December 26, 2010
The Tax Deal: A Second Stimulus?
The Tax Deal: A Second Stimulus?—Posner
The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, which President Obama signed into law on December 17, is being described as an $858 billion stimulus bill. But this is imprecise.
The immensely complex Act is well summarized in "CCH Tax Briefing: The 2010 Tax Relief / Job Creation Act," Dec. 20, 2010, http://tax.cchgroup.com/downloads/files/pdfs/legislation/bush-taxcuts.pdf (visited Dec. 25, 2010), which provides the following breakdown of the costs of the two-year program
Individual Tax Cuts.............$ 186 billion
AMT Relief............................$ 136 billion
Payroll Tax Deduction..............$ 111 billion
Estate/Gift Tax Relief.............$ 68 billion
Capital Gains/
Dividend Cuts.......................$ 53 billion
Bonus Depreciation/179
Expensing............................$ 21 billion
Other.................................$ 226 billion
In addition to this $801 billion in tax relief, the Act authorizes a $57 billion extension of unemployment insurance benefits for a maximum of 99 weeks.
All these are just estimates, since the amount of tax relief depends on incomes, the size of estates, and so forth, and the amount of unemployment benefits depends on the number of claims made.
Most of the "costs" represent simply lost tax revenues; the Act extends tax cuts, made a decade ago, that would have expired at the end of this year—but the payroll (i.e., social security) tax deduction and extension of unemployment benefits, along with some of the other tax provisions, are new tax breaks. The benefits extension will probably expire at the end of the two years in which the new Act will be in effect, as unemployment falls. The other provisions of the Act are likely to be continued, given Republican hostility to any tax increases—and refusing to extend a temporary tax cut is rightly perceived as a tax increase. The Act illustrates the nature of compromise between the Democratic and Republican parties in the current political climate: each party seeks tax reductions for its constituents (the payroll tax deduction being the Democrats' preferred form of tax break) and the Democrats in addition seek to increase spending (hence the extension of unemployment benefits).
The aggregate federal deficit is about $14 trillion, and is increasing at a rate of about $400 billion a year. All other things unchanged, the Act, assuming permanence, will almost double the annual increase in the deficit, putting the country farther along the road to bankruptcy—unless, as the Administration argues, the Act will operate as a stimulus (Keynesian deficit spending in a depression or recession) that will bring down the deficit by accelerating economic growth.
This would be unlikely if the tax breaks were new rather than for the most part merely continuations of the Bush tax cuts of a decade ago (I explain the significance of this qualification below).
The normal (not recessionary) rate of the nation's economic growth is about 3 percent a year, but is usually much higher in the recovery period following a depression or recession. The economy is expected to grow by only about 3 to 4 percent in 2011; if the new Act added 2 percent to the higher figure, which I don't think anyone expects, so that the Gross Domestic Product grew by about $800 billion (6 percent of our $14 trillion GDP), this would, it is true, reduce the rate of growth of the deficit. Suppose the additional $800 billion in GDP yielded $160 billion in additional federal tax revenues (20 percent). Then the 2011 deficit, instead of being roughly $800 billion, would be "only" $640 billion—we would still be on the road to bankruptcy.
Moreover, the benefits in deficit reduction from the Act would soon peter out; there is no basis for thinking that the level of taxation in the Act, compared to the higher tax level in the 1990s, will produce a higher rate of economic growth than the normal 3 percent.
It is nevertheless possible to defend the new Act on two grounds. The first, and I think less important, is that it indicates the possibility of compromise between the Obama Administration and the resurgent, and increasingly conservative and assertive, Republican Party, though compromise will be more difficult come January when the Republicans take control of the House of Representatives and significantly increase their representation in the Senate. Second, and more important, estimates that GDP would grow by at least 3 percent in 2011 were premised on the expectation that the bulk, at least, of the Bush tax cuts would be continued. Given the weakness of the economy, a sudden tax increase in 2011, which would have been the effect of allowing those cuts to expire, could easily have knocked one or two percentage points off the GDP growth rate.
