Cutting Taxes = Squeezing U.S. Power?

Would a tax cut actually be a bad thing for the United States?

January 17, 2001

Would a tax cut actually be a bad thing for the United States?

As it stands, the first business before the new U.S. Congress will be a cut in income taxes. U.S. business executives who recently met with President-elect Bush endorsed the action and urged Congress to act quickly. Confronted with a rapidly deteriorating U.S. economy, the Republican members of Congress are anxious to act. Even many Congressional Democrats support action on this front.

However, a tax cut is precisely what the U.S. economy does not need today. While economic growth is slowing, the forthcoming recession is caused by a lack of capacity to supply energy, not a decline in demand. Thus, the trouble with the current situation in the United States is a problem which a tax cut is not designed to cure.

Specifically, the nation’s energy sector has reached its limits. For at least the next two years, the supply of energy (whether electricity, natural gas or petroleum) cannot be increased — unless the nation accepts a drastic deterioration in air and water quality. And, in the absence of an increased supply of energy, the economy must limp along.

Take California, which, by itself, is large enough to rank as the world’s 8th largest economy. Here, electricity is in short supply, and utility companies — on the verge of bankruptcy — are threatening so-called rolling blackouts to manage the limited supply they have available.

Last summer already, the manager of the state’s power grid reported that the system had reached its capacity. What the state now needs more than anything is a pause in the recent breakneck rate of economic growth, thus providing time for new capacity to come on line.

But the problems in the U.S. energy sector are far from being limited to California. The absence of additional capacity can also be observed in the U.S. natural gas industry, where the price today is 250% higher than a year ago.

Over the past decade, Americans have gone on a feeding frenzy, using “clean, environmentally friendly” natural gas, instead of coal and oil. Delivery vans today are powered by natural gas. Buses in many cities are powered by natural gas. Most new power plants are powered by natural gas.

Unfortunately, all the while that this feeding frenzy has been going on, no one worried about the supply of natural gas. Instead, supply has been considered someone else’s problem.

“Someone else,” however, turned out to be nobody. The natural gas supply did not grow with demand. Instead, prices have tripled and will triple again.

The United States is also short of refining capacity. Last summer, California and the Midwest suffered from tight supplies of gasoline. This past fall the East coast has been threatened with a shortage of heating oil. Since little has been done to increase capacity, the supply of these products will be little changed in 2001 or 2002 over the level reached in 2000.

Under these circumstances, enactment of a large tax cut will fail to stimulate the U.S. economy as intended, namely by increasing output. While demand will increase somewhat due to a tax cut, many U.S. manufacturers will find that they cannot afford to boost production. Energy will either be unavailable — or will be available only at much higher prices.

This means that President-elect Bush’s planned tax cut will have one of two possible effects: Either it will cause an increase in the rate of inflation — or it will contribute to a further increase in the U.S. trade deficit. Neither effect will be welcome.

Wonder why? Well, inflation rates will rise if the tax cut is spent at home because U.S. manufacturers, confronted with tight energy supplies, will be unable to produce more. And if the money is used to buy imported goods, the tax cuts will obviously boost the U.S. trade deficit.

The most likely outcome is that cutting taxes will do a bit of both — that is, cause the trade deficit to rise and add to inflation. The international reaction to these developments is likely to be quick and negative.

Foreign investors in the United States can be expected to dump dollars, causing the exchange rate to decline.

To make matters even worse, a strong reaction by international investors could force the Federal Reserve to raise interest rates to defend the dollar, effectively neutralizing part or all of the effect of the envisaged tax cut. Tragically, a collapse of the dollar and increase in interest rates could magnify the effect of the recession.

Ironically, top U.S. policy makers faced a similar problem thirty years ago when another Texan ran the nation. George W. Bush may thus be tempted to reflect on what happened back then.

When the administration of Lyndon Johnson desperately attempted to avoid imposing the costs of the Vietnam war on Americans, President Johnson pursued a policy of guns and butter. His administration hoped to spend substantial amounts of money on alleviating poverty while fighting the war in Vietnam.

The inevitable consequence was inflation. In 2001, Americans seek a different, but equally elusive goal: strong growth without any environmental cost. This goal too will prove equally elusive. In the ultimate analysis, given the cards they’ve been dealt, Americans must choose between unfettered growth and clean fuels.