Report Taxes

The Economic Effects of President Bush's and Senator Daschle's Economic Stimulus Plans

November 7, 2001 15 min read

Authors: Rea Hederman, Ralph Rector, D. Wilson and William Beach

INTRODUCTION

On November 6, 2001, Senate Majority Leader Thomas Daschle (D-SD) reaffirmed his intention to introduce a two-component economic stimulus package that would combine the plans of Senators Max Baucus (D-MT) and Robert Byrd (D-WV). It now appears likely that the upcoming Senate debate on economic stimulus legislation will center around Senator Daschle's plan and a plan proposed by Senator Charles Grassley (R-IA) that is strongly supported by President Bush.

Although both plans are intended to ease the impact of the the economic recession and improve the incentives to work, save, and invest (the real catalysts for economic growth), there are substantial fiscal policy differences between them. On the one side are those, led by the President and Senator Grassley, who believe that vigorous tax cuts combined with limited spending increases will do the most to lift the economy out of its current slump. On the other side are those, led by Senator Daschle, who believe that substantial spending increases combined with limited, targeted tax cuts will do the most to remedy the economic problems worsened by the September 11 attacks.

This Report addresses the question of which approach-significant tax cuts with limited spending or significant spending with limited tax cuts-would do more to boost the economy. It evaluates both of the Senate stimulus plans, using the same economic model, against the same baseline, to determine which approach would produce the best economic results over the next five years.

Analysts in the Heritage Foundation's Center for Data Analysis (CDA) used the WEFA U.S. Macroeconomic Model, the Center's Individual Income Tax Model, and work by the staff of the Joint Committee on Taxation to address this question. Specifically, CDA economists estimated the economic effects of the Bush-Grassley plan and Daschle plan using the same model of the U.S. economy, one that contains a two-quarter recession beginning in the third quarter of 2001 and ending during the first quarter of 2002. This analysis shows that:

In FY 2002, the Bush-Grassley plan produces nearly twice as many jobs as the Daschle plan does (211,000 vs. 108,000). From FY 2002 to FY 2006, on average, the Bush-Grassley plan produces over 7 times more jobs than the Daschle plan (283,000 per year vs. 38,000 per year). (See attached table)
From FY 2002 to FY 2006, the inflation-adjusted disposable income of an average family of four would increase by an average of $1,060 per year under the Bush-Grassley plan and by only $236 per year under the Daschle plan.
In FY 2002, the Bush-Grassley plan increases inflation-adjusted consumption expenditures by $27.9 billion - 28 percent more than the $20.0 billion increase under the Daschle plan.
By the end of FY 2002, the average savings for a family of four (adjusted for inflation) would increase by $752 under the Bush-Grassley plan, compared with an increase of $536 under the Daschle plan.
From FY 2002 to FY 2006, the nation's (inflation-adjusted) investments would increase by an average of $13.4 billion per year under the Bush-Grassley plan and by only $1.1 billion per year under the Daschle plan.

Although both plans transfer income to low- and moderate-income taxpayers through rebates and both assist the unemployed, the fact that the economic outcomes produced under the Daschle plan fall far short of those produced under the Bush-Grassley plan raises serious questions about the utility of cash payments and increased government spending as the primary tools for boosting economic activity. The better approach would be to lower tax rates and the tax burden on labor and capital to improve incentives for workers and business owners, producing more jobs and generating higher incomes, which, in turn, translate into higher investment and consumer spending.

SUMMARY OF PLANS

CDA analysts evaluated two economic stimulus plans for this Report: the plan proposed by Senator Charles Grassley and strongly supported by President Bush, and the plan proposed by Senator Majority Leader Thomas Daschle that would combine the plans of Senators Max Baucus and Robert Byrd.

The Bush-Grassley plan consists of five elements: individual income tax reductions, tax policy changes that reduce capital costs, cash relief to low- and middle-income workers, extending and expanding unemployment insurance, and expanding health insurance coverage. The plan is expected to result in static federal revenue reductions and spending increases totaling $248 billion over next five years. Specifically, Senator Grassley and the President propose:
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Accelerating into 2002 all of the tax rate reductions that are currently scheduled for 2004 and 2006;
Accelerating the depreciation of capital acquisitions for the next three years by enacting a 30 percent "bonus" depreciation for those years;
Repealing the corporate alternative minimum tax on a prospective basis;
Providing supplemental cash payments to taxpayers who were not qualified to receive the full amount of last summer's tax rebates ($300 for singles, $600 for married taxpayers, and $500 for head-of-household taxpayers);
Establishing a temporary emergency extended unemployment compensation program to provide an additional 13 weeks of unemployment benefits to workers laid-off as a result of the September 11 attacks;
Providing states with $3 billion in National Emergency Grants to pay for unemployment insurance benefits to laid-off workers not eligible for the temporary extended benefit program, to pay up to 75 percent of health insurance premiums covered by CORBA, and to strengthen job placement assistance; and
Encouraging states to use $11 billion in unspent S-CHIP matching funds to expand health insurance coverage for the uninsured.

