Tax cut stalemate in Congress adversely affects the economy

Vijay K. Mathur

Published in Standard-Examiner, October 10, 2010, Ogden, UT

The current debate between the GOP, Democrats and Tea Party enthusiasts on the continuation of Bush tax cuts has created a stalemate in Congress.

Congressional Democrats and the Obama administration would extend most of the Bush tax cuts for individuals with incomes less than $200,000 and families with incomes less than $250,000 a year starting in 2011 (close to 98 percent of income earners) and end tax cuts for those with higher incomes (comprising nearly 2 percent of high-income earners).

Republicans and some blue-dog Democrats, who are fearful of losing upcoming elections, are pushing for extending Bush tax cuts for all income earners, including the top 2 percent. This stalemate adversely affects most Americans and the economy.

Note, since the Bush tax cuts are still in place, all the expansionary effects of the tax cuts are already being incorporated in the current state of the economy. Hence continuation of tax cuts is not likely to provide any more stimulation than it already has, except in some cases.

The unemployed may be enticed to enter the labor market due to the increase in after-tax real wage rate, and others in low to middle income groups may increase their work effort and firm up their consumption plans in response to the certainty of low taxes. The GOP proposal to include top 2 percent of income earners in the tax cut plan is couched in the supply side doctrine, which became popular in Reagan administration.

It professes that lower taxes will encourage work effort, saving, investment, and perhaps productivity. The historical evidence on supply side effects is thin at best. The Tax Policy Center estimates show that under Obama's proposal marginal tax rates will be 0 percent to 15 percent for 85.4 percent of the tax units (tax filers comprising singles, married filing separately or jointly and head of households), 25 percent to 28 percent for 8 percent of the tax units, and the highest rate of 39 percent for 0.1 percent of the tax units; 6.5 percent will be non-filers.

Given a very small fraction of tax filers in the top tax bracket, one should not expect significant supply side effects in response to their tax cuts. It is the uncertainty of tax rates at the current time which matters more to very high income tax payers than the reversion of marginal tax rates to Clinton era levels.  It seems that the GOP and their sympathizers have an exaggerated view of the tax burden of Americans, especially high-income earners.

Many conservative economists support tax cuts for very high-income groups as well. Some cite a June 2010 study by Christina Romer, former chair of CEA (Council of Economic Advisors) in the Obama administration, and David Romer to support their argument. The Romer and Romer (RR) study does find a significant and large expansionary effect of legislated tax decreases, as measured by changes in tax revenue, on output growth. Its maximum effect occurs after 10 quarters (Bush tax cut was enacted in 2001). However RR do not examine effects of changes in marginal tax rates or in different taxes or reducing tax rates of high-income earners on output growth. In addition, the RR study does not claim to prescribe the mechanism through which taxes affect growth, i.e., supply side effect or demand side effect.  Finally, RR admit that their estimates, though significant, are not precise.

The supply-side argument cannot be supported by the RR study. However, evidence on the expansionary effects of lower taxes on the demand side is more convincing, hence lower taxes for 98 percent of income earners makes more economic sense.  Since real wages of many in low to middle-income groups have declined, continuance of lower taxes will tend to increase consumption by removing uncertainty of taxes, thus providing them incentive to increase their work effort, plan for consumption and saving in response to higher after-tax wages.

Laura Tyson, former chair of CEA under the Clinton administration, suggests that part of the revenue gained due to the expiration of the Bush tax cuts for high-income earners could be used to spend on investment programs to increase employment, and part could be used to reduce the deficit; it is a better idea at this time in the recovery process.

One of the most important components of any tax policy is that it should minimize uncertainty. Postponing extension of the tax cuts now for 98 percent of Americans creates uncertainty and will make people hedge on their economic actions beneficial to the economy. However it would be advisable if the Obama administration does look into the modification of taxes -- personal income, payroll, capital gains, corporate and estate -- in the near future. I would be more inclined to reduce corporate tax, increasing income limit of payroll tax, and closing the loopholes in defining capital gains, if the decision is made to reduce capital gains tax in the future.

It is hoped that the decision on tax cuts will be based on evidence and not on ideology.  At the present time, Congress should pass the Obama tax proposal to remove tax uncertainty, put the economy on the path of growth and full employment with minimal inflation, and set the trajectory for deficit reduction.

Mathur is former chair of the economic department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He resides in Ogden. He also posts original blogs for the Standard-Examiner at http://blogs.standard.net/economics-etc/.