July 31, 2014

Why the President Should Break His Promise on Taxes

I have never been a fan of the Bush tax cuts. I’ve always felt they were too costly, too skewed to the rich, and did too little to make the tax system more efficient. Concord also warned about the 2001 and 2003 tax cuts before they were enacted and has since continuously said they should not be extended without a plan to address the nation's unsustainable fiscal outlook.

The expiration of the cuts, at the end of this year, is fast approaching and policymakers in Washington are struggling to decide what to do with them. President Obama has promised to continue most of the same tax cuts that he himself has criticized for being fiscally irresponsible. Not only has he promised to extend the tax cuts for all households with incomes below $250,000 (at a budgetary cost of $2.2 trillion over ten years), but he also promised to never raise any taxes on households below that income.

However, President Obama has also promised to get the deficit down to a "sustainable" level of around 3 percent of GDP in five years. But the President's own budget, which includes the deficit-financed extension of those "middle-class" Bush tax cuts (that $2.2 trillion worth), isn't consistent with such a low deficit. CBO says that under the President's budget, the deficit would be 4.3 percent of GDP in 2015.

Given the long-term nature of entitlement programs, ongoing war costs, and the fact that the President's budget already calls for a freeze on non-defense discretionary spending (which only totals one-sixths of the federal budget) it is likely that tax increases will have to make up a substantial portion of any effort to quickly reduce the deficit. And these additional higher taxes will have to come despite the President's promise to not raise taxes on those households with incomes under $250,000.

A nice new analysis from the Tax Policy Center, in a paper called "Desperately Seeking Revenue," demonstrates how difficult deficit reduction will be. Table 2 in the "desperate" paper shows that the Administration's budget proposals (on both the spending and revenue sides of the budget) fall $534 billion short of the Administration's 3 percent of GDP deficit goal in 2015. (In contrast, current law, which assumes all the Bush tax cuts expire as scheduled at the end of this year, would fall just $40 billion short of the goal.) Table 3 shows how marginal tax rates (the tax rates on the next dollar of income earned -- those that affect economic incentives) would have to be increased to reduce the deficit to that 3 percent of GDP goal in 2015. If the Bush tax cuts are first extended (as assumed in the Obama Administration's "policy baseline") and then all marginal tax rates are raised proportionately to get us to 3 percent of GDP deficits in 2015, the top marginal rate would rise from its current 35 percent rate to 48 percent. On the other hand, if only the top two marginal tax rates -- those affecting primarily households above $250,000 -- can be adjusted to achieve the deficit goal, then the top marginal rate would have to rise from 35 percent to 77 percent and the second highest rate would rise from 33 percent to 72 percent). The larger the population that is exempt from the tax increase, the more the marginal rate has to rise on those left to pay the higher tax.

While this strategy of limiting deficit-reducing tax adjustments to the top two tax brackets is a highly progressive one, I'm going to step out of character and sound like a supply-sider for a minute here, and argue that the "Obama promise" tax policy would not necessarily be a "good deal" for even the vast majority of households not in the top 1 to 5 percent -- because of that 77 percent top marginal tax rate.

Having a pattern of marginal tax rates that rises so steeply at the top (go back to Table 3, bottom panel, last column on the right) -- with rates of 10, 15, 25, 28, 72.4 and 76.8 percent -- would create huge disincentive effects on labor supply and saving. See, all economists are "supply siders" in a sense, because we all believe that marginal tax rates affect economic decisions at the margin.  

Why did the "supply siders" of the 1970s and 80s worry about high marginal tax rates? The theory was that high rates were so stifling to economic growth that if you reduced these tax rates, the benefits to the economy would "trickle down" from the rich people enjoying the tax cut down to the middle-class people who would get employed by the growing companies the rich people were investing in.

In theory, "trickle down" can work in a negative way, too. If marginal tax rates are raised to prohibitive, other-side-of-Laffer-curve levels, then the labor supply and saving of the rich are reduced, overall economic growth is reduced, and employment and wages -- economy-wide and throughout the income distribution -- suffer. And on top of that, revenue falls (because we're on the wrong side of the Laffer curve), which raises the government deficit, reduces national saving, and in turn reduces economic growth. And the effects of economic growth, particularly on the down side, are very broadly distributed.

I know it must seem odd that I would pull out this supply-side argument as a reason why even middle-class and lower-income households should hope the President doesn't keep his "no middle-class tax increase" promise. But I'm saying so because it's just not good or sustainable tax policy to rely on such a huge increase in taxes on such a small percentage of the population to fund a cause (deficit reduction) that would otherwise have large and broadly-distributed benefits.

I get back to my position that the easiest way to stick with current-law baseline revenue levels (which get us close to the 3 percent of GDP deficit goal) is to stick with current law, where all of the Bush tax cuts expire as scheduled at the end of this year. No taxes would need to be reformed, and in fact no tax legislation would need to be passed and signed! Of course, a better way would be to stick to current-law revenue levels by reforming the tax system -- broadening the tax base to make it more efficient so that marginal tax rates would not even have to come up and we could still raise more revenue to achieve our deficit goal. But people (regular people and policymakers) seem to forget that if we let the Bush tax cuts expire, in the "worst" (or laziest) case we just go back to Clinton-era tax policy, which really isn't so bad. In fact, if you go back to the "desperate" paper and Table 3, the first two columns on the left in the bottom bank show marginal tax rates if the Bush tax cuts expire (those Clinton-era tax rates of 15, 28, 31, 36, and 39.6 percent), and if those rates are raised proportionately (and just a little) to achieve the 3 percent of GDP deficit goal. The marginal rates in that "break tax promise, keep deficit promise" scenario are 15.5, 28.9, 32.0, 37.1, and 40.9 percent. I would argue that this structure of tax rates would be much better for our economy as a whole than the "Obama dual promise" rates that go up to that Laffer-esque 77 percent at the top and yet are barely lower at the bottom and middle.

So this is one of my arguments for why the Bush tax cuts should be allowed to expire and why President Obama's campaign promise on taxes needs to expire, too.

Update: The Wall Street Journal has a widely circulating graphic that shows some of the Tax Policy Center data on tax rates: