The outsized tax cuts enacted in President George W. Bush’s first term are scheduled to expire at the end of the year, giving Congress the opportunity, in theory at least, to simplify the grotesquely complex tax code, eliminate the problematic Alternative Minimum Tax, broaden the tax base and lower rates without exacerbating the deficit.
But that would be the politically hard thing to do. Instead, Republicans and Democrats are delaying action on taxes while they jockey for rhetorical advantage, each side accusing the other of seeking to ruin the economy or further enrich the rich. Given how little time lawmakers have to enact a bill this year, the only options left on the table are to extend some or all of the tax cuts, either permanently or temporarily —or let them all expire. Although neither side wants to go that far, partisan gridlock in the Senate make it a real possibility.
The foot-dragging adds another layer of uncertainty and risk to the economy in the near future, making employers even more wary about increasing their payrolls. That’s the last thing this country needs as it struggles to grow its way out of the deepest recession since the Depression. With the economy expanding but unemployment remaining stubbornly high, lawmakers need to promote growth.
Granted, that involves far more than just tax policy, and it’s as much an art as a science. Businesses and consumers respond to emotional currents as well as checkbook realities. Tax decisions by Congress that increase the deficit may just increase the public’s anxiety about the burgeoning national debt. But government belt-tightening could also backfire, slowing the economy and promoting pessimism among consumers and business owners. A survey released Tuesday showed consumer confidence at its lowest level since the recession hit, and recent data on prices have more economists warning about a dangerous cycle of deflation.
Some Republicans argue that tax cuts cause the economy to expand so rapidly that they actually yield more revenue and reduce the deficit. Recent history proves, however, that that is not true; tax cuts don’t pay for themselves. The economy may grow faster after a tax cut, but not enough to make up the lost revenue. The country couldn’t afford the Bush tax cuts when they were enacted, and it’s even less able to afford them now.
Nevertheless, allowing all the cuts to lapse entirely would be too harsh a blow to the economy, because it would drain too much money from consumers’ pocketbooks. All together, the cuts — including lower income tax rates, more deductions for high-income taxpayers, lower rates on capital gains and dividends, a phased-out estate tax and larger deductions for married couples, parents, retirement savings and capital spending by businesses — are projected to be worth more than $2.5 trillion over the coming decade, and they affect nearly three-fourths of U.S. taxpayers. A better course for Congress would be to extend the ones that matter most to growth, while letting others expire in the name of deficit reduction.
The former category would include the cuts with the most direct connection to business investment. A place to start would be the tax rate on capital gains and dividend interest, which the Bush cuts capped at 15% for all Americans. If Congress takes no action, the top capital gains tax rate will rise to 20%, and dividend income to 39.6%. Rates that high would make the U.S., which already has one of the highest corporate tax rates in the world, even less competitive in the global market for capital.
Even with abundant capital, businesses won’t expand unless there’s demand for their products and services. That’s why it makes sense to keep lower rates in effect for most taxpayers. In the upper income brackets, however, individuals are less likely to spend more in response to lower rates because they save a higher percentage of their earnings. Therefore, allowing the two highest tax brackets to rise to 36% and 39.6% (from 33% and 35%, respectively) would have a less dramatic effect on consumer spending than ending the cuts for less wealthy taxpayers. The top two brackets kick in on taxable income above $172,000 for individuals or $209,000 for couples.
The biggest potential problem with letting the top two tax brackets climb to their previous levels is the impact on entrepreneurs and small-business operators who pay personal income taxes on their business profits. The percentage is small — a 2004 study found that only 3% of the filers reporting income from small businesses were in the top two brackets — but there’s still a risk that the hike would make it harder for business owners to tap their profits to fuel growth. That’s all the more reason for Congress to make credit more available to small businesses through community banks and self-help groups, something it should be doing regardless of the course lawmakers take on taxes.
Just how much any extended tax cut helps the economy will depend to some degree on its duration. A permanent cut is more likely to promote growth than a temporary one because it enables businesses to plan better for the long term. But it would be misleading for lawmakers to pretend that anything they do now is more than just a stopgap. They won’t be able to close the government’s yawning budget gap unless tax revenues climb back to their historic levels — about 18% of the gross domestic product — and simply raising rates on the rich won’t do it.
Again, there are no easy fixes to the intertwined problems of the sluggish economy and the growing deficit. It might make sense to extend all of the Bush tax cuts if lawmakers also adopted a credible plan for bringing the deficit under control over the next few years, as Federal Reserve Chairman Ben S. Bernanke has advocated. But Congress is nowhere close to developing such a plan. Meanwhile, taxpayers need to know what’s going to happen to tax rates next year, and they need some assurance from Congress that the deficit matters. The best way to do that is to extend the Bush tax cuts that matter most to economic growth, and let the rest expire as a downpayment on the deficit reduction to come.