tax cut might offset the hike in oil and energy costs over the past couple of years, figures Mr. Sinai.

In its first year, the 10-year Bush plan would provide "permanent" tax reductions of $75 billion, Sinai calculates.

His mathematical model finds this cut would stimulate real economic growth in the year from July 1 by one-half to three-quarter percentage points from what it would otherwise be.

That would help counter what some number crunchers say is merely a modest slowdown.

Others maintain the US has already entered a recession, with the nation's output of goods and services actually shrinking.

"There's a 1-in-3 chance it's a recession," says Jeffrey Frankel, a Harvard University economist.

"The boom is definitely over," says Zarnowitz of the Conference Board. "The boom was not sustainable. The risk of a recession is high and rising. But I don't see it yet."

(c) Copyright 2001. The Christian Science Publishing Society

You've read  of  free articles. Subscribe to continue.
QR Code to How tax cuts will, and won't, aid economy
Read this article in
QR Code to Subscription page
Start your subscription today