Friday, May 28, 2010

Will Tax Increases Derail the U.S. Economic Recovery?

With great trepidation, fear of being tarred and feathered, burned at the stake, thrown under the bus, or tied on the rails in front of a high-speed locomotive, the concern over tax increases derailing the U.S. economic recovery may, just may, be too narrow a view of economic policy.

The debate on tax increases, always hot, is heating up. Supply-siders warn that raising tax rates during an economic slowdown, especially on capital income, is just plain dumb. They argue that higher tax rates will reduce the supply of new capital, discourage small business formation, retard job creation, all the while failing to achieve the projected revenue in pursuit of deficit reduction.

On January 1, 2011, barring an extension of all the Bush tax cuts, the top marginal rate on households is scheduled to rise from 35% to 39.6%. Rates of tax on dividends, interest, and capital gains will also increase.

Among the most contested changes is a proposed rise in the capital gains rate of 15% on “carried interest,” to a split of 75% of the top marginal rate and 25% at the full marginal rate in 2013. As both of these will be increasing, the total tax rate on carried interest will reach 38.5%. Proposals and amendments to extend or amend other taxes and/or impose new taxes to “pay” for some of the extensions are directed disproportionately at upper income households.

Supply-siders say if you tax something you will get less of it. Critics of supply-siders say that the increase in the top marginal rate from 31% to 39.6% in 2003 went hand-in-hand with a rising stock market, strong job creation, and large budget surpluses in Clinton’s second term. Facts are facts. The Clinton years provide evidence to the contrary. How does a voter choose between the two points of view?

Strictly speaking, the supply side claim assumes ceteris paribus in all other economic factors that affect economic activity and fiscal conditions. Other factors can have as large as, or an ever larger, impact on economic activity and budget deficits. Among these are productivity, monetary policy, debt, regulation, global business conditions, labor markets, resource prices, natural disasters, external shocks (e.g., September 11), and war. Events or policies that reduce the cost of business or consumption amount to a (implicit) tax cut; conversely events or policies that raise the cost of business or consumption amount to a (implicit) tax increase. Changes in economic factors can offset the benefits of tax rate reduction or the harm of tax rate increases.

An ideal mix would be low rates of tax (especially the Hall-Rabushka flat tax), stable non-inflationary monetary policy (John Taylor), sustained productivity growth, absence of war, low energy prices, and so on. That synchronization rarely occurs. In a world of debt-ridden households and governments, restoring fiscal sensibility is a high priority. This may necessitate a combination of spending cuts, always hard to achieve, and tax increases, despite their potentially negative consequences, that flies in the face of supply-side doctrine.

Charles Dickens put it bluntly: Earn 20 shillings, spend 19 shillings 6 pence, result happiness. Earn 20 shillings, spend 20 shillings 6 pence, result human misery. Perhaps David Copperfield should be required reading of all government officials.

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