Why we should want Obama to break his promise on taxes

Debt Held by the Public Under CBO’s March 2010 Baseline and CBO’s Estimate of the President’s Budget (Percentage of gross domestic product) - from CBO, “An Analysis of the President’s Budgetary Proposals for Fiscal Year 2011″

All of my readers know how I feel about the Bush tax cuts. I’ve never liked them–not from day one. They were too costly, too skewed to the rich, and did too little to make the tax system more efficient. I disliked them even more as a Democratically-controlled Congress during the Bush Administration couldn’t muster the courage to let them expire as scheduled when challenged by the Republican charge of “the largest tax increase in American history.” But the final kick in my stomach was when a new president who campaigned on the “change” we could believe in promised to continue the same tax cuts that he himself criticized as being fiscally irresponsible and yet not his fault.

So of course I want President Obama to break his stupid campaign promise to extend the Bush tax cuts for all households with incomes below $250,000. The tax cuts are still unaffordable (CBO shows that even the <$250K portion would cost $2.2 trillion over ten years–all but around $400 billion of the full complement of Bush tax cuts), would still go mostly to the rich (high income households “march” through all the lower tax brackets after all and hence get the highest dollar benefit of lower-bracket rate reductions, and they also benefit the most from the lower rates of taxation on capital income), and would still do nothing to broaden the tax base to make the system more efficient.

But I submit that even people who love the Bush tax cuts and believe in “supply-side economics” (even the extreme Laffer-curve view) and sympathize or even participate in the “tea party movement” and just generally like low taxes (or dislike taxes in general) should want President Obama to break his campaign promise.

Why?

Because many of these same people who like low taxes also claim to not like the large budget deficits we’re running now or the unsustainable fiscal path that lies way out in front of us… and because President Obama has also promised to get the deficit down to a “sustainable” level of around 3 percent of GDP in five years. But the President’s own budget, which includes the deficit-financed extension of those “middle-class” Bush tax cuts (that $2.2 trillion worth), isn’t consistent with such a low deficit. CBO says that under the President’s budget, the deficit would be 4.3 percent of GDP in 2015–a level considered unsustainable because it exceeds the typical rate of economic growth. That’s why the President’s budget also proposed a fiscal commission that would recommend policies (by the end of this year) to help squeeze out the remaining 1 to 1.5 percent of GDP difference.

Most of that gap will have to be filled with new revenues, because within the next five years there’s hardly any hope of reducing the deficit by cutting spending. Cuts in discretionary spending are too small to make much difference. Cuts in mandatory spending via the big entitlement programs aren’t going to happen soon–both because that’s politically infeasible and because on health reform we will barely be getting started in five years (and will really just be figuring things out as we go along).

So when the President says he wants to get the deficit down to 3 percent of GDP by 2015, most of the heavy lifting will have to come from higher taxes–and I mean higher taxes other than the higher taxes on the rich that the President already proposes in his budget and that were already included in the health reform bill. And these additional higher taxes will have to come despite the President’s promise to not raise taxes on those households with incomes under $250,000.

Enter the very nice new analysis of the Tax Policy Center, in a paper called “Desperately Seeking Revenue.” Len Burman, the TPC’s former director (now at Syracuse University’s Maxwell School), cited this work in recent testimony before a Ways and Means subcommittee. Table 2 in the “desperate” paper shows that the Administration’s budget proposals (on both the spending and revenue sides of the budget) fall $534 billion short of the Administration’s 3 percent of GDP deficit goal in 2015. (In contrast, current law, which assumes all the Bush tax cuts expire as scheduled at the end of this year, would fall just $40 billion short of the goal.) Table 3 shows how marginal tax rates (the tax rates on the next dollar of income earned–those that affect economic incentives) would have to be increased in order to reduce the deficit to that 3 percent of GDP goal in 2015. If after the Bush tax cuts are first extended (as assumed in the Obama Administration’s “policy baseline”), then all marginal tax rates are raised proportionately to get us to 3 percent of GDP deficits in 2015, the top marginal rate would rise from its current 35 percent rate to 48 percent. On the other hand, if only the top two marginal tax rates–those affecting primarily households above $250,000–can be adjusted to achieve the deficit goal, then the top marginal rate would have to rise from 35 percent to 77 percent (and the second highest rate would rise from 33 percent to 72 percent). The larger the population exempt from the tax increase, the more the marginal rate has to rise on those left to pay the higher tax.

