July 30, 2010
During the George W. Bush administration, Congress enacted a number of large tax cuts, none of which were made permanent. They all expire at the end of this year, which will impose a large tax increase on Jan. 1 unless they are extended. Congress is now in the midst of deciding what do to.
More than likely, Congress will just kick the can down the road and extend all of the tax cuts for another year. Given the weakness of the economic recovery, it would be unwise to raise taxes; economists across the political spectrum are united on that. Unfortunately, this means that substantive debate on the efficacy of the Bush tax cuts and alternatives that might be better for the economy will be put off until next year.
The only issue that is really at stake is an effort by the Obama administration and Democrats in Congress to allow some of the tax cuts affecting those making more than $250,000 per year to expire. Naturally, Republicans are up in arms about the possibility, insisting that the rich are the drivers of growth, while Democrats argue that a small increase in the top statutory income tax rate from 35 percent to 39.6 percent is justified by fairness and is very unlikely to affect growth.
Politics Trumps Substance
Basically, both sides are talking past each other, trying to score cheap political points rather than make substantive arguments about the actual effects of extending some or all of the Bush tax cuts. Republicans want to paint the Democrats as tax boosters whose ideological hatred of the rich threatens to derail the recovery. Democrats are seeking to portray Republicans as plutocrats concerned only for the well-being of the wealthy and indifferent to the problems of average Americans.
What neither party seems much concerned about is the cost to the economy of having a tax system with many key elements that cannot be predicted more than a few years in advance. To the extent that businesses and consumers have concerns about government policy, the uncertain course of tax policy is probably the biggest. Yet it has been the explicit policy of Republicans in Congress for the last 10 years to make tax policy as unpredictable as possible. The result has been to greatly diminish the positive effect of their own tax cuts.
When supply-side economics was first developed in the 1970s, one of the main arguments for it was that there had to be some permanence to tax changes or they would not affect behavior. Thus the supply-siders argued strongly against temporary tax changes and those that did not affect incentives but merely altered disposable income. One of the defining episodes in the development of supply-side economics was Jimmy Carter’s proposal for a $50 rebate in early 1977, which the supply-siders ridiculed. Only a permanent tax rate reduction would do any good, they argued.
The supply-siders were also strongly influenced by something called the permanent income hypothesis, which was devised by the great economist Milton Friedman. His research showed that people only change their spending in response to a permanent change in their income, such as a pay raise, but not to one-time or temporary changes. Windfalls tend to be saved and losses of income not viewed as permanent are covered by borrowing or withdrawals from saving so as to keep consumption on an even keel.
Unfortunately, this thinking was completely forgotten when George W. Bush took office in 2001. One of his first actions was to support a $300 tax rebate for individuals and $600 for couples. The idea was really pure Keynesian economics — just put dollars in peoples’ pockets and they will run out and spend them, sales will rise, workers will be hired and growth will be stimulated, so the theory goes.
Not surprisingly, subsequent research by University of Michigan economists Matthew Shapiro and Joel Slemrod showed that the 2001 rebate was mostly saved, just as Friedman’s theory predicted. Consequently, it had little impact on consumption or growth. Yet despite the failure of the 2001 tax rebate, the Bush administration demanded another one in 2008 that was also a failure according to the Congressional Budget Office.
Expiring Tax Cuts: A History
Many other tax cuts were enacted in 2001 and 2003, as well. But because of an obscure legislative process called reconciliation that the Republicans needed to avoid a Democratic filibuster in the Senate, none of the tax cuts could be made permanent. Of course, Republicans could have negotiated with Democrats on a bipartisan package of tax cuts that would not have been threatened by a filibuster and could have been made permanent, but they chose not to go that route.
Republicans rationalized that it was better to do what they wanted to do the way they wanted to do it even if it was only for 10 years, rather than water down their tax proposals with Democratic provisions. Furthermore, Republicans believed that when the time came and the tax cuts expired, Democrats would not dare to allow a de facto tax increase to take effect and would support their extension. Thus the temporary tax cuts would effectively become permanent, Republicans believed.
The problem is that tax cuts really have to be permanent before you get a supply-side effect, which often involves investments that take time to pay off. Unless people have some reasonable expectation that the tax regime under which they make the investment will still be in place when the payoff comes, they won’t make it. This includes investments in human capital, such as getting additional education or training.
Some Republicans respond that even permanent provisions of the tax code are not actually permanent because the law can always be changed and indeed often is. Nevertheless, there is a difference between a permanent tax change and one with an expiration date. People’s expectations are sensitive to the difference and the economic impact is significant.
For example, the research and experimentation tax credit was first enacted in 1981 and never made permanent despite repeated requests from Republican and Democratic administrations. Although the credit has always been renewed, studies show that the lack of permanence greatly inhibits its effectiveness. Businesses tend to treat the R&E credit as a reward for what they were going to do anyway and not as an incentive to do additional research and experimentation.
In other cases, the lack of permanence makes it impossible to do financial planning. One of the stupidest things the Republicans did was to phase out the estate tax and abolish it for one year only — this year. Already, some billionaires, including New York Yankees owner George Steinbrenner, have died and their estates saved hundreds of millions of dollars in taxes. But because the abolition is not permanent, the estate tax comes back next year just as it was before the phaseout began. No one has any idea at this point what estate tax regime will exist in 2011 — a nightmare for anyone needing to write a will.
The irony of this is that Republicans have always maintained that their tax policies were based on supply-side economics and they continue to do so. But except for a few isolated provisions, such as the cut in the top rate and reduction in the capital gains tax, the overwhelming bulk of Republican tax cuts consisted of tax rebates and tax credits with no incentive effects whatsoever. And the lack of permanence severely undermined whatever supply-side effects might have been achieved from the good provisions.
Under normal economic conditions, it wouldn’t be hard to argue that there isn’t much to lose in terms of economic growth from letting all the Bush tax cuts expire and using the money to reduce the deficit. According to a Pew Research poll, only 30 percent of Americans want to keep all of the tax cuts and 31 percent say we should get rid of all of them. At worst, we would go back to the tax regime we had in the 1990s, when growth was far more robust than in the 2000s.
It would have been far better to use the expiration of the Bush tax cuts to reform the tax system and put everything on a permanent basis or get rid of it. But these are not normal times, either economically or politically. Consequently, kicking the can down the road is really the only option available under the circumstances.