About Those Tax Cuts

One has to question the political wisdom of the Obama administration's decision to let the Bush tax cuts expire on those making over $200,000 annually. While our exploding deficit will probably require a combination of entitlement reform (cutting spending) and raising taxes in the future, letting the tax cuts expire this year while the recovery has stalled and we're still hovering around 10% unemployment will impede growth in the short term. The Obama administration may be resigned to large GOP gains in the midterm election, and will probably use the tax cut issue as a foil against the GOP who they'll charge as hypocrites for posturing as deficit hawks, and chanting forever more it's a return to the failed policies of Bush.  However, it's a double-edge sword for the administration if the tax raises hurt the economic recovery, which in all likelihood, they will. And the GOP can always comeback by not appropriating funds for Obamacare if they win the House.

Bernake recently told Congress he supported more short term stimulus for the economy, saying these tax cuts would be a way to help strengthen the recovery, although he qualified they needed to be offset. While Greenspan is in favor of letting the cuts expire in order to tackle the deficit, he also admits it will probably slow growth. A CNBC article notes that analysts at Deutche Bank believe letting the tax cuts expire will hurt economic growth quite a bit:

Deutsche said the drag on gross domestic product should they lapse could be as much as 1.5 percent, with the more likely impact at 1.1 percent.

The impact would be worse, the analysts said, if Congress fails to fix the Alternative Minimum Tax, which was enacted in 1969 to make sure rich people pay taxes but was never indexed for inflation, and thus is now hitting middle-income workers.

"In a worst-case scenario, allowing the Bush tax cuts to expire and failing to fix the AMT could result in (1.5 percent) of fiscal drag in 2011 on top of the 1 percent fiscal drag we expect to occur as the Obama fiscal stimulus package unwinds," Deutsche said in a note to clients. "If the recovery remains soft/tentative through early next year, this additional drag could be enough to push the economy to a stalling point."

This on the heels of a AP survey of economists who believe the GDP will grow weakly at less than 3% for the remainder of the year, and unemployment will be unchanged. Economists say the economy has to grow at least 5% a year for unemployment to come down 1 percentage point.  As AP notes, consumer spending is still tepid; raising taxes on high earners isn't going to give it a shot in the arm. And as the Bloomberg article points out, Bernake doesn't have much room left to maneuver in monetary policy; the federal funds rate is already at 0.25%.

Further, the raises in marginal tax rates will hurt many small businesses who fall within the top two rates, as noted by Americans For Tax Reform. While liberal think tanks like the Tax Policy Center like to tout that only a small percentage of small businesses make over $200,000, they don't like to mention that these are the small businesses that employ the most people.  Industry standards for small businesses in some sectors of the economy like manufacturing and mining employ up to 500 people. Moreover, most small businesses are organized as either a sole proprietorship or as a pass through entity for tax purposes. That means while the dollar amount of profit may sound high as reported to the IRS, it is often split among ownership and then taxed at personal rates. Much profit is also reinvested back into business for purchasing new equipment, advertising, more hires, etc.  Finally, profit from one good year can ride out a bad year (like the current one) and prevent forcing business owners into layoffs.

Harvard Economics Professor Greg Mankiw has written a thoughtful article that examines whether  government spending or tax cuts would be more effective in stimulating the recovery.  Some major points:

1) Research shows that broad cuts in marginal rates are a better stimulus for the economy than government spending. One study showed they were 4x as potent as government spending.

2) A stimulus needs to be injected quickly in the economy. Government spending often goes through so much bureaucratic red tape before it actually is spent, and is often allocated inefficiently. Tax cuts can be felt immediately by small business owners (a sector that accounts for the majority of job creation) who will allocate the returns more efficiently.

3) Not all tax cuts are created equal. While Obama's stimulus plan had some tax cuts and tax credits, narrowly targeted cuts like, for example, providing tax credits to businesses who make new hires are difficult to implement. Some industries like construction are so far below their baseline of employees to be eligible for tax credits, that it will not offer them any additional incentive to hire new employees. It may even cause existing businesses to layoff employees and instead contract services out to new startups to be eligible for the credit. The lesson here is that tax cuts should be implemented broadly, at marginal rates.

The bottom line is that while taxes will eventually have to go up to cover the deficit, it would be sensible to take a pause and delay the expiration of the Bush tax rates until the recovery is more solid. Democratic Sen Bayh explains why this is his position with Larry Kudlow. The money quote is around 4:45 where Bayh specifically rejects class warfare rhetoric and points out we're all in this together.