The Daschle plan consists of five elements: cash relief to low- and middle-income workers, tax policy changes that reduce capital costs, extending and expanding unemployment insurance, expanding health insurance coverage, and significantly increasing spending for infrastructure and national security projects. The key contrast between the Bush-Grassley plan and the Daschle plan centers on the amount of tax relief vs. the amount of increased spending that each provides. Specifically, the Daschle plan would consist of:

Supplemental tax rebate checks for taxpayers who did not receive the full amount during the summer of 2001;
A 10 percent "bonus" depreciation for investment in capital and software placed in service over the next 12 months;
Expansion of Section 179 expensing for small businesses;
Expansion of the carryback period for Net Operation Loss Carrybacks;
Extension of expiring tax credits;
Temporarily extending and expanding Unemployment Insurance;
Subsidized COBRA coverage;
Expansion of Medicaid to cover the unsubsidized portion of COBRA coverage; and

Significant spending increases for agriculture, highway projects, transportation security, border security, bioterrorism prevention, and state and local anti-terrorism grants.
The Daschle plan would reduce federal tax revenue and increase spending by a total of $88 billion over the next five years.

COMPARISON OF ECONOMIC EFFECTS

There may be many good political reasons for Congress to pass an economic stimulus package, but there is one overriding economic reason: the intervention should improve the incentives to work, save, and invest--the real catalysts of economic growth. Fiscal policy changes that focus on these economic incentives will lay the foundation for stronger economic growth and reduce the depth and shorten its duration of the current slowdown. Indeed, the competing stimulus plans should be evaluated with respect to their effects on depth and duration of the recession as much as, or more than, with respect to any other criteria.

To determine how the two plans compare in terms of their effect on the expected depth and duration of the current recession, CDA analysts developed projections of the economic impact of each of the plans. The chart below shows how each plan will affect the change in employment between the beginning of the recession (the end of the second quarter of 2001) and the time when total employment returns to the level it would likely have attained had their not been the recession of 2001 (i.e. the first quarter of 2004). This chart shows that, while both proposals lessen the depth of job loss, only the Bush-Grassley plan significantly shortens the time before employment regains the level it would have attained without a recession. As Chart 1 shows, the Bush-Grassley plan reduces the employment trough by nearly 33 percent and shortens the length of the job slowdown by six months.

Both plans affect economic activity but the Bush-Grassley plan, which contains significant tax relief and limited spending, produces uniformly better economic results than a plan based on substantial spending increases combined with limited tax cuts. For example, in FY 2002:

The Bush-Grassley plan would produce nearly two times the number of jobs than the Daschle plan would (211,000 vs. 108,000).
Under the Bush-Grassley plan, the inflation-adjusted disposable income of an average family of four would increase by $1,176, compared with $844 under the Daschle plan.
The Bush-Grassley plan increases inflation-adjusted consumption expenditures by $27.9 billion - 28 percent more than the $20.0 billion increase under the Daschle plan.
The average savings for a family of four (adjusted for inflation) would increase by $752 under the Bush-Grassley plan and by only $536 under the Daschle plan.
The Bush-Grassley plan would increase inflation-adjusted investment by $7.8 billion, compared with a $4.9 billion increase under the Daschle plan.

Moreover, as the attached table shows, the differences in the effects of the two plans will be even more pronounced in future years. The Bush-Grassley stimulus package creates more jobs, provides more income to families and does a better job expanding economic activity than the Daschle plan. These differences become more dramatic as the pro-growth elements of the Bush-Grassley plan take hold. On average, from FY 2002 to FY 2006:

The Bush-Grassley plan produces 7 times the number of jobs than the Senate plan does (283,000 per year vs. 38,000 per year).
The inflation-adjusted disposable income of an average family of four would increase by $1,062 per year under the Bush-Grassley plan and by only $236 per year under the Daschle plan.
The Bush-Grassley plan increases inflation-adjusted consumption expenditures by $45.4 billion per year, compared with an increase of only $10.3 billion per year under the Daschle plan.
Personal savings (adjusted for inflation) would increase by $27.3 billion per year under the Bush-Grassley plan and by only $5.4 billion under the Daschle plan.
The Bush-Grassley plan would increase inflation-adjusted investment by $13.4 billion per year, while the increase under the Daschle plan would be only $1.1 billion per year.

CONCLUSION

The two economic stimulus plans analyzed in this Report clearly reflect the two major views of government's role in economic planning. On the one hand, the Bush-Grassley approach primarily relies on changes in the tax rates on capital and labor to boost economic performance. By lowering tax rates and the tax burden on investment and capital assets, this supply-side plan provides incentives for business owners and workers, producing more jobs and generating higher incomes, which translate, in turn, into greater investment and consumer spending.

