You’ve all heard the cliche enough times used in international diplomacy: “All options are on the table.” Of course, that’s code for the military option or even the nuclear option. Here, I want to use that metaphor to discuss our current debate about tax policy. Since the previous administration and legislature wrote into law that the “Bush tax cuts” must expire, we’re now faced with the predicament that lots of taxes will be raised amidst an anemic economy if something isn’t done, but if we extend them the deficit problem will be even worse. The locus of the debate or, if you will, the options on the table seem to be that we do nothing and let all the tax cuts expire, extend all the tax cuts, extend all but those for the wealthiest taxpayers, or compromise by extending the tax cuts for only 2 years.
The argument for extending all the tax cuts is pretty simple. Raising taxes now during a weak economy is going to make the economy worse, not better. Cato’s Jeff Miron wants to see them extended permanently.
Extending the Bush tax cuts — permanently — is a crucial step in restoring economic growth. The Bush cuts provided lower taxes on ordinary income, especially for taxpayers at the high end of the income distribution. These are some of the most energetic and productive people in society; raising tax rates would discourage their effort and entrepreneurship. High-income taxpayers also have multiple ways of avoiding high tax rates, so any revenue gain from raising rates would be modest.
Alan Viard of AEI likes them all too.
The figure shows the increases that will occur in marginal tax rates at the top income levels if the high-income rate reductions (including the dividend tax cut) expire. Beginning in 2011, the top income-tax bracket for wages and self-employment income, and for ordinary investment income, would revert from 35 to 39.6 percent; wages and self-employment income would continue to face an additional 2.9 percent Medicare tax. The top capital-gains tax rate would revert from 15 to 20 percent. Dividends would lose their current 15 percent tax rate and become taxable as ordinary income, subject to the new 39.6 percent rate. All four categories of income would also face a 1.2 percent stealth-tax-rate increase, from the restoration of a provision that phases out itemized deductions at high income levels.
Economists left of center like Paul Krugman think that extending the top-rate tax increases is not worth the $700 billion price tag (sounds hypocritical but it’s well reasoned).
Now, consider first what would happen if we extend the [high-end] tax cuts for the next 10 years. This would add $700 billion to the debt (pdf). If the rich spread their windfall evenly across the decade, that’s $70 billion a year in additional consumer spending — or $140 billion during the period when we need it. So, $700 billion in deficits for $140 billion in stimulus; not a good bargain!
Alternatively, suppose we extend the tax cuts for only 2 years. That’s only $140 billion on the deficit. But the rich, knowing that it’s temporary, won’t spend much of it — if they really operate on a 10-year horizon, they’ll spend only $14 billion a year more, so $28 billion of stimulus when we need it, in return for $140 billion of debt; still a lousy bargain!
Just for the record, it’s not like the rich wouldn’t get a tax cut under the Democrat’s proposal.
Most famously President Obama’s former OMB director, Peter Orszag wants to extend all the tax cuts for 2 years, then let them all expire.
In the face of the dueling deficits, the best approach is a compromise: extend the tax cuts for two years and then end them altogether. Ideally only the middle-class tax cuts would be continued for now. Getting a deal in Congress, though, may require keeping the high-income tax cuts, too. And that would still be worth it.
In a great piece, Bruce Bartlett explains why the Bush tax cuts were inefficient, of little benefit, and harmful to the debt, but acknowledges that during this
recession recovery economy it’s probably best we just extend them.
Subsequent research by Federal Reserve economists has found little, if any, impact on growth from the 2003 tax cut. The main effect was to raise dividend payouts. But companies cut back on share repurchases by a similar amount, suggesting that only the form of payouts changed. (See here, here, and here.) Moreover, according to a study by Steven Bank of the UCLA law school, the fact that the dividend tax cut was temporary was a key motivation for higher dividend payouts; had the dividend tax cut been permanent, as the supply-siders favored, the impact probably would have been much less.
Maybe the answer is obvious (politics) but I’m not sure why these are the only options on the table. Can’t we extend the table? The nuclear option doesn’t even seem to be an option right now. But now may be the perfect time to blow up the tax code and put a new one in place. Here’s the diplomatic stick for the Administration to use: “Let’s put in a simpler, better tax code or all the tax cuts are going to expire and opponents will be responsible for raising taxes on Americans at the worst possible time.” There’s a carrot too: “You get to support a simple efficient tax code that everyone has long claimed they support.”
I honestly have trouble understanding why we have to extend poorly designed, little bang-for-the-buck tax cuts rather than doing something that could really be a huge boon for the economy. Talk about a game-changer from the Obama Administration! A Democratic administration gets to be the one supporting fundamental and economically productive tax reform while forcing the Republicans (or Democrats), if they vote against it, to be essentially responsible for raising taxes and blocking what a lot of their supporters favor. If Republicans are really worried, rest assured that the tax reform wouldn’t be able to save the economy soon enough to have a dramatic positive effect by the election so the GOP candidates will still have a great chance to pick up a ton of seats – and most likely take the House. Will businesses, conservative intellectuals, and angry tea-partiers (so-called small government types) really be able to support the Republicans ever again if they don’t jump on an opportunity like this?
I’ve long touted a VAT as a potential replacement for our absurd tax code. Many mainstream conservatives have even had good things to say about it assuming it was replacing the tax code, not being added on top of it. Here’s a favorite option of progressive policy wonks – something that might appeal to Obama, that I’d be excited to support: the progressive consumption tax. Maybe the Democrats could even slip in some decent energy policy (that they’ve given up on) by raising energy taxes as part of tax reform. Even a flat tax that conservatives have often pushed for would be better than the status quo. Lots of different and better options have to exist rather than being stuck with tinkering with the Bush tax cuts.
If the problem is just lack of time, I’m not sympathetic – everyone has known since the Bush tax cuts passed that they were going to expire. It seems difficult to imagine a potentially better time to force lawmakers’ hands to simplify the tax code than now. We’re in desperate need of new revenue, the weak economy could strongly benefit from a more efficient tax code, taxes will automatically rise if nothing is done, and sometimes it takes the people you’d least expect to be able to dramatically shift course. Think of Nixon going to China or Clinton with welfare reform. What Republican wants to be outflanked by a “socialist president” on tax reform? President Obama might be able to drag along enough in his own party to support a tax reform that the business community surely must favor.
It seems perverse that such extreme options can be on the table for international relations but are so limited for domestic issues. When it comes to tax policy, I welcome the mushroom cloud.