ECN 111 Extra Credit Assignment
Tax Cut Debate
1 point per question. 33 questions.

Read the following articles on the pro’s and con’s of the Bush tax cut passed in 2003.

Published on May 1, 2003 by the Los Angeles Times
" The Economy Is on the Move -- Downward"
by Robert Reich

Listen to Wall Street analysts and you'd think the American economy was on the rebound. Yes, profits are up a bit for the first quarter and companies are beating earnings expectations. But profits and earnings are up because companies are cutting jobs.

Listen to Main Street and you hear a different and truer story about the economy: It's going nowhere. Data released Friday show almost no growth during the first quarter of the year. Other reports show almost half a million jobs disappeared just in January and February.

The official unemployment rate — 5.8% — doesn't even tell us about the number of Americans who have simply left the labor force. To be counted as unemployed you've got to be actively looking for a job. But over the last two years, a lot of people have stopped bothering; the portion of American adults who are working or actively looking for work fell 0.9% to 66.2%. That's the largest drop in almost 40 years. More than 74.5 million adults are not working — up more than 4 million since March 2001. The average amount of time out of work has been rising too. Two years ago it was 13 weeks. Now it's 18 weeks.

In other words, the job picture is simply awful. Corporate profits and earnings are rising because companies are becoming more aggressive about cutting their costs. Payrolls are their biggest single cost, so they've been slashing jobs.

But corporate profits and earnings can't go on rising if there aren't enough consumers to buy the goods and services that companies produce. Ultimately, Wall Street depends on people spending their paychecks. If more and more people lose their jobs or drop out of the labor force altogether or are worried about losing a job, Americans will hold back spending.

So far, people are continuing to spend despite the awful job picture because mortgage interest rates have dropped so low that homeowners have been able to refinance and get their hands on a lot of cash. We're talking real money here: Homeowners raised $130 billion through home-equity loans last year, nearly double the amount in 2001. But the borrowing binge will soon reach its natural limit.

Companies are also buyers. They buy equipment, supplies and raw materials. But companies have stopped buying because they're worried they won't have enough customers. Between January and March, business purchases of these sorts of capital goods dropped — the ninth drop out of 10 quarters.

The White House says businesses need investment tax breaks, but that's nonsense. Interest rates are so low that businesses could easily afford more capital goods if they wanted them. But they won't buy more until they know there's a healthy market for what they produce.

Government is also a purchaser, and government spending is way up. The federal government's extra spending on the military has more than made up for state government cutbacks. Problem is, it's not nearly enough to get a $10-trillion economy moving again. And deficit hawks correctly worry about the long-term effects of large and seemingly endless federal deficits. The boomers' Social Security and Medicare bills will start coming due within the decade. That's one reason why Bush's whopping 10-year tax cut is dangerous. So how do we get out of this quagmire? Not by giving rich people bigger tax breaks, as Bush wants to do. Rich people won't spend any extra money they get. They already spend what they want to spend. That's the definition of being rich. Don't just take my word for it. Both Alan Greenspan and the Congressional Budget Office agree that the Bush tax plan won't stimulate the economy.

The best and the fastest way to get more money into the pockets of people who are likely to spend it quickly is to cut the taxes of average working people. Most people pay more in payroll taxes — primarily for Social Security and Medicare — than they do in income taxes. So a temporary cut in payroll taxes — say, by exempting the first $15,000 of income from payroll taxes — would put an extra $1,200 into most working people's wallets this year alone. And because businesses wouldn't have to pay their portion of that payroll tax, they'd be encouraged to keep more workers on the payroll.

Purists will complain I'm endangering Social Security because that's where most payroll taxes go. But they don't understand (or won't admit) that the Social Security trust fund is nothing more than an accounting device, and Social Security is a pay-as-you-go system.
The best way to make sure Social Security is there for boomers is to get this economy moving again, as quickly as possible. That's also the best way to get more Americans working. The Bush tax plan won't do it.

Robert B. Reich, Secretary of Labor in the Clinton administration, is a professor of social and economic policy at Brandeis University.

The Great Deficit Mystery and Cutting Taxes
by Norbert Michel (May 5, 2003)

Can we afford a big tax cut right now?

That’s what the arguments against the president’s $726 billion proposal boil down to, really. The fact that we’ve been at war, that the economy remains sluggish, that we’ve returned to deficit spending -- all amount to a concern about price.

