Commentary

Bear Traps for the Economy

House Democrats and White House Republicans have conspired to set a bear trap for the next president: Whatever goosing of the economy their “stimulus” bill achieves will come at the expense of next year’s growth.

Indeed, the winner this November could face two traps, because key parts of the Bush tax cuts are scheduled to expire at the end of 2010. That would be an illusory hit of speed for the economy in late 2010 — at the expense of a vicious hangover in 2011.

The GOP ‘08 candidates seem to sense the danger — most want to make the Bush cuts permanent, at a minimum, and few show any enthusiasm for any one-year quick fix. The Democrats, by contrast, seem eager to leap into both the tax-timing traps awaiting in 2009 and 2010.

Start with the stimulus plan now on the table. This would encourage consumers and businesses to spend more this year and less in 2009. The initial plan (before the Senate adds billions for spending giveaways) would send a check for $300 to $1,200 to 117 million households.

The point of doling out borrowed money, whether via checks to many or benefits to a few, is to encourage brief shopping sprees at Wal-Mart, Best Buy and McDonald’s. Similarly, businesses could write-off a big chunk of the cost of new equipment if they buy it this year, not next year.

To the extent such ephemeral gimmicks might work, they do so at the expense of next year. Consumers aren’t really expected to buy more cell phones or plasma TVs than they need — just to stock up this year rather than the next. Businesses aren’t expected to buy more office equipment than they need — just to purchase it this year, instead of the next.

The administration hopes to bribe households and firms to rush out and buy anything, like restaurant meals or imported gadgets, but hurry up and do it quickly before President Bush leaves office. That may make his tenure look better — at the price of making his successor’s economy look more grim.

The second trap is even more pernicious. It too involves what economists call “intertemporal substitution,” which means people change the timing of activities to take advantage of changing tax incentives. A famous example was when Arkansas attorney Hillary Clinton requested that her bonus be paid in December 1992, rather than the following January — because she knew tax rates would be higher when Bill became president.

The 2009 trap involves shifting spending forward, from 2009 into 2008. The 2010 trap is similar yet different. It involves shifting income and stock sales forward, from 2011 into 2010, to dodge the threat of higher tax rates in 2011.

A fascinating example of how Democrats think about such matters was provided by Leonard Burman of the Tax Policy Center, an economist who worked in President Clinton’s Treasury.

Burman argued in The New York Times for repealing all the Bush tax cuts in 2009 rather than 2011. Why? Because, he says, “If they were repealed in a year, the Bush tax cuts could spur a burst of economic activity in 2008.

“If people knew that their tax rates were going up next year, they’d work to make sure that more of their income is taxed at this year’s lower rates. Investors would likewise have a giant incentive to cash out their capital gains now to avoid paying higher taxes later.”

In other words, let’s encourage people to live high right away before the party ends — to heck with what that means for the future.

But if people are induced to shift income into one year to avoid taxes in the next, that process shifts abruptly into reverse in the following year. The shifting of income and stock-sales into the year before a big tax increase can bring a brief flurry of activity in that earlier year — but clearly becomes a nasty depressant, once that tax hike kicks in.

Under the now-planned end of the Bush tax cuts (an end that Democrats ardently support), this time bomb starts ticking at an accelerating pace throughout 2010 — and then suddenly blows up in 2011.

If the Bush tax rates on top salaries, capital gains and dividends are allowed to expire at the end of 2010, then incomes of entrepreneurs, professionals and investors will indeed appear to surge at the end of 2010. But that will be instantly followed by a steep slump in the economy and tax collections in 2011.

Taxes from realized capital gains would likewise surge in 2010, then collapse. If investors expect the tax on dividends to rise from 15 percent to 39.6 percent in January 2011 (as Democrat candidates propose), there will be mass liquidation of blue-chip stocks in 2010. The result could be ugly for investors and pensioners even before tax rates go up.

Presidential hopefuls from the Democratic Party seem surprisingly eager to leap into two treacherous tax-timing traps waiting for them in 2009 and 2010. Perhaps Hillary Clinton, John Edwards and Barack Obama believe a Republican is going to win the presidency. Why else would Democrats be trying so hard to make the economy look better under George Bush and worse under his successor?

Alan Reynolds is a senior fellow at the Cato Institute; his latest book is Income and Wealth.