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Monday, October 11, 2010

What Effects Would the Expiration of the 2001and 2003 Tax Cuts Have on the Economy?

Marc Labonte
Specialist in Macroeconomic Policy

In 2001 and 2003, Congress enacted major tax cuts (popularly referred to as the “Bush tax cuts”), the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; P.L. 107-16) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA; P.L. 108-27), that are scheduled to expire at the end of 2010. (Subsequent legislation extended or increased certain provisions of those acts.) Congress is currently debating whether to extend some or all of those expiring tax cuts on a temporary or permanent basis in the context of large budget deficits. Two main economic arguments are made against allowing the tax cuts to expire. First, it is maintained that the long-term economic performance of the economy would suffer if the tax cuts were allowed to expire. Second, it is asserted that extending the tax cuts would be beneficial to the economy in the short run as it emerges from the recession.

Opponents of allowing the tax cuts to expire argue that doing so would reduce long-run incentives to work, save, and invest in the long run. According to economic theory, it is ambiguous whether tax cuts lead to more or less work, saving, and investment. The expiration of the tax cuts would nevertheless reduce the budget deficit, absent other policy changes, which economic theory predicts would have a positive effect on the economy in the long run.

To gauge whether the long-term effects of the tax cuts’ expiration on the economy would be significant, this report compares the performance of economic indicators in the period before (1993-2000) and after (2003-2007) the tax cuts were enacted. GDP growth, median real household income growth, weekly hours worked, the employment-population ratio, personal saving, and business investment growth were all lower in the period after the tax cuts were enacted. Average unemployment was the same over the two periods, and productivity growth was slightly higher after the tax cuts were enacted. One interpretation of these data is that the tax cuts contributed to the deterioration in economic performance, perhaps because of the negative economic effects of the higher budget deficits. An alternative interpretation is that the tax cuts did not have significant enough effects to show up in the data at a time when other factors were causing the economy to perform relatively poorly. In this interpretation, the tax cuts could have small positive, small negative, or no effects on the economy.

Opponents of allowing the tax cuts to expire argue that doing so at this time risks pushing the economy back into recession. The economy has already recorded several consecutive quarters of positive economic growth, and double dip recessions are rare. The size of the tax cuts is large, however, compared to projected GDP growth, assuming alternative minimum tax (AMT) relief were also allowed to expire. If one assumes that AMT relief is extended regardless, then the expiration of tax cuts would be expected to have a more modest effect. Another argument in favor of extending the tax cuts is a concern that the economy may continue to grow, but at a sluggish pace for the foreseeable future, as occurred in Japan. An argument in favor of allowing the tax cuts to expire is the potential danger of a fiscal crisis if investors become unwilling to continue financing the government’s large budget deficit. Related to this argument is the fear that as the economy continues to recover, a large deficit could push rates of borrowing from abroad back up to unsustainable heights.

A comparison of economic growth and changes in fiscal policy since 1990 indicates that deficit reduction need not lead to subpar growth in the short run if other sectors of the economy are growing strongly. Even during the 1990-1991 recession, deficit reduction did not stop the economy from growing in 1992 and growing solidly in 1993.

Date of Report: October 5, 2010
Number of Pages: 13
Order Number: R41443
Price: $29.95

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