The Labor Department said Friday that the U.S. jobless rate fell to 5% in June, the lowest since 2001. Federal tax revenues continue to rebound, at a nearly 15% annual rate so far this year (see below), and economic growth continues to average nearly 4% despite $60 oil and rising interest rates. Maybe it's time to give the tax cuts of 2003 the policy credit they deserve.
More broadly, it's time to draw a few lessons from the fiscal policy debates of the Bush years. For we now know who was right, and who wasn't, going back to the proposals that were offered to restore growth after the dot-com bubble burst and through the 2001 recession and the aftermath of 9/11.
The big economic fight of the first Bush term was over fiscal policy, especially the size and design of tax cuts. The neo-Keynesians and believers in Rubinomics proposed temporary tax cuts through tax rebates to boost consumer spending. Jon Corzine, the point man on taxes for Senate Democrats, was insistent on the rebate idea.
Unfortunately, President Bush agreed, in part to get 12 Democratic votes in the Senate and in part because some of his advisers also fell for the Keynesian illusion that temporary tax cuts would spur growth. So he agreed to phase in his own marginal-rate income tax cuts over several years, while passing out $500 rebate checks immediately to American families in order to increase demand for goods and services. While this tax cut may have been a political success, it was an economic flop, as growth retreated again in 2002 after a one-time bounce.
The tax cut debate resumed in January 2003, however, as Mr. Bush decided to pursue a more supply-side course. This time he aimed his tax cuts directly at the collapse in business investment, proposing to eliminate the double tax on dividends and to accelerate his income tax cuts at the top marginal rates. House Ways and Means Chairman Bill Thomas compromised on a 15% dividend rate but added a capital gains cut to 15% (from 20%).
Almost from the very day in May of 2003 when those tax reductions became law, the U.S. has experienced a robust expansion driven by investment and productivity gains, not by consumer spending. This is demonstrated by the nearby graph comparing the trend in consumption versus investment over the past five years. Consumer spending has been close to flat over the period with a modest dip at the very bottom of the recession. But investment has experienced a stunning U-turn.
One result has been a strong stock market recovery, especially in 2003 and 2004, with shareholder wealth rebounding by roughly $2 trillion since the market collapse that began in 2000. Another sign of growth is the return of venture capital funding for start-ups -- the leading candidates to be tomorrow's Dell or Home Depot. This market has recovered enough from its 2002 trough that the National Venture Capital Association says, "We're in the beginning stages of a new cycle of venture capital financing, and the capital gains cut has had a lot to do with that." Initial public offerings have also quadrupled since 2002, despite the new burdens of Sarbanes-Oxley.
One lesson in all of this is that not all tax cuts are created equal. Tax rebates and other temporary measures aimed at stimulating consumer demand don't work. Consumers aren't irrelevant, but prosperity is created on the supply side of the economy with the incentives to produce goods or services that people want to consume. So tax cuts in marginal rates that boost incentives to work and invest provide a much bigger bang for the buck.
Ronald Reagan once quipped that he knew his policies were working when his critics stopped calling them "Reaganomics." And so it goes this time as well. The same critics who said the tax cuts wouldn't work are now saying those cuts had nothing to do with our current expansion. They want to give all the credit to monetary policy, or dismiss this as another case of a Keynesian, demand-side boom. Certainly monetary policy has played a role, especially in sustaining housing and consumer spending. But monetary easing did little to revive corporate investment, which remained stagnant throughout 2002.
The critics also say the current prosperity won't last, which conveniently means they will eventually be right. Recessions do happen, but they usually arrive because of new policy mistakes. The risks today are trade protection toward China, high energy costs and rising interest rates as the Fed by necessity tries to make up for its mistake of staying too easy for too long in 2003 and 2004.
The other, albeit ironic, danger is that even many Republicans don't seem to recognize their tax-cutting policy success. Congress lacks the votes to make the 2003 tax cuts permanent, and even Mr. Bush missed the opportunity to push for permanence immediately after his re-election. Most of the Bush tax cuts expire in 2010, or 2008 in the case of dividends and capital gains. But their impact will ebb if investors begin to worry that they are only temporary. Amid their many other priorities, Republicans can't afford to forget that tax-cutting remains their most important achievement of the last five years.
