Why Bush’s Tax Cuts Failed

As we all know, Bush pushed through two massive tax cuts — “the largest tax relief in history,” according to the Bush campaign. Yet the current recovery is among the weakest in history, as illustrated in the previous post. Shouldn’t the largest tax cuts in history have had more effect? How could such massive tax cuts have such little impact on the economy?

The answer is that it matters a great deal exactly how you cut taxes. Some tax cuts have bigger effects on the economy than others, for a given dollar amount of taxes cut. And clearly, the specific types of taxes cut by the Bush administration had just about the smallest bang for the buck imaginable.

Why? There are several ways in which those tax cuts were terribly designed to stimulate the economy. I won’t go into all of them here, but let me address a couple of ways. First of all, the lion’s share of the tax cuts went to the richest housholds. Since the marginal propensity to save is so much higher among high-income households than lower and middle-income households, this meant that a large proportion of the tax cut was simply saved, adding no demand to the US economy. The graph below illustrates.

Much of the tax cut’s 2003 effect was lumped into the third quarter of 2003. According to the BEA, the 2003 tax cut, which took effect in July of 2003, reduced personal income taxes by nearly $100 bn in the third quarter of 2003 compared to the same quarter a year earlier. The graph above suggests that the majority of that tax giveback was saved, not spent.

A recent piece in Slate notes another way in which the specific tax cuts Bush enacted were not helpful to the recovery, as described by Barry Ritholtz of the Maxim Group. (Thanks, Barry.) His point is that because the tax cuts gave preferential treatment to purchases of capital goods through the end of 2004, some businesses may be buying new machines instead of hiring back workers as demand picks up. Casual observation of the continuing growth in industrial capacity despite weak demand over the past two years suggests that this analysis is plausible.

The Bush tax cuts were indeed big, and very, very expensive. But as many economists predicted, they were ineffective. Bush made the Wrong policy choices to try to get the economy moving, just as he has made so many other Wrong choices.