The announcement that real gross domestic product grew at a 4.2 percent rate in the first quarter is good news. But one cannot help but feel that we should be doing better. Real GDP normally grows much more rapidly in the early stages of economic expansions following a recession. One possible culprit for the less-than-hoped-for growth may be the phasing-in of key elements of the 2001 tax cut.
The way tax policy affects individual decision-making is complex. Some tax changes mainly affect the average tax rate -- taxes as a share of income. Others affect the marginal tax rate -- the tax on each additional dollar earned. Because average and marginal rates affect people differently, when both are changed simultaneously, it is sometimes hard to figure out their economic effects.
For example, an increase in average tax rates with no change in marginal rates theoretically could increase labor supply. That is because workers will have to work more to make up the income lost to higher taxes. Conversely, a reduction in average tax rates might lower labor supply because workers need not work as much to have the same after-tax income. Economists call this the income effect.
Changes in marginal tax rates are less ambiguous. If average tax rates are unchanged and marginal rates are increased, people clearly will have less incentive to earn taxable income because they will keep less of each additional dollar they make. They will work and save less and put more effort into saving taxes. All other things being equal, a reduction in marginal tax rates with average rates unchanged will always lead to increased output. Economists call this the substitution effect.
Another complicating factor is timing. We saw this in 1992, when there was a bulge in income realizations late in the year as people anticipated higher taxes after the election of Bill Clinton. Hillary Clinton's law firm, for example, distributed bonuses in 1992 that otherwise would not have been paid until 1993. While the number of people who have this much flexibility in the timing of their income this way is small, the same principle applies to all income earners. In the aggregate, the impact can be large.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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