Choose Tax Cuts for Economic Recovery

Story Stream
recent articles

It’s April 16, and you’ve finished the arduous task of assembling your tax documents and receipts and filing your return. Although the economy is in a recession and times are tough, you scraped together the dollars to pay Uncle Sam his share.

Yet, even though the unemployment rate stands at 8.5%, the highest in 25 years, the Democratic Congress is planning to turn its attention to raising your taxes when it returns from recess next week and goes to work on President Obama’s proposed budget.

It includes income tax hikes for upper-income Americans and increases in prices of energy-intensive products, increases to be paid by all consumers.

Fair Warning: tax increases would prolong the recession and discourage employers from hiring. This was shown by Mr. Obama’s chair of the Council of Economic Advisers, Christina Romer, in a paper coauthored with her husband David Romer last November when both were professors of economics at the University of California at Berkeley.

Yet Mr. Obama has proposed new limits on carbon emissions, known as “cap-and-trade.” This is projected to raise $646 billion in revenue over the next 10 years, a significant tax increase that would impose a drag on the American economy. Manufacturers and utilities would receive an allocation of permits to emit carbon (the “cap”), and would have to purchase additional permits from other firms or the government, or pay penalties for noncompliance, if their emissions exceeded their permitted cap (the “trade”).

In addition, Mr. Obama would have the two top income tax rates rise, from 33% to 36%, and from 35% to 40% in 2011. That would affect singles making more than $172,000 in taxable income and couples making more than $209,000. And that would be a blow to many unincorporated small businesses.

Upper-income taxpayers would also face limits on their deductions—for example, for charitable gifts and mortgage interest. That would be an additional, thinly-disguised tax increase.

Raising taxes, whether now or in 2011, is exactly the wrong way to help America recover from the recession, because higher taxes cramp economic growth.

The Romers’ paper is entitled “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks.” The innovative feature of the paper is to distinguish between the effects of tax changes arising from legislation and those tax changes that occur automatically, for instance as individuals move into higher tax brackets or stock prices change.

Looking at data from 1947 to 2006, and studying the legislative record behind the tax changes, they conclude that legislated tax changes have far more effect than automatic tax increases. They write, “Our estimates suggest that a tax increase of 1% of GDP reduces output over the next three years by 3%.” A major reason is that higher taxes have a markedly negative effect on investment.

Arizona State University Nobel Prize-winning economist Edward Prescott, looking at tax rates over major industrialized countries, has shown that the higher the levels of taxes, the lower are the hours of work. In highly-taxed France, for example, people on average worked only three-fourths of the American workweek. In the early 1970s, when American taxes were higher, the French worked more than the Americans. Mr. Prescott’s results also hold for countries as diverse as Japan, Chile, and Italy.

Rather than raise taxes, Wisconsin Representative Paul Ryan, ranking Republican on the House Budget Committee, has introduced a bill, H.R. 6110, that would lower all income tax rates and reform the complex tax code by simplifying it, together with spending cuts that halve the 2019 deficits projected by the Obama White House.

People could elect to pay their taxes on a postcard, with only two rates. If they chose the card, couples would pay 10% of their first $100,000 of taxable income, and then 25% on any earnings above that. There would be no itemized deductions, only a refundable credit to help with the purchase of private-sector health insurance. The rate on capital gains and dividends would be 15 percent, and the rate on interest would be zero.

The system would be progressive due to retention of standard deductions and personal exemptions, so that a family of four would start paying tax only after earning $39,000.

Under Mr. Ryan’s proposal, those who prefer the present system, with the 2003 tax rates and complex scheme of deductions, could continue to file as they did this week. In sum, there would be two parallel systems of taxation in place, to minimize the opposition to abandoning one and adopting another. Mr. Ryan would limit the number of times a tax payer could switch between the two systems to minimize gaming the tax code.

The primary objective of Congress and the White House should be to put our economy back on track. That’s why Congress should be debating how to lower taxes and government spending, rather than how to raise them.

Show commentsHide Comments

Related Articles