Stimulus that Actually Stimulates

With the House of Representatives passing a pork-laden and special interest satisfying spending spree that is being called stimulus, it is important to realize there are genuine alternatives that can help the economy.

The Cato Institute ran a full-page ad in the Washington Post this week which contradicts President Obama's assertion that there is widespread agreement on the need for massive government spending to stimulate the economy, with hundreds of economists including Nobel laureates signing the statement. Even more economists have added their names to the statement since it was published (here).

Aside from the fact that the House plan is mostly about satisfying a leftist wish list of pet projects and causes than it is about stimulus, the very premise that government spending will solve the problem is in question. This plan shares a key premise with the stimulus plan passed in early 2008, which comprised tax rebates: if the government puts money in people's pockets, it will stimulate economic activity.

The problem with such efforts is that the money has to come from somewhere. Specifically, the additional spending or tax rebates are paid for with additional government borrowing, which means there is less money available for other forms of investment or spending. So the impact is not nearly as great as it seems.

Instead, an economic stimulus plan can be crafted that can change the behavior of individuals, businesses, and investors to increase economic activity. An across-the-board cut in all income tax rates, including corporate, capital gains, and dividend tax rates, increases the incentives for everyone to make new investments, start new ventures, and in general work harder - since the payoff from all such efforts is now greater.

Yes, such a tax cut puts money in taxpayers' pockets like a tax rebate or infrastructure spending, but it does much more by encouraging effort and risk-taking - which is the key to stimulating real economic growth.

John McCain did a poor job in the campaign explaining why his plan to cut corporate tax rates was so beneficial. The reason such a tax cut promotes economic growth is simple. When companies make decisions to build a new factory or R&D facility, they compare many variables, all with the goal of maximizing their after-tax income from the investment. If corporate tax rates are reduced for investments in the U.S., then companies (both domestic and international) will be find investments in America more profitable and hence more likely to make such investments in America.

Ireland has experienced dramatic economic growth by using a low corporate tax rate to induce companies to locate operations there. And since the U.S. corporate tax rate is now among the highest in the world, cutting that rate will make investing here more competitive. That will mean more jobs, and more tax revenue, generated in the U.S.

A 30% cut in all such tax rates would cost the government approximately $500 billion, before any stimulating effects of higher economic activity are considered. For individual taxes, the 15% tax bracket would be 10.5%, the 25% tax bracket would become 17.5%, and the 35% tax bracket would be 24.5% - all dropping by 30%. The corporate tax rate of 35% would be 24.5%, which when adding in state taxes would make it about 29% - higher than many countries but much more competitive than today.

A second important element of a pro-growth stimulus plan is to expand free trade globally, rather than threaten to reduce trade as Barack Obama did during the campaign by suggesting he would change the terms of NAFTA or refuse to approve free trade agreements with Colombia, South Korea, and Panama as the Democratic Congress has done. Approving these trade agreements and in general seeking to expand free trade will send a strong signal of America's commitment to expanding trade - which will encourage economic activity as businesses seek new opportunities that more open trade permits.

A third element of a pro-growth stimulus plan is to look to cut regulations that impede economic activity. The auto industry has long been hamstrung with fuel efficiency standards and limits on rationalizing its dealer network. Reducing or eliminating those restrictions won't immediately solve the auto makers deep woes, but will help - and are an example of the type of constraints that limit business activity throughout the economy. Naturally, instead President Obama and Congress want to increase the constraints on the auto industry which will only make economic recovery harder.

Lastly, pro-growth government policies would not include attacking businesses and Wall Street to score PR points. President Obama has resoundly failed in this regard with his recent bashing of Wall Street: if Wall Street didn't pay bonuses to its employees, as the President suggested, then these firms would wither as employees left to work for other firms (existing or new ventures) that haven't received TARP funds.

The key to reviving the economy is having people willing to take risks by investing money and time in new ventures and investments. Lowering taxes, increasing free trade, and reducing regulations all help create incentives for such risk-taking. Criticizing businesses will discourage risk taking by creating an atmosphere of fear - better to hoard cash since you don't know when the next assault will occur or to what restrictions your business will be subject.

All of the above suggestions stand in sharp contrast to the policies pursued during the Great Depression, when taxes were raised significantly; free trade was devastated with high tariffs; new regulations were unleashed; and business leaders were subject to verbal and legal assault.

Contrary to the popular mythology of the New Deal, all of these policies exacerbated the crisis of the 1930's and prevented a full recovery from occurring for over ten years. After six years of the New Deal in 1939, unemployment was about 19% - down from 25% in 1933 but still at depression levels. Note that today's unemployment rate is 7.2%.

Let's not repeat the same mistakes again. Pro-growth policies, consistent with our capitalist heritage, give us the best chance to begin a sustainable recovery.