It’s Time for Tax Cuts

The Wall Street Journal’s Gerald Seib has an excellent column this morning on the threat of an economic downturn and the relevance of tax cuts to reignite the economy. He notes that Republicans have an important opportunity to push tax cuts as a spur to the slumping economy, whereas Democrats are still stuck with a tired tax-hike message and an obsessive desire to undo the Bush tax cuts.

Seib does not go into the incentive effects of lower marginal tax rates versus the one-shot demand-side effects of temporary tax cuts.

Former Clinton Treasury Secretary Lawrence Summers is now predicting a 2008 recession. But he’s calling for temporary tax cuts for low and middle-class families. Unfortunately, history clearly shows this approach will not work.

Many years ago, the late Milton Friedman wrote about the permanent-income hypothesis. The basic idea is that temporary additions to income (from tax cuts) won’t be spent, they will be saved. On the other hand, permanent reductions to personal tax rates will be spent, will be saved, and will be invested.

Moreover, Nobel Prize–winning economist Ed Prescott has successfully argued that economic behavior is highly responsive to changing tax rates. So there’s a big difference between the Republican approach and the Democratic approach.

Democrats also will try and make the case that taxes should be cut for the so-called middle class, and raised on upper-income earners. This is futile. It’s also bad politics. Taxing successful earners is a tax on capital and investment, which has recently become scarce during the housing crisis.

Republicans should take care to propose lower tax rates on middle-income earners, as well as successful investors. The real supply-side “bang for the buck” comes at the top-end, but across-the-board rate reductions do have positive economic and political benefits. Collapsing the middle-income brackets — 15 percent, 25 percent, and 28 percent — would make a lot of sense.

GOP presidential hopeful Fred Thompson’s embrace of the House Republican Study Committee’s plan for a two-rate tax choice of 10 percent and 25 percent would really fit the bill. For joint filers, that would be a 10 percent tax rate up to $100,000 and 25 percent above that. Not only is that good tax reform and simplification, it would really help middle-income tax payers and it would reduce their combined Social Security and income-tax burden.

Given the economic and credit-market concerns sweeping down Wall Street and Main Street these days, it’s time to talk tax cuts. But the right kind of tax-rate reduction must be part of the new-tax-cut riff.