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Senate Tax Cut Proposal Not Enough To Repair US Economy

Introduction
The market was anticipating a massive tax cut coming out of the Bush administration of around $750 billion. Now the Senate wants to cut the package down to $350 billion, almost half of the originally expected amount.

Analysis
The Senate believes that due to widening budget deficits and future war funding, the US economy can't afford a big tax cut. On the other hand, a tax cut could be pushed if politicians cut spending. Although, needing to please its constituency, spending will do anything but march lower. As such, to expect the budget deficit to narrow requires increased revenues, lower spending, or a compromise somewhere in the middle.

The Argument
The Bush Administration believes putting money back in the private sector over public sector is a boon for the economy. We side with the Bush Camp. On the other side, we have the deficit hawks clamoring that higher deficits lead to higher interest rates. One must look no further than Japan to argue that higher public deficits need not lead to higher interest rates. Japanese interest rates are zero and real rates are negative despite one of the highest budget deficits as a percentage of GDP of any developed country. Furthermore, the US public deficit as a percentage of GDP is far smaller than it was in the early 80's or early 90's. In addition, we know that without a tax cut public spending will be required, AT SOME POINT, to stimulate growth. And on that point, we can look at the Japanese experience. Despite several public works projects, the Japanese economy remains in sluggish form. The private sector has little confidence and consumers won't spend.

A Compromise
So with the Japanese experience as a guidepost, Congress seeks a compromise. How about a tax cut but just a smaller one? Instead of the $750 billion dollar tax cut proposed by Bush, the Senate just proposed a reduced $350 billion dollar tax cut package.

Senate proposal
To put this tax cut in perspective, turn your attention to the following charts:


The first chart depicts US GDP around 10 Trillion for 2002. The second chart is our forecast of the proposed tax cut as a percentage of US GDP in years 2004- 2006. Tax cuts would make up only .5% of GDP, a drop in the bucket. The tax cuts we forecasted included frontloading the numbers as opposed to a straight line calculation over the 10 year period.

Not enough of the right medicine
In our view, what the US economy needs to heal is balance sheet restoration. The US consumer needs to save. Whether it comes from a tax cut that consumers save or whether its consumer retrenchment, the government must make sure that consumers build a cash hoard to solidify a sound future for our economy. And please note, the savings rate during the prior Gulf War was close to 9% more than double the current rate. One of the reasons why following the first Gulf War the economy rebounded so quickly and why this time around the economy won't follow the same path. THE PENT UP DEMAND ISN'T THERE THIS TIME AROUND!

The main reason i don't believe the US economy can sustain its current growth rate is due to a low US savings rate. Without a tax cut to push the private sector towards net surplus, we can only tap our savings so much before we turn to debt. From our work, the US economy needs growth with solid savings and lower debt levels. Until that happens, the current situation is an imbalance in need of a correction.

As we can see from the chart, when the consumer doesn't have savings debt is used to propel the economy. This is not a sustainable situation. You can't borrow your way to prosperity.

Conclusion
The US economy needs a massive tax cut to boost savings and repair household balance sheets. Instead, we could get a tax cut that amounts to a drop in the bucket relative to the size of the US economy. This will do nothing to stimulate spending nor will it do anything to help resolve any imbalances in the US economy. Ironically, a move to curb budget deficits today could signal a shift for the public sector to take even greater share of the economy from the private sector in the future. History has lessons to teach us, we choose to ignore the Japanese experience. It has been oft stated, "Those who fail to learn from history are doomed to repeat it".

Charts courtesy of: http://www.economagic.com

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