Unless Congress acts before the end of this year, the largest tax increase in American history is due to take effect when the Bush tax cuts expire at midnight December 31. According to the Tax Foundation, in the absence of Congressional action we can expect:
- The two “marriage penalty elimination” provisions will expire, so that:
- The standard deduction for married couples will fall, no longer double what it is for single filers; and
- The ceiling of the 15 percent bracket for married couples will fall, no longer double what it is for single filers.
- The 10 percent tax bracket will expire, reverting to 15 percent.
- The child tax credit will fall from $1,000 to $500.
- The tax rate on long-term capital gains earned by middle- and upper-income people would rise from 15 to 20 percent.
- The tax rate on qualified dividends earned by middle- and upper-income people would rise from 15 percent to ordinary wage tax rates.
- The 25 percent tax rate would rise to 28 percent.
- The 28 percent rate would rise to 31percent.
- The 33 percent rate would rise to 36 percent.
- The 35 percent rate would rise to 39.6 percent.
- The PEP and Pease provisions would be restored, rescinding from high-income people the value of some exemptions and deductions
- The estate tax would be restored with an exemption level of $1 million and rates that top out at 55 percent.
Some high-profile economists have recently expressed support for allowing at least some of these tax hikes to take place as scheduled. Two weeks ago, Paul Krugman wrote in the New York Times that the tax cuts should expire, at least for high earners, and last week Alan Blinder said essentially the same thing in the Wall Street Journal. On the same day Krugman’s Times column appeared, former Federal Reserve Chairman Alan Greenspan told Bloomberg’s Judy Woodruff that all of the tax cuts should be allowed to expire.
All three of them cited the deficit as the reason for letting taxes go up. They are assuming, of course, that raising tax rates raises revenues. This is a questionable assumption, even in the short run. As Arthur Laffer has noted, high-income taxpayers and businesses can shift income from 2011 to 2010 by accelerating the receipt of wages and year-end bonuses. People can also convert their standard IRAs, Keough plans and 401(k)s to Roth IRAs, paying the taxes due in 2010 and so insuring themselves tax-free income in the future when tax rates are higher.
There is some room for disagreement about the revenue impact of an increase in tax rates. In the end that’s an empirical question to be answered after the fact by statistical investigation. But there can be no disagreement about the effect on the economy. Every school of economic thought — Keynesian, monetarist, rational expectations, disequilibrium, supply-side, neoclassical, Austrian, even Marxist — agrees that raising taxes has a depressing effect on the economy. There is not an economic model in existence that predicts otherwise.
It is sheer madness to raise taxes in a deep recession. Krugman and Blinder try to convince us that raising taxes on “the rich” is relatively harmless because they spend a smaller proportion of each additional dollar of income than people with lesser incomes. As a result, they say, the net effect of letting the Bush tax cuts expire for high earners and at the same time extending unemployment benefits (which was done last week) is actually stimulative.
This kind of reasoning is based on a naive, dumbed-down Keynesian economic model of the kind taught in introductory economics courses from the 1950s through the 1970s. This model sees consumption spending as the engine driving the economy, with national income stimulated through exogenous increases in private investment and government spending. According to this model, the higher the proportion of new income spent on consumption, the more powerful the stimulus from any exogenous spending increase. Saving, or unspent income, is regarded as a drag on the economy. This is tantamount to assuming that income not spent on consumption just disappears into private hoards. It is not even deposited in a bank where it can be lent.
We know that in the real world this picture is false. Private saving provides the fuel for private investment, and it is private investment that creates jobs. This is a key insight of supply-side economics, although few people seem to grasp it. Even Republicans, who embraced the theory because it seems to lend support to their tax-cutting goals, have acted as though its message is that “deficits don’t matter”. It isn’t, and they do.
Greenspan, at least, admits that raising taxes will depress economic growth. But, he says, “these are choices between bad and worse”, and he regards the size of the deficit as the worse problem. Unlike Krugman and Blinder, he does not support an additional stimulus, because that, too, would increase the deficit.
Raising taxes on “the rich”, who save at higher rates, will starve businesses of the funds they need for investment. And without new investment we won’t get new jobs. The tax increases that are most damaging in this regard are increases in rates on qualified dividends from 15 to as much as 39.6 percent, and on long-term capital gains from 15 to 20 percent.
It is a truism in political economy that if you want less of something, tax it, or more of something, subsidize it. For people who save a lot of their income, taxing the rewards to equity ownership causes them to look for other uses for their money. For businesses, it makes equity financing more expensive relative to debt financing — leading to more highly leveraged financial structures — and long-term financing more expensive in general, slowing growth.
We may be seeing some of the effects of this already. News reports in the last few months have noted that corporations have been hoarding cash and not using it to rehire people. Various explanations have been offered for this: tight credit, regulatory uncertainty and the generally poor economic outlook. Undoubtedly there is some truth in each of these explanations. But there is another: corporations may be stockpiling cash in anticipation of the higher cost of new equity financing that would accompany the expiration of the Bush tax cuts. If so, an easy way to get corporations to disgorge some of that cash and rehire people would be to extend all of the Bush tax cuts, now.
Presumably Krugman, Blinder and Greenspan can figure this out for themselves. The question is, why haven’t they? For Krugman, the explanation is pretty obvious: he’s a left-wing, class-warfare ideologue who will come up with any explanation that sounds even halfway plausible if it will justify soaking the rich. Greenspan is a deficit hawk who is wedded to the long-outdated Phillips curve; he believes there is a trade-off between inflation and unemployment and, in any choice between the two, always chooses the latter. Blinder, who like Krugman is on the faculty at Princeton, is another liberal, but does not have the reputation of being an ideologue that Krugman has; however he has supported some screwy ideas (e.g., Cash for Clunkers) and, like Greenspan, appears to be wedded to the economic ideas of an earlier era.
Most other economists — including, surprisingly, Federal Reserve Chairman Ben Bernanke — see the iceberg ahead and are shouting their warnings. The problem is, the ship is being steered by liberal politicians motivated more by ideology than economics. If they turn the ship in time, it will only be because they fear the results at the polls this November.