The 2003 Tax Cuts…Did They Work?
Late last week, U.S. Treasury Secretary John Snow took to the pages of the Wall Street Journal to praise the 2003 tax cut package. According to Snow, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) was one of the main reasons the slow recovery (from the 2001 recession) picked up steam. Perhaps Snow is correct.
One of the main components of JGTRRA was a reduction in the tax rate on capital. Specifically, JGTRRA lowered the maximum tax rate on individuals’ dividend income. Prior to JGTRRA, dividend payments from a C corporation to an individual would have been taxed at the individual’s top personal income rate. The bill reduced the tax rate on such income to 15 percent (for most dividend recipients).
So, the story goes, JGTRRA made it easier for a corporation to provide a return to its shareholders, thus lowering corporations’ “price” of investing in projects. Naturally, when the price of something decreases, we expect to see a higher quantity demanded. Therefore, JGTRRA should have resulted in corporations investing in more projects (new plants, new equipment, new buildings, etc.).
Why am I writing about this now? A recent post on Café Hayek discusses whether the upward trend in the corporate investment data started before JGTRRA was passed. If so, we would have to conclude that the law had very little to do with the quicker pace of the economic recovery.
The post on Café Hayek really doesn’t offer an explanation as to why the law may not have worked as designed, so I’ll offer one plausible explanation: phase-outs. To sign JGTRRA into law, Congress had to allay the fears of the federal deficit hawks. They did this by writing a law that would expire (phase out in beltway language) after 2008.
As a result, all of the pre-JGTRRA capital tax rates return after 2008. This somewhat unseen part of the bill (it certainly has not been focused on by many journalists) could have a serious impact on the way corporate managers estimate their cost of capital. For starters, corporate managers had, at most, a four-year window for which they could be certain of having a lower cost of capital.
To make matters worse, it was widely believed by the time JGTRRA passed (May 2003) that the 2004 presidential election promised to go down to the wire. Candidate John Kerry’s promise to repeal JGTRRA, therefore, would have provided an excellent reason to put off investing in some projects. If most corporate managers were still, in 2004, planning which projects to invest in, then none of the 2003 corporate investment data would include much of a behavioral response to JGTRRA.
The success of JGTRRA’s capital tax reduction depends on a behavioral response, and the bill’s phase outs certainly provided a disincentive to responding quickly. To answer the question of whether these capital tax cuts worked, I would argue we have to start our investigation after 2003. Sorry Mr. Snow.
For discussion: Can anyone think of additional reasons that the investment response to this tax cut would not show up in 2003? At least one should be rather obvious.
Also, for anyone interested, here’s a short summary of two empirical studies that looked at this issue.
Norbert Michel
