Tax vs. Interest Rate Cuts

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Includes: DIA, QQQ, SPY
by: Vahan Janjigian, CFA

David Wessel wrote an excellent article in yesterday's Wall Street Journal about the need to stimulate the economy. While everyone agrees that the economy is slowing and needs a boost, Wessel wonders if it is better for the Fed to continue cutting interest rates, or if a tax cut would be more effective. He pretty much rules out hope for a tax cut arguing that Congress is unlikely to agree to one.

That's too bad because the Fed cannot realistically cut rates anymore, and because tax cuts are indeed much more effective in stimulating economies. Even former Clinton-era Treasury Secretary Lawrence Summers is now pushing for tax cuts.

Why can't the Fed cut rates? Because inflation is rising. Since September, the Fed dropped both the discount rate and the fed funds rate by a hundred basis points each. Although it takes time for interest rate cuts to stimulate the economy, these recent cuts appear to be having little (if any) effect. They have, however, helped to trash the dollar. While U.S. exports have risen, which is certainly a good thing, so has the level of inflation. Higher inflation makes it very unlikely that the Fed will keep cutting rates.

Many economists are hoping that lower interest rates will soon revive the housing market. But the Fed's actions have not lowered mortgage rates. Furthermore, the housing market will remain in the doldrums for quite some time. There is simply too much inventory on the market. And no rational person would buy a house if he expects the price to keep falling--even if he could get a zero percent mortgage.

That brings us back to tax cuts, which of course are not popular with the liberal set. Liberals argue that tax cuts typically benefit only the wealthy. Yet if tax cuts must be implemented, liberals would rather see those in the lower income brackets get the cuts.

But how is that possible? After all, by definition tax cuts only benefit those who actually pay taxes. Because our income tax code is so progressive, those in the lower income brackets hardly pay any tax at all. How many Americans realize that the bottom 50% (by income) of our population pay only 3% of all individual income taxes? How could Congress possibly deliver a meaningful tax cut to this group? The only way to truly help those in lower income brackets is to implement policies that stimulate economic growth and create opportunities for all members of society.

For many working Americans, the tax burden is much too heavy. The combination of federal income taxes, state income taxes, property taxes, sales taxes, and all those other hidden taxes can easily eat up more than one-half of income. Property taxes, in particular, have literally gone through the roof in many parts of the country. If politicians really want to stimulate the housing market, the most effective way would be to immediately cut property taxes and limit how high they could go in the future.