The 2001 Bush Income Tax Cut: A Major Policy Mistake

September 9, 2010, 9:02 am

The 2001 Bush income tax cut is one of those issues whose fate has been sealed by objective economic conditions. Simply, if the U.S. economy had registered robust growth during the final two years of the Bush administration, and no other negative economic events occurred, the tax cut, which will increase the deficit by $336 billion this fiscal year, $295 billion in fiscal 2011, and by more than $320 billion per year through fiscal 2019, perhaps would have had a chance of being extended. But that robust GDP growth did not occur. Neither did robust job growth. The tax cut did, however, instantaneously turn a federal budget surplus into a budget deficit. Further, failing to phase-out the tax cut would seriously impair the nation’s ability to balance the federal budget. Must Avoid Rattling Bond Market Equally important, extending the tax cuts would send the wrong signal to credit markets. The bond market has already factored-in the expiration of the 2001 Bush tax cut, and the lower budget deficit it implies. Reverse that policy and the bond market is not likely to pleased, to say the least. Rattled is more like it, and another financial shockwave is not what credit markets need, given that they’ve only semi-healed from the first two shockwaves (Lehman Bros. collapse, European debt crisis). If the tax cuts don’t expire, U.S. interest rates would likely rise, and the dollar would probably weaken even more — with the latter pushing dollar-based commodity prices higher, especially oil. Further, congressional Republicans don’t appear to be willing to compromise with President Obama and congressional Democrats on the income tax issue — their view is ‘retain them in full or nothing’ — hence the tax cuts that favor upper-income citizens will likely expire. Also, the literature is mixed regarding the GDP-impact from extending the cuts: Some times upper-income investors flush with extra cash act in ways that stimulate U.S. GDP growth, sometimes they don’t. And most of the literature also says only a minute segment (up to 5%) of small businesses will be substantially hurt by seeing the tax cuts expire. Fiscal/Economic Analysis: The clincher in the debate is the bond market. You think actions that rattle the stock market are best avoided — trust me — you really don’t want to rattle the bond market. The expiration of the tax cuts will result in an extra, cool $300 billion and up rolling into the U.S. Treasury’s coffers each year — dramatically improving the nation’s fiscal condition. In other words, the United States will be better than one-third of the way toward a balanced budget — and that’s sweet music for bond owners’ ears.

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