On the other hand, Senator Daschle's demand-side approach principally relies on cash transfers to displaced workers and distressed businesses to stimulate economic activity. While this plan produces some increase in employment and income and is better than doing nothing, it fails to substantially increase the fundamental incentives for stronger economic activity. In fact, the Senator's plan never creates the large consumer response that would be needed in order for a demand-side, expenditure-based stimulus proposal to produce the job and income increases that are generated by supply-side proposals. While both plans transfer income to low- and moderate-income taxpayers through rebates and both assist the unemployed, the fact that the economic outcomes produced under the Daschle plan fall far short of those produced under the Bush-Grassley plan raises serious questions about the utility of cash payments and increased government spending as the primary tools for boosting economic activity.

William W. Beach is Director of the Center for Data Analysis at The Heritage Foundation; D. Mark Wilson is a Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation; Rea S. Hederman is Manager of Operations for, and Ralph Rector is a Research Fellow in, the Center for Data Analysis at The Heritage Foundation.

APPENDIX A: METHODOLOGY

Heritage Foundation economists in the Center for Data Analysis (CDA) followed a two-step procedure in analyzing the budgetary and economic effects of the two stimulus plans evaluated by this Report.

First, preliminary static tax revenue estimates for the economic stimulus plan were generated by either the Center's Individual Income Tax Model or obtained from the Joint Committee on Taxation (JCT). The CDA and JCT tax revenue estimates are based on a static methodology that generally does not account for the macroeconomic effects that would result from a reduction in tax rates. These effects include changes in gross domestic product (GDP), interest rates, employment, personal income, and inflation that can significantly affect tax revenues. Therefore, the static estimates provide a very limited analysis of the economic and budgetary impact of any policy change. To forecast the change in federal tax revenue, spending, and the economy more accurately, a dynamic model must be used.

Static fiscal year revenue estimates for tax rate changes were computed using the CDA Individual Income Tax Micro-simulation model. This model estimates the change in tax liability for a national sample of over 100,000 tax filers. The sample contains tax return data from the Public Use Tax File that is produced by the IRS. In addition, the sample contains demographic and other information from the Census Bureau's Current Population Survey. Economic data from the CBO August 2001 forecast were used to project the sample data forward to 2011.

Second, the static revenue changes were introduced into the WEFA U.S. Macroeconomic Model. The WEFA model is a dynamic model of the U.S. economy designed to estimate how the general economy is reshaped by policy reforms, such as tax law and spending changes. Heritage economists developed a revised WEFA model for Heritage work that embodies the economic and budgetary assumptions published by the Congressional Budget Office (CBO) in August 2001, the recent increases in federal spending, and the latest Blue Chip forecast for economic growth following the September 11 terrorist attacks. This specifically adapted WEFA model produces dynamic responses from the modified CBO baseline as a result of the proposed policy changes.

THE SIMULATION

The WEFA model contains a number of variables that are used to simulate proposed policy changes. The following sections describe how the CDA static estimates were introduced into the WEFA model to estimate the dynamic economic and budget results.

Average Effective Personal Income Tax Rate.
The WEFA model contains a variable that measures the total amount of all federal taxes on individual income as a percentage of the nominal personal income tax base. Heritage economists adjusted this average effective tax rate downward for each of the forecast years to reflect the static revenue decrease estimates.

Average Effective Corporate Tax Rate.
The WEFA model contains a variable that measures the total amount of federal corporate tax revenue as a percentage of nominal corporate profits. Heritage economists adjusted this average effective tax rate downward for each of the forecast years to reflect the static revenue decrease estimates.

Labor Force Participation and Average Weekly Hours.
Small adjustments were made in the model's exogenous labor force participation rate and in the number of hours worked to account for the dynamic effects of accelerating the marginal income tax rate reductions.

Business Sector Price Index.
The business sector price index was reduced to reflect the lower tax rates on business income that would be reported on personal income tax forms.

Corporate AAA Bond Rate.
The corporate AAA bond rate was reduced to reflect the lower tax rates on business (capital) income in the three plans.

Government Transfers.
The WEFA model contains variables that measure the amount of federal transfers to persons. Heritage economists increased these amounts to reflect the tax rebates, unemployment insurance benefits, and any other transfers to persons in the three plans.

Government Grants to States.
The WEFA model contains variables that measure theamount of federal grants to states. Heritage economists increased these amounts to reflect any increased spending on medical insurance and other state grants in the three plans.

Government Spending.
The WEFA model contains variables that measure the amount of federal defense and non-defense spending. Heritage economists increased these amounts to reflect any increased spending in the three plans.

Monetary Policy.
The model assumes that the Federal Reserve Board will react to this policy change as it has historically. This assumption was embodied in the Heritage model simulation by including the stochastic equation in the WEFA model for monetary reserves.