Raise taxes now, cut them later

Announcing he had reached a deal with the Republicans to extend the tax cuts enacted under his predecessor, President Barack Obama extolled the virtues of compromise.

Yes, he had agreed to hold taxes at current levels, not only for those earning less than $200,000 ($250,000 for couples), as he had previously vowed, but for everyone, as the Republicans had insisted. But in return, he had obtained GOP agreement to extend eligibility for unemployment insurance for another 13 months to those whose benefits would otherwise have run out.

Or in other words, the two sides agreed that, in exchange for taking in less revenue, they would spend more of it. The cost of the agreement: an estimated $900 billion over two years, “to be financed,” as the New York Times reported, “entirely by adding to the national debt.” Amazing what can be done by people of goodwill, provided you leave the people who will actually pay for it all out of the negotiations.

To be sure, the agreement is only for two years. Just as the Bush tax cuts are scheduled to expire on Jan. 1 if no legislation is passed to extend them, so the Obama extension would also carry an automatic expiry date—at least for the people he had previously targeted, the top two per cent of all tax filers. So the top rate of tax would remain at 35 per cent now, but would revert to the 40 per cent rate that prevailed under president Bill Clinton in two years’ time.

But this has things exactly backwards. Rather than freeze taxes where they are now, only to have to raise them later, far better to raise taxes now, and cut them later. That is, let the Bush tax cuts expire, but only for two years—putting an expiry date on the expiry, as it were. Let me explain.

Everyone agrees that the deficit has to be cut sometime. Most agree the sooner the better, since the longer it takes, the higher the debt mounts, and the greater the toll in interest costs. And there’s at least a substantial body of opinion that it will take some combination of tax increases and spending cuts to do the job, given the size of the U.S. deficit.

Spending cuts of any size are harder to do in the short term—we’re talking about redesigning government, here—but more essential in the long run, to prevent deficits from returning. Conversely, tax increases are arguably easier to enact in a hurry, but cause more damage to economic growth in the long run, in the form of disincentives to work, save and invest. So the optimal mix would be immediate time-limited tax increases, coupled with deep spending cuts in the longer term.

The concern, heard on both the Republican and Democratic side of the aisle, that raising taxes now would throw the economy into a tailspin—the “leave money in consumers’ pockets” argument—is simply the flip side of the age-old wisdom that now is never the time to cut spending: can’t do it in a recession, because it will stall the recovery; can’t do it in a recovery, because it will tip us back into recession. It is steeped in the Keynesian belief that economies are ruled by aggregates: aggregate demand, total spending or taxes or what have you.

But just as deficit spending has little positive impact in the long run—before the government can put money “into” the economy, it has to take it out of it—so the short-run impact of raising taxes is overstated. To be sure, higher taxes sting: the average American family would see a $3,000 increase in their tax bill were the Bush tax cuts to lapse. But set against that the benefits of cutting hundreds of billions of dollars out of the deficit.

In fact, people do not make decisions based on aggregates, but at the margin: based on the cost of the next investment, the next hour worked, and so on. That’s why marginal tax rates are so important. But their effect is felt less in the short run—cutting taxes is a dubious recession cure—than over the longer haul, the cumulative impact of millions of individual economic decisions.

Indeed, the best way to restore confidence in the short run is to give people some assurance of stability in the long run. A short-run tax hike that promises lower taxes later on might be just the ticket.

In fact, if Obama really wanted to do the right thing for the economy, he’d keep the top marginal rate where it is, while allowing other tax rates to rise. Why? Because that’s who makes most of the investment decisions: those in the top tax bracket—above $373,000, in the U.S. They’d still pay more tax on the first $373,000. But they would face no added tax burden on income above that: that is, the earnings on new investments.

Yeah, I know. But narrowing the gap between the top tax rate and those lower down wouldn’t make the system regressive: it would just make it slightly less progressive. Notwithstanding its famously low tax rates, the U.S. tax code is surprisingly progressive. The top 30 per cent of taxpayers pay two-thirds of all taxes in the U.S., more than in any developed country except France. The Bush tax cuts didn’t change that. In 2001, when Bush first proposed his tax cuts, the top one per cent of taxpayers earned 18 per cent of all income and paid 34 per cent of all federal income taxes. By 2008, they were earning 22 per cent of the income, and paying 38 per cent of the taxes. Would it be so bad if they went back to paying the same share they did in the Clinton years?