Table 7 in the “desperate” paper shows that the strategy of limiting deficit-reducing tax adjustments to the top two tax brackets is a highly progressive one. Compared with either current law where all the Bush tax cuts expire as scheduled (and where revenue is a little short of the 3 percent of GDP deficit goal) or current policy with all of the Bush tax cuts extended (and where revenue is way short of the deficit goal), the “Obama dual promise” strategy raises average tax burdens significantly for only the top 1 to 5 percent of households and reduces or holds steady the tax burdens on all others.

But I’m going to step out of character and sound like a supply-sider for a minute here, and argue that despite having this very steeply progressive distributional pattern, the “Obama dual promise” tax policy would not necessarily be a “good deal” for even the vast majority of households not in the top 1 to 5 percent–because of that 77 percent top marginal tax rate. Having that pattern of marginal tax rates that rises so steeply at the top (go back to Table 3, bottom panel, last column on the right)–with rates of 10, 15, 25, 28, 72.4 and 76.8 percent–would create huge disincentive effects on labor supply and saving. See, all economists are “supply siders” in a sense, because we all believe that marginal tax rates affect economic decisions at the margin. Not all economists, however, are radical, right-wing, “Laffer-esque” supply-siders who believe that increasing tax rates lead to decreases in revenue. But that is because for most of U.S. history, we haven’t had marginal income tax rates high enough to worry about the Laffer curve theory. Some empirical work on this (done decades ago by my dissertation advisor, Don Fullerton, in fact), has indicated that the revenue-maximizing tax rate is far above our current highest rates of 30-40 percent–in fact, in the…70-80 percent range. Hmmm.

Why did the “supply siders” of the 1970s and 80s worry about high marginal tax rates? The theory was that high rates were so stifling to economic growth that if you reduced these tax rates, the benefits to the economy would “trickle down” from the rich people enjoying the tax cut down to the middle-class people who would get employed by the growing companies the rich people were investing in.

In theory, “trickle down” can work in a negative way, too. If marginal tax rates are raised to prohibitive, other-side-of-Laffer-curve levels, then the labor supply and saving of the rich are reduced, overall economic growth is reduced, and employment and wages–economy wide and throughout the income distribution–suffer. And on top of that, revenue falls (because we’re on the wrong side of the Laffer curve), which raises the government deficit, reduces national saving, and in turn reduces economic growth. And the effects of economic growth, particularly on the down side, are very broadly distributed.

I know it must seem odd that I would pull out this supply-side argument as a reason why even middle-class and lower-income households should hope the President doesn’t keep his “no middle-class tax increase” promise. But I’m saying so because it’s just not good or sustainable tax policy to rely on such a huge increase in taxes on such a small percentage of the population to fund a cause (deficit reduction) that would otherwise have large and broadly-distributed benefits.

I get back to my position that the easiest way to stick with current-law baseline revenue levels (which get us close to the 3 percent of GDP deficit goal) is to stick with current law, where all of the Bush tax cuts expire as scheduled at the end of this year. No taxes would need to be reformed, and in fact no tax legislation would need to be passed and signed! Of course, a better way would be to stick to current-law revenue levels by reforming the tax system–broadening the tax base to make it more efficient so that marginal tax rates would not even have to come up and we could still raise more revenue to achieve our deficit goal. But people (regular people and policymakers) seem to forget that if we let the Bush tax cuts expire, in the “worst” (or laziest) case we just go back to Clinton-era tax policy, which really isn’t so bad. In fact, if you go back to the “desperate” paper and Table 3, the first two columns on the left in the bottom bank show marginal tax rates if the Bush tax cuts expire (those Clinton-era tax rates of 15, 28, 31, 36, and 39.6 percent), and if those rates are raised proportionately (and just a little) to achieve the 3 percent of GDP deficit goal. The marginal rates in that “break tax promise, keep deficit promise” scenario are 15.5, 28.9, 32.0, 37.1, and 40.9. I would argue that this structure of tax rates would be much better for our economy as a whole than the “Obama dual promise” rates that go up to that Laffer-esque 77 percent at the top and yet are barely lower at the bottom and middle.

So this is just a different argument I’m making for why the Bush tax cuts should be allowed to expire and why President Obama’s campaign promise on taxes needs to expire, too.

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