The Senate is expected to vote soon on the Bush tax cut package. Republicans are pushing their big tax cut, claiming that it will "unleash capital" and thereby drive growth. Opponents, who so far have focused on the impacts on equity and fiscally discipline, need to take aim at the Republican's claim that the tax cuts will produce growth. In an economy in which knowledge is the scarcest and most important factor of production, tax cuts to stimulate the supply of capital are at best irrelevant to growth and at worst, downright harmful.
It's not that the opponents' arguments are not valid and important. In an economy where the highest income earners have done much better over the last two decades than low and moderate income earners, it's the height of unfairness to push for tax cuts that will predominately accrue to the top earners. And in an economy where the national debt is already over $6.4 trillion and we are about to face big costs associated with the reconstruction of Iraq and the retirement of the baby boom generation, it's fiscal folly to push large permanent tax cuts.
But opponents need to forcefully articulate an even more basic argument against an economic policy that consists of nothing more than serial tax cuts for high earners -- they don't create economic growth. Why? Because they are aimed overwhelmingly at stimulating the supply of an item that the economy today actually has enough of: investment capital.
With the advent of global capital markets and proliferation of a host of innovative financial instruments over the last two decades, America has access to far larger sums of investment capital than at any time in history other than the absolute peak of the 1990s boom. To use one measurement of available capital, the ratio of M3 (the broadest definition of money, including bank deposits, money market deposits and long-term deposits) to GDP rose from 60 percent in 1960 to 81 percent today, while bank credit increased from 37 percent to 56 percent. There's five times as much venture capital under management than there was in 1995. Though dropping last year because of slow growth, foreign direct investment totaled over $300 billion in 2000, up from just $45 billion in 1995. The market value of the Wilshire 5000, the broadest index for the U.S. equity market, increased from 35 percent of GDP in 1982 to 75 percent in March 2002. And the cost of capital, as measured by interest rates, is obviously at historically low levels.
The problem is not a lack of money, but a lack of good investment opportunities and a willingness to invest in the face of weak demand. Therefore, supply-side tax cuts are not going to make much difference in the availability of capital and even if they did, they're not the key factor driving growth.
Not only do they not produce growth, they don't even produce more capital. In contrast to supply-sider doctrine, between 1981 and 2002 there has been a strong positive correlation between higher top income tax rates and savings. In other words, lower tax rates have been associated with lower savings rates. Not surprisingly, the growth effects of the Bush tax cuts are virtually nil because a large share of tax cuts would be spent and not invested, and because they would boost the national debt, they would lead to higher interest rates. This is why the Congressional Budget Office concluded that the supply-side effects of the Bush tax cut would actually end up reducing private investment by more than 4 percent over the next five years.
The 21st century knowledge economy requires a fundamentally different approach to boosting growth than simply cutting taxes on the richest investors. A small set of Promethean investors seeking to maximize their portfolios might have powered growth in an industrial economy driven by huge capital-intensive factories, but in a knowledge economy, it's the creativity, inspiration, knowledge and risk-taking of all Americans that are the drivers of growth. Creative entrepreneurs, skilled workers, cutting-edge researchers, and innovative companies are now the source of the wealth of nations. Tax cuts to boost the supply of capital do little to support their efforts, and to the extent that they reduce the ability of government to make investments in knowledge, research, skills, and next generation infrastructure they are actually injurious to growth. Our long-term economic problem is not investment capital, it's intellectual capital -- to turn a phrase, there's plenty of dollars chasing too few good ideas.
Instead of more budget busting, long-term tax cuts we should pursue both a short-term and moderate-term economic strategy. The former should focus on temporarily boosting demand for goods and services to get the economy going and create investment opportunities. The best way to boost consumer demand is to get money into the hands of those most likely to spend it: the large swath of average American families. The latter should focus on boosting public and private investments in basic science, research, increased skills and cutting-edge infrastructure -- the same strategy that helped boost productivity and incomes in the 1990s. Both should have an eye out for maintaining fiscal discipline.
In short, the Republican economic agenda, such as it is, is not only unfair and irresponsible: it won't work and can't work because it's focused on the wrong economic problem. The Democratic agenda of short-term stimulus and long-term investments in the building blocks of the knowledge economy does work and will work.
