Monday, August 16, 2010

More on the extension of Bush's tax cuts

Here are three articles written recently about the tax cuts set to expire at the end 2010.

Robert Frank (our textbook author) argues in favor of letting the tax cuts expire for the rich

Mark Zandi (chief economist for Moody's) discusses the benefits of not letting the tax cuts expire immediately for the rich.

Jeff Frankel (Harvard economist) discusses the political conundrum facing the republicans.
Stemming from the dot com bubble and subsequent economic growth during the late 1990's the U.S. government experienced their first annual government surplus since the 1960s. The graph below shows the net government saving from 1960-2010. To help offset the recession in 2001 both Democrats and Republicans were pushing for tax cuts. In the end George Bush lowered the tax rates and capital gains taxes through 2006 (in 2003 the tax cuts were extended through 2010). Many economists were against these tax cuts. They were very large and would worse the federal deficit (you can see this in the graph below). These tax cuts were not designed to help the economy recover but were politically driven. Tax cuts to help the economy recover would have been lasted a shorter duration, been more targeted toward businesses, and lower income households. Nevertheless, in 2003 Bush decided to extend the tax cuts while simultaneously embark on two wars. The Bush administration argued that reducing tax rates will increase tax revenue (see the previous post). Nearly all economists question this result. 

Here we are nearly a decade later, still engulfed in the largest economic downturn since the Great Depression. The federal government has already passed an $800 billion stimulus bill and now have found themselves wondering what to do now. Unemployment rates are near 10% and show little sign of returning to normal levels. Letting the tax cuts expire in their entirety will save the government between $3-5 trillion over the next ten years. This is a sizable chunk of the $20 trillion debt that is currently being projected. But given the current state of the economy letting the tax cuts expire is infeasible.

The Democrats want to extend the tax cuts to all but the wealthiest Americans (singles making over $200,000 and families making $250,000) while republicans want to extend the tax cuts for all Americans. So who's going to win? I think Frankel makes some very good points, can the Republicans afford (politically) to not vote for a bill that excludes extending the tax cuts on the wealthiest Americans? This is an election year.

By letting the tax cuts expire for the highest income group (less than 3% of American) will save approximately $1 trillion dollars. The old adage used to say the highest income group would save the money, channel it into financial institutions and allow these institutions to make more loans (home, consumer, and small business loans). Right now banks are not making more loans, the economic uncertainty has contributed to a massive slowdown in bank lending. Tax cuts should be targeted toward income groups that are most likely to spend them locally. These are the biggest bang for the buck programs.

In an ideal world here's what I would like to see happen. Republicans should negotiate with the Democrats to allow the tax increases to be phased in over the next 3-4 years. As it stands the highest tax brackets the 33% and 35% groups will increase to 36% and 39.6%, why not allow for gradual increase say 1% per year. This will prevent a further economic slowdown. Further if Republicans cared about the budget (like the say they do) they should push the Democrats for spending cuts (after 3-4 years) to pay for the tax cuts. This way you get the extension of the tax cuts for all income groups in the short run and future deficits will not be increasing in the long-run.

Of course this option requires political cooperation, something we've seen very little of. Whether or not all or a portion of the tax cuts get extended does not solve the long-term fiscal imbalances facing our country. The government needs to focus on medicare and social security. The CBO shows nearly half of all government spending programs will end up in either medicare or social security

You may notice net interest payments amount for 14% of government spending. That's right, by 2020 the government will be spending nearly $1 trillion a year to pay interest on the government debt.

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