StanCollender'sCapitalGainsandGames Washington, Wall Street and Everything in Between



Five Myths About the Bush Tax Cuts and the Scourge of Stimulus

31 Jul 2010
Posted by Andrew Samwick

Coming up in tomorrow's Washington Post, Brookings economist Bill Gale discusses these five myths about the tax cuts passed in 2001 and 2003:

  1. Extending the tax cuts would be a good way to stimulate the economy.
  2. Allowing the high-income tax cuts to expire would hurt small businesses.
  3. Making the tax cuts permanent will lead to long-term growth.
  4. The Bush tax cuts are the main cause of the budget deficit.
  5. Continuing the tax cuts won't doom the long-term fiscal picture; entitlements are the real problem.

I recommend the whole thing.  You can look through nearly 6 years of my blogging and not find a single post in support of these tax cuts.  Whatever is left of them should be allowed to expire, and Congress should make its tax policy changes in a deliberate fashion. 

Of the five myths that Bill discusses, I continue to find the first to be the most frustrating.  Here's what Bill says about extending the tax cuts as a means of fiscal stimulus:

But a good stimulus policy can't just be big; it should also offer a lot of bang for the buck. That is, each dollar of government spending or tax cuts should have the largest possible effect on the economy. According to the Congressional Budget Office and other authorities, extending all of the Bush tax cuts would have a small bang for the buck, the equivalent of a 10- to 40-cent increase in GDP for every dollar spent.

I don't even think about tax policy in this way.  I think the government should be only as large as it has to be to complete its essential functions.  Given the required spending, taxes should be high enough to balance the budget over a business cycle.  So I would never suggest a cut in tax rates without also suggesting a time frame over which the foregone revenue would be recouped.

In December 2008, I wrote:

If I had my druthers, the word "stimulus" would be expunged from public discussion, along with "bailout" and "rescue."  These words convey the idea that, because we have so mismanaged our economic and financial affairs, we are somehow able or entitled to conjure up additional funds out of thin air to fix our problems.  There are two problems with this idea. 

First, the purpose of government spending is to purchase goods and services that the government needs to meet its responsibilities, not to hand out resources to those who pandhandle most loudly for them.  The reason to spend more in a recession is not to employ idle resources -- it is to be able to stretch the taxpayers' money further by getting a better price for its purchases because workers without jobs will work for less and owners of empty factories will charge less. 

Second, there is no free lunch: the money we spend today is a loss to the Treasury, whether as "timely, temporary, and targeted" tax cuts that have no discernible impact; payments to delay bankruptcy for large, mismanaged entities, whether AIG or the Big 3; or the largest public works program since the interstate highway system.  That loss to the Treasury must be made up at some future date, by later cohorts of taxpayers. 

Fortunately, both of these problems can be overcome by focusing all new spending on investment rather than consumption and on public investment rather than private investment.  By their nature, capital investments last for years or decades, so that there is a better chance that those who are paying for the spending are reaping its benefits.  Public investment also meets the criterion that the spending goes for projects that are within the government's responsibilities.  Repairing roads today removes the need to repair them for a number of years.  In 2005, the American Society of Civil Engineers released a report card in which it estimated that $1.6 trillion would be required over a five-year period to restore the nation’s physical infrastructure to good condition.  If I had a target of $500 billion to spend, every dime would go for public infrastructure investments, and we'd still have quite a bit of work to do.

Shorter version: Buy what you need and only what you need.  Given that we need trillions of dollars of public investment to meet the government's essential functions, there is plenty of room for fiscal stimulus.  Cutting taxes while leaving needs unmet makes no sense.

Some thoughts on the tax system

I'd really like to see the re-examination of some of the basic features of our tax system:

1. Why should we tax capital gains and dividends at a lower rate than ordinary income?
2. If there are valid reasons for taxing capital gains and dividends at a lower rate, why do we tax them at an essentially flat rate rather than the steeply progressive rate at which we tax ordinary income?
3. If we are going to have a progressive income tax rate structure, why should the top rate kick in at only around $370k per year? Should an individual making $400k per year and an individual making $400 million per year face the same top marginal rate?
4. Why do we allow so many distortionary deductions, such as the home mortgage interest deduction?
5. Why do we have a separate estate tax, instead of just taxing inheritances as income to the recipient?

