There is a valid concern that, when the economy recovers, the federal government's large borrowing needs could "crowd out" investment. While there is absolutely no evidence that this is a problem now or in the immediate future (as evidenced by continued low Treasury yields), the scheduled reversion of the tax code to the status quo ante-Bushum does create a unique opportunity to deal with the long run problem.
As it happens, the projected level of revenue if the tax cuts expire looks close to about right in the long run (see the "extended baseline" in the CBO's long-run outlook). While the Clinton-era tax code isn't ideal in terms of equity or efficiency, clearly we didn't do too badly when it was in effect. The beauty of "current law" is that it makes Washington's natural tendency towards gridlock work for, rather than against, a solution. All we need is for any of (i) congress to not agree, (ii) a Senate filibuster not to be overcome, or (iii) the president not to sign, and our deficit problem is largely solved.
If unemployment wasn't 9.8%, I might therefore be in the "let them expire" camp (even the "middle class" parts), but, as things stand, the economy urgently needs more fiscal policy support now. A tax increase is the exact opposite of what we need in the short run.
Before this week's deal between the administration and Republican leadership, my preferred outcomes, in order of preference, would have been:
- The expiration of the tax cuts is used to force a tax reform that simplifies the tax code and eliminates tax expenditures (i.e., closes loopholes). This broadening of the tax base could raise revenue, and maintain progressivity (since it is high incomes that benefit most from loopholes), while keeping marginal rates low. The Bowles-Simpson proposal did move in this direction - on progressivity, it landed between the Clinton and Bush tax codes (according to the TPC) - but it had an arbitrary cap on revenue at a too-low level. At full employment, the ideal reform would be revenue neutral compared to a "current law" baseline (i.e., it would bring in the same revenues as the Clinton tax code over the long-run). The short-run negative effect of the resulting tax increase would be offset (and thensome) with explicitly temporary fiscal stimulus, perhaps with a built-in trigger mechanism to unwind it automatically as the economy recovers, which would serve to minimize the inevitable push for extensions.
- The tax cuts are allowed to expire, reverting to the Clinton-era tax code, but accompanied by the same type of stimulus described above.
- The original Obama-Democratic policy of making the "middle class" tax cuts permanent while reinstating the Clinton-era rates for income above $250K. Raising taxes on the rich is anti-stimulative, but not very (the multiplier is low), so the long-run deficit reducing benefit outweighs the short-term cyclical cost.
- The whole thing expires (which may still happen - its not clear the deal will get through Congress), which solves our long run problem, but leaves us hoping even more fervently that Fed gets enough traction to keep the recovery going, even as the tax increase makes the headwinds stronger.
- The preferred Republican policy of making all the tax cuts permanent, which has the virtue of not making things worse in the short run, but will eventually lead us back to the low-investment economy of the late 1980's and have us talking about cutting social security and medicare.
David Leonhardt calls it a "second stimulus" (third, if you count the spring 2008 tax rebate). The Center for American Progress applied existing multiplier estimates to the deal's provisions to estimate that it would increase employment by about 2.2 million (relative to unemployment of 15 million). Macroeconomic Advisors estimates a GDP growth bump of 0.5-0.75 percentage points. (Both of these come to my attention via the invaluable Ezra Klein).
Of course, it would be better still if the unemployment insurance extension was for two years (even if the recovery gathers steam, there will still be many people unemployed in 2012), and included something for the "'99ers" who have hit the 99-week limit on benefits (recall that the recession began at the end of 2007). They also should have raised the debt ceiling, so it doesn't become the next "hostage". One might hope the outrage of Congressional Democrats gives them some leverage to make improvements (indeed, if the Democrats were an organized political party, I might think there was a clever "good cop, bad cop" routine being employed here).
Note: the title of the post refers to the official name of the 2001 tax cut, the Economic Growth and Tax Relief Reconciliation Act.