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The tax compromise

What’s at stake: The compromise between the Administration and congressional Republicans announced on December 6 (the McConnell-Obama Deal) includes the extension of significant temporary tax cuts relative to current law and extends emergency unemployment benefits. The net budgetary effect relative to current law is estimated to be roughly $900 billion over the next 10 years […]

By: Date: December 16, 2010 Topic: Global economy and trade

What’s at stake: The compromise between the Administration and congressional Republicans announced on December 6 (the McConnell-Obama Deal) includes the extension of significant temporary tax cuts relative to current law and extends emergency unemployment benefits. The net budgetary effect relative to current law is estimated to be roughly $900 billion over the next 10 years and confirms the absence of willingness of the US administration to tighten fiscal policy at this stage. Beyond the deal’s impact on the US economy, its consequences for fiscal sustainability and for the chances of Obama to be re-elected, the deal accentuates the divergence of approach between the US and Europe.

What’s in it?

Macroadvisers has a summary of the deal. It extends for two years essentially all Bush-era tax cuts; extends emergency unemployment benefits through the end of 2011; provides for new business investment incentives in the form of 100% expensing of most types of capital equipment in 2011, and 50% bonus depreciation in 2012; provides during 2011 for a one-year payroll tax reduction for employees of two percentage points; provides for a two-year fix of the alternative minimum tax (AMT); provides for the two-year extension of a variety of the American Recovery and Reinvestment Act (ARRA) and other stimulus-related business and individual tax provisions (EITC, American Opportunity Tax Credit, Child Tax Credit).

Austan Goolsbee, Chairman of the Council of Economic Advisers, discusses the President’s compromise framework on tax cuts, unemployment insurance and job creation on a video at the White House Blog. James Kwak writes that Goolsbee is basically trying to convince you that Obama won: Republicans wanted the top-end tax cuts and Obama wanted the “middle-class” tax cuts, and Obama conceded the top-end tax cuts, but in exchange he won lots of other great things: unemployment insurance extension, some sweeteners to the earned income tax credit, the American Opportunity tax credit (for college), some sweeteners to the child tax credit, lower payroll tax, and an extension of some business investment credits. But it’s all tax cuts (except for unemployment insurance), so also clearly a win for Republicans. As Felix Salmon puts it: this is tax cutting, Oprah-style: you get a tax cut! And you get a tax cut! And you! And you! You all get a tax cut!

David Leonhardt says that, quantitatively, the President got a good deal: of its estimated $900 billion-plus cost over two years, roughly $120 billion covers the high-end tax cuts and the estate tax cut, $450 billion covers Mr. Obama’s wish list and $360 billion covers the tax cut extensions both parties favoured. Yet Rortybomb argues in this post that the breakdown of who won what is substantially different and that the Republicans were in fact advocating themselves a number of extensions and new tax cuts which the administration now considers its victory.

Impact estimates

The Congressional Budget Office has released an estimate of the cost which adds to USD 857bn budgetary outlays over the next 10 years and about USD 373bn in 2011.

Mark Zandi presents a table of the multiplier for each tax measure and argues that the deal’s surprisingly broad scope meaningfully changes the near-term economic outlook. Real GDP growth in 2011 will be nearly 4%, approximately 1 percentage point greater than previously anticipated. Job growth will be more than twice as strong, with payrolls growing by 2.6 million. Unemployment will be more than a percentage point lower; instead of hovering near 10% through the year, it will end 2011 well below 9%.

Paul Krugman suspects that Zandi’s multipliers assume that more of the payroll tax cut would be spent than is likely to be the case, and has severe doubts about whether the business tax cut would do anything noticeable. Instead, he thinks that this will raise GDP by 0.7 percent relative to otherwise; rule of thumb is that one point on GDP is half a point on unemployment, so add 0.35 points to the CBO numbers. FT Alphaville has an interesting discussion on the extent of deleveraging and the size of multipliers. In a recent essay, Greg Ip argued that the savings rate seemed to stabilise at around 6% and household deleveraging was far enough along that it could continue even while consumers started spending again, meaning that we could expect most of the tax cut to be spent contrary to what happened in 2009.

