Nothaft Weighs Economic Implications of Tax Cut

With both major political parties advancing a fiscal stimulus package, it appears rather likely that some form of tax cut will be enacted before mid-year to help promote growth into 2004. Major components of the administration's proposal are acceleration of cuts in tax rates and an elimination of the double taxation on corporate dividends.

Making income tax cuts effective this year will help add to consumer spending power. These cuts include the reduction in marginal tax rates, an increase in the child tax credit to $1,000 and the elimination of the "marriage penalty." A full or partial elimination of taxes on dividends at a personal level will likely stimulate both business capital and consumer spending. This type of tax cut may lower the cost of equity capital for some firms, boosting capital spending. Stock values for dividend-paying companies may also be bid up, which can stimulate consumption spending through a wealth effect.

Tax cuts have a complicated effect on the economy. Below are some questions that often arise:

What will be the overall effect on the economy?

By stimulating consumption and business investment spending, the short-term effect will be to accelerate economic growth and reduce the unemployment rate more rapidly. The "cost," however, is larger federal budget deficits that raise real interest rates (current rates minus inflation) and crowd out private-sector borrowings longer term. Economy.com has estimated that enactment of the administration's proposal by the end of the first quarter will lift 2003 GDP growth by 0.7 percent. Macroeconomic Advisers estimated that enactment by mid-year with tax cuts retroactive to January 1 will boost growth by a whopping 1.1 percent in 2003 and 0.6 percent in 2004, with the unemployment rate 0.6 percent lower in 2004 than it otherwise would be; however, cumulated over the next five years, the effect on GDP is negligible, as higher interest rates reduce growth in 2005-2007.

What will be the effect on the housing market?

Increased employment and family income growth increases demand for housing while higher long-term interest rates reduce housing demand, so the net effect is complicated. Interest rates are higher because consumers and the government buy more goods, reducing national saving and pushing up real interest rates. This is one effect that most card-carrying economists agree on.

Macroeconomic Advisers simulated the effect of the administration proposal and found that fixed-rate mortgage rates would average about 40 basis points higher over the next five years because of the stronger consumption activity. Housing starts would be 4 percent to 9 percent higher (about 100,000 units per year) in 2003 to 2005, but then would be a lot lower in 2006 and 2007, so the cumulative total of new dwellings constructed would be the same. The difference is that construction would be accelerated.

Will Freddie Mac pay out more dividends?

That's up to the Board of Directors. However, one can expect that some companies which have traditionally paid dividends and engaged in stock repurchases may find it's more cost-effective to pay out more earnings in the form of dividends. Regardless, the effect on stock values of dividend-paying companies is likely to be positive. Glenn Hubbard, chair of the Council of Economic Advisers, said elimination of double taxation on dividends could boost stock equity values by 20 percent. Economy.com has estimated the aggregate increase in values at 5 percent. Macroeconomic Advisers estimated that the equity value of dividend-paying companies would rise by about 9 percent. Whatever the ultimate effect, a boost in stock market values will support household wealth and stimulate consumption spending.

That sounds pretty good. Are there any real estate investments that may fair poorly?

Real Estate Investment Trusts (REITs) will likely underperform alternative investments, and Low-Income Housing Tax Credits (LIHTCs) may become less valuable. REITs already benefit under current tax law since their dividends are not taxed at the corporate level; thus, REIT dividends are taxed once, not twice. REITs will not benefit from the elimination of double taxation on dividends. A healthier economy will improve the values of assets held in equity REITs, but alternative investments will look relatively more attractive, thus reducing the relative valuation of REITs overall.

LIHTCs reduce the amount of corporate tax. Under the administration's proposal, dividend-paying firms that used LIHTCs to reduce taxes might have a portion of their dividends remain taxable. This could reduce the overall attractiveness and use of LIHTCs and could lower their value. Because LIHTCs have been extensively used to provide equity capital for affordable multifamily construction, new multifamily construction could be scaled back.

Fiscal policy inherently has lags before it affects the real economy, primarily because of the length of time it takes to be enacted. Quick action in Congress is important if the tax cuts are to have much effect this year. In the meantime, the Fed will likely continue its accommodative monetary policy: We see no rate hikes in the first half of the year, with the Fed "taking back" some of its rate cuts in the second half if economic growth accelerates. Thus, interest rates should remain close to their current low levels for much of the first six months of 2003, then rise in the second half. With this rate scenario, 2003 should be an excellent year for housing, with new construction and sales close to 2002's mark. Home-purchase originations are expected to be at or above last year's level and refinance activity will remain strong over the first half of 2003 before falling about 40 percent, with total originations down 20 percent relative to 2002.