BY LEE OHANIAN

As the Bush administration stands ready to go to war with Iraq, a thorny question awaits us: How will we pay the price for peace? With the economy still weak, choosing the wrong means of financing the war could be all too easy.

The government has three options: to reduce other federal spending; to borrow by issuing bonds and other treasury securities; or to raise taxes, either through a temporary tax surcharge or by scaling back the Bush tax cut.

Cutting federal spending isn’t a likely option. This leaves borrowing or taxing, and with Federal Reserve Chairman Alan Greenspan sounding new alarms about the rate at which the federal deficit is growing, there will be significant pressure within Congress to raise taxes.
I have compared economic performance during American and British wars going back to revolutionary times and found that debt-financed wars — such as World War II — are much better for the economy than tax-financed wars — such as the Korean War.

The main benefit of borrowing to finance a war is that the debt can be gradually repaid. The approach spreads the cost over a much longer period of time and thus requires relatively small increases in income tax rates. In contrast, a wartime tax surcharge can raise tax rates significantly, which reduces the incentives to produce and invest and thus keeps economic output down.

I estimate that economic output would have been 40% lower during World War II had Congress adopted a balanced-budget policy, such as the one Harry Truman championed during the Korean War. A balanced-budget policy would have prolonged the Great Depression by at least five years and possibly cost us the war, since the Allies might not have been able to afford to stay at war long enough to vanquish Axis powers.

Because a war with Iraq will likely be short and much less costly than World War II, the practical difference between debt and taxes will be small. What is important, however, is how any war finance package affects tax policy in the long run. In the early 1960s, President Kennedy initiated a major long-run improvement in government policy by lowering income tax rates, particularly tax rates on capital income, which includes interest and property income, dividends and capital gains.

These lower tax rates have fostered a strong economy. Prior to the Kennedy administration, only about 45% of the U.S. adult population worked. In contrast, about 58% of the U.S. adult population worked during our last economic expansion.

Reversing this positive trend would be a big mistake. New York University economist Thomas Cooley and I have found that Britain raised capital income taxes to more than 80% during World War II and left them near that level after the war. As a result, private investment in Britain was a paltry 7% of gross national product after the war, and British economic performance lagged sharply behind that of the United States. But over time, British capital tax rates fell substantially to U.S. levels, private investment rose to about 18% of real gross national product and British economic performance improved considerably.

Taxes matter a lot for the level of economic activity, and one reason the United States is the world’s economic leader is because of relatively low taxes. Let’s not throw away 40 years of tax progress.

Ohanian is professor of economics.