Broadly, I'd like to see the following:

1. Abolish the corporate income tax. This would get rid of the perverse incentive that encourages debt over equity financing for corporations in a way that eliminating dividend taxes for individuals does not. It would also eliminate quite a bit of unproductive activity where US corporations route transactions around the world to be able to take profits in low tax rate jurisdictions.
2. Tax dividend income as regular income, subject to the same progressive rates as ordinary income. Since the corporate income tax has been abolished, there can be no whining about double taxation of income.
3. Tax capital gains as ordinary income, with the basis adjusted for inflation over the period the asset is held.
4. Eliminate the vast majority of deductions, including the one for home mortgage interest. Increase the standard deduction somewhat.
5. Replace the estate tax by simply taxing inheritances as ordinary income, perhaps with some sort of allowance to prevent having to sell-off family businesses and farms.
6. Add another tax bracket somewhere above the current top bracket but below $1 million. This bracket would be an increase of a couple of percent over the current top rate. Add a second bracket at an income level somewhere between $2-$3 million, this would be a sharply higher rate.

This isn't intended to be complete, just a first pass at getting us closer to sanity while being pragmatic enough to not take the route of throwing out the current system entirely.

I'm curious what you think of this.


"Abolish the corporate income

"Abolish the corporate income tax. This would get rid of the perverse incentive that encourages debt over equity financing for corporations in a way that eliminating dividend taxes for individuals does not. It would also eliminate quite a bit of unproductive activity where US corporations route transactions around the world to be able to take profits in low tax rate jurisdictions."

Lots of companies don't pay dividends despite having profits.


Calling them myths doesn't make it so

Only #4 is actually a myth as proven by fact.

The rest of Gale's "analysis" is based on opinion, not facts:

1. Even the CBO acknowledges that their scoring on the "stimulus" effects of spending vs tax cuts is based on a model--there's no way to measure the differences directly in reality. The idea that tax cuts for high earners don't "stimulate" is simply a built in assumption of the model, not a result. Since lack of capital is a large part of today's downturn, giving high income earners a tax cut will also result in more capital availability due to their higher rate of savings.

2. High income earners don't have to directly own small businesses in order for a tax increase to hurt small businesses. Raise the high income earner's taxes by several thousand a year and they will respond by cutting spending on services they buy, like their home gardener, pool guy, maid, nanny or babysitter or the local deli. And *those* are classic small businesses that will be hurt by tax increases.

Also, lower income earners will see their tax bills rise much more as a percentage of their whole income than high income earners. Adding 50% to the tax bill of a low income earner (from 10% to 15% tax bracket) will affect them much more than adding 10% to the bill of a high income earner.

3. How much government debt affects interest rates is a very disputed topic.

5. You miss the point of those who say that "entitlements are the problem". Cut entitlements solves the problem--something Gale doesn't even address.


1)"The idea that tax cuts for

1)"The idea that tax cuts for high earners don't "stimulate" is simply a built in assumption of the model, not a result."

They don't calculate the multiplier by assuming what the multiplier is. That's a circular argument.

Between 2002 and 2007, real GDP per capita grew at an annualized rate of 1.84%. That's a very sluggish economy. For the sake of comparison, between 1975 and 1980, real GDP per capita grew at an annualized rate of 2.56%. Between 2002 and 2007 we had tax cuts, low interest rates, a housing boom and a defense build up. Hard to argue that the tax cuts had much of an impact with that sluggish number and those other factors.

2)"Raise the high income earner's taxes by several thousand a year and they will respond by cutting spending on services they buy"

If govt spending stays at the same level, the same amount of money is pulled out of the private sector. Govt either gets money by borrowing or taxing. If they tax less, they borrow more. Tax cuts can only stimulate the economy by providing incentives. Again, refer to the sluggish numbers between 2002 and 2007 and you see they failed to provide incentives. Most of the growth was due to the housing boom. 2/3 of all jobs were created in the housing sector during that time.

3)"How much government debt affects interest rates is a very disputed topic."

That's true but again if spending is not cut, the same amount of money is pulled out of the economy. It's a wash unless there are some incentives to invest. For example the appreciated depreciation allowance provided an incentive to invest. Simply giving the hedge funds a tax cut does nothing to encourage business activity as we can see from the sluggish growth numbers between 2002 and 2007.

5)"Cut entitlements solves the problem--something Gale doesn't even address."

No need to address it since voters don't want entitlements cut. According to Harris Poll that Bartlett referred to in his blog, only 18% support cuts in health care. 21% support cuts in unemployment benefits.

Bottom line is that if voters want spending, they need their taxes raised.