Ezra Klein argues that it is more accurate to say that this money is anti-contractionary rather than stimulative since most of the money just keeps programs that are currently in effect from expiring. It’s important that the White House doesn’t repeat the mistake it made in the original stimulus and overpromise how much this will do for the economy.

The Payroll Tax cut as a hidden threat to social security

Mark Thoma sees the payroll tax reduction as potentially troublesome. Though the revenue the Social Security system loses due to the tax cut will be backfilled from general revenues, the worry is that the tax cut will not expire as scheduled. That’s especially true in this case since labour markets are very unlikely to recover within the next year and it will be easy to argue against the scheduled "tax increase" for workers. In fact, it will never be a good time to increase taxes on workers and if the tax cut is extended once, as it’s likely to be, it will be hard to ever increase it back to where it was. That endangers Social Security funding – relying on general revenue transfers sets the system up for cuts down the road. For that reason, Thoma would have preferred that this be enacted in a way that produces the same outcome, but has different political optics, that is, leaving the payroll tax at 6% on the books and keep sending the money to Social Security, and fund a 2% tax "rebate" out of general revenues. The rebate would come, technically, as a payment from general revenues rather than through a cut in the payroll tax, but in the end the effect would be identical. But the technicality is important since this alternative option would have preserved the existing funding mechanism for Social Security even if the payroll cut is permanently extended.

The Payroll Tax cut: right cut, wrong side?

EconLog argues that Obama is giving all of it to employees, where it does the minimum good. With perfectly flexible wages, it doesn’t matter whether tax law says "employees pay" or "employers pay." Tax incidence depends on supply and demand elasticity, not legislative intent. If wages are nominally rigid, however, the law matters. If you cut a tax on employers, this reduces labour costs, increases the quantity of labour demanded, and reduces surplus labour. If you cut a tax on employees, in contrast, this increases worker compensation, increases the quantity of labour supplied, and increases surplus labour. Instead of giving the tax cut to employers, where it would do the maximum good, or splitting it evenly, where it would do intermediate good, Obama is giving all of it to employees, where it does the minimum good.

The CBO backs up the claim that the payroll tax cut would be more stimulative if it went to employers rather than employees. And Greg Mankiw adds that it would also have increased business cash-flow and, to the extent that firms are cash-constrained, increased business investments.

The fiscal danger: temporary cuts becoming permanent

Antonio Fatás points that there is one clear lesson from this experience: reducing budget deficits in the U.S. will be a challenging task. Given what we have seen this week, finding a balance between short-term goals and long-term sustainability and making difficult decisions to reduce budget deficits will require substantial changes in the way politics and policy are done in the U.S. Mohamed El-Erian adds that officials must explain how further short-term deterioration in America’s budget deficit will eventually give way to medium-term fiscal responsibility if they don’t want the impact of the measures on economic growth to erode over time.

The tax deal and the political cycle

Paul Krugman argues that the tax-cut deal makes Obama’s re-election less likely. Estimates of the new deal point to a boost to the economy in 2011, which is then given back in 2012. So growth is actually slower in 2012 than it would be without the deal. Now, what we know from lots of political economy research — see Larry Bartels especially — is that presidential elections depend, not on the state of the economy, but on whether things are getting better or worse in the year or so before the election. It’s outrageous — but it’s what the evidence says.

Lane Kenworthy writes that comparisons to Jimmy Carter are becoming commonplace. But Bill Clinton got the same kind of flak and managed to get re-elected. In the end, the key difference between the Carter and Clinton presidencies wasn’t clarity of vision, a big idea, decisiveness, toughness, progressiveness, or partisanship. It was how the economy performed as each approached re-election. If our economy gets back on its feet, President Obama and his party are likely to fare well in the 2012 elections, and images of Obama as Carter redux will be a distant memory.

Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.


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