April 2 , 2003

When the Senate pared back the President's tax cut to half its proposed size in a budget resolution, were they rejecting the benefits going to the retired wealthy, were they thinking about "guns and butter", or was it a little of both.

Of course, the budget resolution will go to a conference committee because the House approved all the monies needed for President Bush's proposed tax cuts.  Thus, some reduction in taxes on dividend income still could be approved in a compromise.  However, even some Republicans in the House appear to be wondering if so many revenues should be returned to the people when wartime spending remains uncertain. 

I am not going to say much more about the double taxation of dividends that I already discussed in several other columns.  The amount of growth it generates is open to question, its impact upon near term economic activity is minor according to almost all economists who opined on the subject, and most of its benefits are received by higher income people. 

To be sure, most of those "wealthy" are retired and probably will spend as much of any tax cut as even the poor people will.  Indeed, without unreasonable assumptions I can show how the dividend recipients may spend more per dollar of dividend tax reduction than the poor would from tax credits. 

There undoubtedly was legitimate concern of including a double taxation of dividend reform into a tax stimulus package. 

However, I think the weightier question is the one of "guns and butter."  That phrase was coined by the Johnson administration during the Vietnam conflict.  That Texas president maintained that spending on military action was compatible with spending to develop society's infrastructure.

Whether the training and medicare programs of the Great Society actually improved society's infrastructure is open to question.  Nevertheless, the Great Society with its war on poverty did lower poverty, at least until the inflation spawned by too much economic stimulus began to eat away at America's economic competitiveness.  

President Bush is not trying to expand government social investment in addition to more defense spending.  Furthermore, even the most Keynesian economists agree that some incentive to change productive behavior is achieved when marginal tax rates are cut.  Thus, tax cuts try to pay for themselves by expanding the tax base. 

However, only some die hard White House economists believe that the incentives from tax reductions are strong enough to self finance tax cuts.  Art Laffer, one of the originators of the term "supply side economics", indicated that below a certain marginal tax rate, tax cuts would lose tax revenue.

My own empirical work suggests that somewhere below 50 percent, marginal tax rate reductions cannot make up in expanded tax base what they lose from reduced tax rates.  When tax rates fall to 35 percent, something other than tax policy is dictating why additional work is being accepted.  Moreover, if the tax reduction is not on the margin, as in eliminating the marriage penalty, providing a child tax credit, or lowering the initial tax bracket rate for those paying above that bracket, then no supply side response should be expected. 

Therefore, only a small portion of the tax cut will be financed from an expanded tax base derived from additional work.  The remainder is the Republican equivalent of Johnson's "butter." Not surprisingly, Senators with a sense of history are wary of adding to a deficit when the costs of war remain uncertain. 

Of course, there are differences between  the programs of Johnson and Bush (do all Texas presidents go to war?) I already discussed how one expanded government spending obligations far into the future.  The other lowers government revenue far into the future per dollar of GDP.

Also, Johnson's war and spending occurred after an economic expansion was well along.  Bush really needs to prod this expansion, which most corporations do not view as other than a long recession.  Therefore, a surge of inflation is unlikely to accompany Bush's policies.

Still, those New England Republicans may feel guilty that we gain while our soldiers risk much.  If we don't suffer during a war, will we be more prone to have them? 

As an economist, I would do exactly what the Senate did.  Move those already approved tax cuts forward to prod the economy, but do not provide anything more until we can show the sacrifice that earned it.



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