A question to address

"Cut entitlements solves the problem--something Gale doesn't even address."

No need to address it since voters don't want entitlements cut.

They don't? Wow. Alas, that does not settle that at all.

According to Harris Poll that Bartlett referred to in his blog, only 18% support cuts in health care.

Bottom line is that if voters want spending, they need their taxes raised.

But voters don't want their taxes raised either.

They certainly don't want their income taxes raised a full 50% across-the-board (or to have to pay any other equally large increase) by 2030, with ever more increases rising forever from there, just to pay for today's level of benefits, as will be required according to CBO.

Else, also according to CBO, the economy will crater under the debt load resulting from the unfinanced benefits, with US bonds falling to "junk", as already projected by S&P and others.

So the bottom line also is that if voters don't want to pony up tax increases on the largest scale ever seen -- larger than for WWII and rising from there -- or live through national bankruptcy (which will not protect their benefits!) then they are indeed going to have to cut promised spending in a serious way. QED.

The problem with "the Harris Poll that Bartlett referred to in his blog" is that it didn't ask the relevant, meaningful question.

That meaningful question is not "do you want to cut benefits?". Hey, who wants their benefits cut for nothing?

The meaningful question is...
~~~~

Do you most prefer to:

(1) Avoid any cuts to Medicare and Social Security benefits by becoming subject ot a 50% across-the-board income tax increase on everyone, all individuals and businesses (or by paying another equivalent tax increase) by 2030, with further increases from there.

(2) Avoid any tax increases from today's level by reducing promised Medicare benefits by 50%, and Social Security benefits by 30%.

(3) Compromise -- split the difference between tax increases and benefit cuts -- by increasing income taxes 25% across-the-board by 2030, while also reducing Medicare benefits by 25% and Social Security benefits by 15% (perhaps through a combination of increasing the retirement age and means testing "the rich" out of these programs and the "well off" into smaller benefits).

(4) Neither cut benefits nor increase taxes, so U.S. bonds become "junk" by 2030, with the economy collapsing and national bankruptcy ensuing soon after.

Please select one: ____.

~~~~~

Unfortunately, this question is not part of the debate. Not at all. Nobody is asking it. Not Harris, not any of the politicians, not bloggers here or anywhere else that I know of.

Eventually this question will be asked, of course, inevitably. But the more time passes before it is, the bigger all those unpleasant percentages will become. So at the bottom line, there is still a question that need be addressed.

It's too bad for all us voters that everybody in the political debate works so hard to avoid addressing it.

Although we can certainly understand the political reasons why both political sides avoid it, and jointly keep kicking the can as far down the road and out of sight as possible. Who says there isn't bipartisanship in today's politics?

[FN: The CBO and S&P projections above were as of 2008. Today's projections are much worse.]


"They don't calculate the

"They don't calculate the multiplier by assuming what the multiplier is. That's a circular argument."

It's not my circular argument--it's theirs. The models used assume a particular multiplier, so that's what they get. The model may not assume it as a direct input, but the multiplier can be calculated directly from the model's actual base assumptions.

"Between 2002 and 2007, real GDP per capita grew at an annualized rate of 1.84%. That's a very sluggish economy. For the sake of comparison, between 1975 and 1980, real GDP per capita grew at an annualized rate of 2.56%. Between 2002 and 2007 we had tax cuts, low interest rates, a housing boom and a defense build up. Hard to argue that the tax cuts had much of an impact with that sluggish number and those other factors."

You are cherrypicking your numbers and presuming that the three factors are the only ones that affect the GDP. You ignore the 1980s boom in GDP growth after the Reagan tax cuts simply because it doesn't fit your mental picture.

"That's true but again if spending is not cut, the same amount of money is pulled out of the economy. It's a wash unless there are some incentives to invest. For example the appreciated depreciation allowance provided an incentive to invest. Simply giving the hedge funds a tax cut does nothing to encourage business activity as we can see from the sluggish growth numbers between 2002 and 2007."

Not true. You are ignoring the dead-weight costs of taxation and government spending. That's Economics 101.

"No need to address it since voters don't want entitlements cut. According to Harris Poll that Bartlett referred to in his blog, only 18% support cuts in health care. 21% support cuts in unemployment benefits."

Funny to see this argument tossed out. If "what the voters wanted" was supposed to matter, then Obamacare would be repealed and there would be a 80' tall fence from the Gulf of Mexico to the Pacific ocean.




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