It would be a valid concern, too, if tax cuts simply extracted money from the economy. Then it would be a bad idea to slash our collective income just as our expenses were set to rise. It would make much more sense to go with $550 billion or $450 billion or $350 billion -- or whatever number congressional skeptics such as Sens. George Voinovich, R-Ohio, and Olympia Snowe, R-Maine, are currently embracing.

But that’s not how tax cuts work. Properly constructed, they result in more jobs, more savings and more income.
Indeed, a tax cut that encourages long-term growth by making it cheaper for people to invest -- and eliminating the tax individuals pay on dividends would do that in spades -- is exactly what our fragile economy needs, even (perhaps especially) when there’s a war to pay for.

Yet the dividend portion of the president’s plan is just what congressional tax-cut opponents are targeting. Many would prefer a temporary, “fiscally responsible” tax cut instead. But that idea has already been found wanting: The $300 and $600 rebates mailed to taxpayers in 2001 were a sop to this way of thinking, and they did nothing to boost the economy.

We should never try to induce consumer spending at the expense of our long-term economic health. As the Congressional Budget Office noted in an analysis of the president’s budget, encouraging higher government spending and private consumption hurts economic growth in the long term. By focusing instead on pro-growth tax cuts, lawmakers can ensure a quicker and smoother economic recovery.

A dividend tax cut is an excellent way to do this. It’s why the $726 billion plan would lead to more business expansion and more jobs -- an annual average of 914,000 more jobs over the next five years, a recent Heritage Foundation analysis found. By contrast, a $350 billion tax cut would create about 362,000 new jobs annually. That’s nothing to sneeze at, but why settle for generating only about one-third the number of new jobs we could get if we go with the original $726 billion package?

Tax-cut critics have one more ace up their sleeve, however -- deficits. Look at what happened when Congress enacted a big tax cut in the 1980s, they say. The budget was plunged into red ink because the 1981 cut drained federal revenues.

But facts sometimes have an inconvenient way of wrecking such tidy cause-and-effect arguments. Take a look at the revenue figures for the 1980s, and a different picture emerges. In 1980, the last year before the tax cut, the government took in $956 billion (in inflation-adjusted dollars). Did government revenues drop like a stone, per the hand-wringing predictions tax-cut opponents made then? On the contrary. In all but two of the next 10 years, revenues rose as much as $265 billion (and even in the two “off” years, they came close to matching it).

The real culprit behind the Great Deficit Mystery is government spending, which also rose in the 1980s. But try telling that to the critics, who still accuse tax-cut advocates of pushing “voodoo economics.” They’d rather stick with short-term stimulus, it seems.

Yet it stands to reason that when individuals are faced with job and war uncertainties, providing them with one-time tax rebates will do little to change their outlook, and it’s outlook that drives behavior -- how much people save, spend and invest. And that’s true whether we’re at war or not.

About the Author: Norbert Michel is a policy analyst in the Center for Data Analysis at The Heritage Foundation (www.heritage.org).

Answer the following questions about the first article:

“So far, people are continuing to spend despite the awful job picture because mortgage interest rates have dropped so low that homeowners have been able to refinance and get their hands on a lot of cash. We're talking real money here: Homeowners raised $130 billion through home-equity loans last year, nearly double the amount in 2001. But the borrowing binge will soon reach its natural limit.”

1. Where does Consumer spending fit in the circular flow model?
2. According to Reich, how have consumers been able to keep consumer spending up?

“Companies are also buyers. They buy equipment, supplies and raw materials. But companies have stopped buying because they're worried they won't have enough customers. Between January and March, business purchases of these sorts of capital goods dropped — the ninth drop out of 10 quarters.”

3. Where does company investment spending fit in the Circular Flow model?
4. What happens to Aggregate Demand when business spending declines?
5. Is there a multiplier effect? If so, what is it?

“The White House says businesses need investment tax breaks, but that's nonsense. Interest rates are so low that businesses could easily afford more capital goods if they wanted them. But they won't buy more until they know there's a healthy market for what they produce.”

6. What does this say about business expectations?
7. How do business expectations affect Investment Demand?

“Government is also a purchaser, and government spending is way up.”

8. Where does government spending fit in the Circular Flow model?
9. What happens to Aggregate Demand when government spending increases?
10. Is there a multiplier effect? If so, what is it?

