What’s at stake: 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. An epic fight is brewing over what Congress and President Obama should do about the expiring Bush tax cuts, with such substantial economic and political consequences that it could shape the fall elections and fiscal policy for years to come. President Obama proposes allowing the Bush tax cuts to expire next year — as they are scheduled to do if nothing is changed — for those earning more than $250,000, but changing the law so as to extend the tax cuts for those earning less than that amount. Republican politicians are opposing the proposal. The fight on Capitol Hill over whether to extend the Bush tax cuts is about many things: deficit reduction, economic stimulus, supply-side ideology.
Deutsche Bank economists argue that allowing the Bush tax cuts to expire will likely depress GDP growth significantly in the near term. The range of possible outcomes is to depress growth in 2011 by anywhere from 0.75% to 1.5%, with a best guess of around 1.1 (assumes multiplier of 0.75). If all the tax cuts are extended except that for the top income bracket, the associated drag on growth in 2011 would be a bit less than 0.5%. Passage of the Administration's proposals in full would mean drag of only about 0.25%.
Mark Thoma argues that we should take the revenue generated from the increase in taxes on upper income households and transfer it to lower income households. That way there won't be any decline in aggregate demand due to the increase in taxes, and since the transfer is from high savers to low savers, it could even provide a bit of additional stimulus.
LT growth impact
Glenn Hubbard, who as chairman of the White House Council of Economic Advisers from 2001 to 2003 was an architect of the tax cuts, writes that there are at least four channels through which Mr. Bush's tax reform raised the long-run productive capacity of the economy – that is, increased the size of the pie. First, since lower taxes mean higher returns to investors, those investors allocate more funds to corporate capital. Second, reducing or eliminating the differential tax treatment between corporate and noncorporate investments means that investment flows are not channelled artificially by tax considerations and the overall productivity of the economy increases. Third, lowering or eliminating taxes on capital mitigates distortions in our financial structure. Fourth, low taxes on dividends encourage firms with few growth opportunities to distribute the funds to shareholders. Putting together the effects of greater capital accumulation and improved capital allocation, Hubbard estimated at the Council of Economic Advisers that, despite slightly higher interest rates caused by an increase in government debt, the president's 2003 proposal raised real GDP permanently by about $75 billion annually.
William G. Gale, co-director of the Urban-Brookings Tax Policy Center, argues that the net effect on GDP growth of the Bush tax cuts is negative. A main selling point for the cuts was that, by offering lower marginal tax rates on wages, dividends and capital gains, they would encourage investment and therefore boost economic growth. But when it comes to fostering growth, this isn't the whole story. The tax cuts also raised government debt – and higher government debt leads to higher interest rates. If estimates of this relationship – by former Bush Council of Economic Advisers chair Glenn Hubbard and Federal Reserve economist Eric Engen, and by outgoing Office of Management and Budget Director Peter Orszag and myself – are accurate, then the tax cuts have raised the cost of making new investments.
Mark Thoma argues that much of the growth that was observed during the Bush years was due to the housing bubble. That growth was illusory, and if we were to adjust for the illusory component of the growth that shows up in the measurements usually cited, the Bush years would look even worse.
Fiscal sustainability impact
Simon Johnson and James Kwak argues that, according to the Congressional Budget Office, extending the Bush tax cuts would add $2.3 trillion to the total 2018 debt. The single biggest step our government could take this year to address the structural deficit would be to let the tax cuts expire. And a credible commitment to long-term fiscal sustainability should reduce interest rates today, helping to stimulate the economy. If some tax cuts are extended — as it seems likely that at least those for the middle class will be — there should be provisions to eliminate them automatically when unemployment falls to a preset level.
Menzie Chinn reports a figure from the Center for Budget and Policy Priorities which shows a decomposition of the budget deficits going forward. While the Bush tax cuts do not account for most of the deficit right now, they are slated to account for a much larger proportion by FY2015.
The impact on small businesses
Howard Gleckman of the Tax Policy Center looks at the effect of letting the Bush tax cuts expire would have on small businesses. Would raising their taxes be a job-killer? That is less clear. Some research suggests that higher tax rates actually encourage small business formation. Why? Because these firms allow their owners to shelter lots of income, behavior that is more lucrative when rates are higher. Other research suggests that higher rates do retard investment and hiring by existing firms. Donald Bruce and Tami Gurley-Calvez, who study small business for the Hudson Institute, have written a nice review of all these issues. While we are not certain about what higher taxes will mean for small business, we know these firms will suffer if they are unable to access capital.
Ed Andrews of the Fiscal Times looks at who would be affected. There is a big difference between “business income’’ and the small-business profits. Business income includes profits from real estate, royalties and limited partnerships for anything from real estate and oil drilling to venture capital and private equity funds. It also includes income from estates and trusts – so trust-fund babies are a part of the mix. Put another way, much of what is often equated with small business income is investment income earned by wealthy people who hold stakes in a wide array of ventures.
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