It would have been better to have just continued the tax breaks and not have cut the payroll tax and extended unemployment benefits. A small, and possibly (though not probably) temporary, tax cut is unlikely to stimulate much spending, and extending unemployment benefits can actually increase unemployment by making unemployed workers more picky in their search for a new job. These provisions of the Act are simply the Democratic quid pro quo for the tax breaks for the wealthy, favored by the Republicans.
The Tax and Spending Compromise-Becker
Both supporters and opponents of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 usually confuse its short term-stimulus effects on the economy, and its long-term effects on economic growth. I would give it a grade of C+ as a short-term stimulus to the economy, and a grade of B+ for its effects on longer-term growth.
The Act provides for a one-year two-percentage point reduction in employee contributions to social security taxes at an estimated cost in tax revenue of over $100 billion. This will add a significant amount to the budgetary deficit for the year going forward, while providing very little short-term stimulus. Even the most simplistic Keynesian analysis recognizes that a one-year tax reduction will be mainly saved in order to spread out the added consumption from this additional "wealth" of households over more than a single year. In economics terminology, a one-year tax relief would be considered a transitory increase in income rather than a permanent increase.
Evaluating the desirability of the extension of unemployment compensation to the long term unemployed (up to 99 weeks of unemployment) is more complicated. Although, like the social security rebate, this also is just a temporary windfall to these unemployed, they are likely to have exhausted their liquid assets during their long period of being unemployed. They would tend to become liquidity constrained, and hence would consume a large part of their unemployment benefits.
This extension of benefits to the long-term unemployed could have been made more or less revenue-neutral by reducing, or preferably eliminating, unemployment compensation to the men and women who have been unemployed for less than 3 months (they constitute about 40% of all unemployed). The great majority of the short-term unemployed are not liquidity constrained since they can finance their unemployment from savings, earnings of spouses, and borrowing from relatives and friends.
Unemployment benefits as insurance against the risks of becoming unemployed are best concentrated on the longer-term unemployed because they are more likely to have run out of assets. Just as with other insurance, the optimal unemployment insurance would have a sizable deductible-that is, little payment during the first several months of unemployment- and then significant insurance coverage for longer-term unemployment. Also, as with other insurance, a good program tries to protect against moral hazard; that is, against the unemployed not looking for jobs because they prefer to continue to collect unemployment checks. Such moral hazard considerations imply that payments should begin to fall, and eventually be eliminated, after say six months or so of unemployment. One exception would be during and shortly after severe recessions, as at present.
The largest component of this Tax Relief Act is the extension of the Bush-era tax cuts on incomes, dividends, capital gains, and estates. This extension will have some relatively short-term benefits to the economy by stimulating investments and the formation and expansion of small businesses, but the main case for extending these tax cuts is their effects on longer-term economic growth. The growth rate in per capita incomes is determined mainly by the rates of investments in human and physical capital, and by technological progress. Both these drivers of economic growth are in good part in turn determined by tax rates on personal and business incomes.
I view the maintenance of the Bush tax cuts as only the first important move of the American tax code toward a more effective income tax structure. That structure would have a broad-based low rate flat tax on personal incomes, with little, if any, taxation of corporate incomes, and with dividends and capital gains taxed as ordinary income. As the majority report of the recent National Commission on Fiscal Responsibility and Reform proposed, the income base should be greatly broadened by eliminating the deductibility of interest on mortgages, and a variety of other special deductions that result from the political influence of various special interests.
I showed in a post last month (see 11/07/10) that even a one-half percent increase in the American long-term rate of economic growth would have a large effect in 20 years on both per capita incomes, and on the size of the US debt relative to its GDP, as long as the rate of growth in government spending was not allowed to increase along with the growth in incomes. Control over the rate of growth of spending is essential even with faster economic growth in order to try to prevent the debt to GDP ratio from becoming a major problem.
A broad-based flat income tax could have a relatively modest tax rate- perhaps about 25%- and still raise as much revenue as the tax structure that would exist if the Bush tax cuts were allow to lapse. A flat consumption tax would be even better than a flat income tax since such a consumption tax would not distort the incentive to save. However, this type of consumption tax is unlikely to be introduced as a substitute for the income tax. It could play a role as a supplement to the income tax if that combination were necessary to prevent a narrow-based progressive income tax system from being imposed.