“So how do we get out of this quagmire? Not by giving rich people bigger tax breaks, as Bush wants to do. Rich people won't spend any extra money they get. They already spend what they want to spend. That's the definition of being rich.”

11. In your opinion, would the “rich” spend more or less of a tax cut than the “poor” (or middle class) will? Why?
(There is no right or wrong answer to this one. I just want to see if you can argue a position from an economic standpoint one way or the other. You might want to start by defining "rich." Also, note that we tax income in this country, not wealth.)

“The best and the fastest way to get more money into the pockets of people who are likely to spend it quickly is to cut the taxes of average working people. Most people pay more in payroll taxes — primarily for Social Security and Medicare — than they do in income taxes. So a temporary cut in payroll taxes — say, by exempting the first $15,000 of income from payroll taxes — would put an extra $1,200 into most working people's wallets this year alone.”

12. What does cutting tax rates do to the multiplier?
13. If we did this, what should happen to Consumption and Savings?
14. What should happen to Aggregate Demand and Real GDP?
15. If it is a “temporary cut in payroll taxes,” how will this affect consumer expectations?
16. Business expectations?

“And because businesses wouldn't have to pay their portion of that payroll tax, they'd be encouraged to keep more workers on the payroll.”

17. How would cutting payroll taxes paid by business affect Aggregate Supply.
18. What should happen to Real GDP? The price level?
19. How would it affect employment?

Now look at the second article and answer the following questions.

“It would be a valid concern, too, if tax cuts simply extracted money from the economy. Then it would be a bad idea to slash our collective income just as our expenses were set to rise. It would make much more sense to go with $550 billion or $450 billion or $350 billion -- or whatever number congressional skeptics such as Sens. George Voinovich, R-Ohio, and Olympia Snowe, R-Maine, are currently embracing.

But that’s not how tax cuts work. Properly constructed, they result in more jobs, more savings and more income.”

20. If marginal tax rates are cut, what happens to the multiplier?
21. What happens to consumption and savings?
22. How does that affect Aggregate Demand? Real GDP?
23. According to the AS/AD model, how does a tax cut “result in more jobs, more savings and more income?”

“Indeed, a tax cut that encourages long-term growth by making it cheaper for people to invest -- and eliminating the tax individuals pay on dividends would do that in spades -- is exactly what our fragile economy needs…”

24. How does making it “cheaper for people to invest” affect capital (one of the factors of production.)
25. Would this increase or decrease the amount of capital available to the economy? (Alternately, would capital become more expensive or less expensive?)
26. How would this affect Aggregate Supply?

“We should never try to induce consumer spending at the expense of our long-term economic health. As the Congressional Budget Office noted in an analysis of the president’s budget, encouraging higher government spending and private consumption hurts economic growth in the long term.”

27. Going back to the productions possibilities curve, how does consumption or higher government spending today hurt economic growth?
28. Why would more capital investment today encourage “growth in the long term.”

“A dividend tax cut is an excellent way to do this. It’s why the $726 billion plan would lead to more business expansion and more jobs -- an annual average of 914,000 more jobs over the next five years, a recent Heritage Foundation analysis found.”

29. Why would reducing the cost (or increasing the return) of capital increase jobs?
Start with what happens to Aggregate Supply.

“Tax-cut critics have one more ace up their sleeve, however -- deficits. Look at what happened when Congress enacted a big tax cut in the 1980s, they say. The budget was plunged into red ink because the 1981 cut drained federal revenues.
But facts sometimes have an inconvenient way of wrecking such tidy cause-and-effect arguments. Take a look at the revenue figures for the 1980s, and a different picture emerges. In 1980, the last year before the tax cut, the government took in $956 billion (in inflation-adjusted dollars). Did government revenues drop like a stone, per the hand-wringing predictions tax-cut opponents made then? On the contrary. In all but two of the next 10 years, revenues rose as much as $265 billion (and even in the two “off” years, they came close to matching it).”

30. Why might cutting tax rates increase tax revenues?

“They’d rather stick with short-term stimulus, it seems.
Yet it stands to reason that when individuals are faced with job and war uncertainties, providing them with one-time tax rebates will do little to change their outlook, and it’s outlook that drives behavior -- how much people save, spend and invest.”

31. How do consumer expectations affect Aggregate Demand?
32. How do business expectations affect Aggregate Demand?

33. Having read and analyzed both positions, what’s your opinion? Why?
(Again, no right or wrong answer, just a question of how well you can make an economic argument.)

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