Cheers To Obama On Taxes

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WASHINGTON--President Obama is to be congratulated on his efforts to stave off the 2011 tax hikes.

The deal would preserve current tax rates on income and capital for two years, reduce the estate tax below the draconian levels that would otherwise apply in 2011, and keep in place most existing tax credits for individuals and businesses.

Plus, in 2011 the plan allows businesses to write off investments in equipment immediately, rather than over several years, encouraging them to spend more to expand or modernize their facilities.

In return, the Republicans have been forced to agree to yet more spending-to extend unemployment insurance benefits for the long-term unemployed (over 26 weeks) by 13 months, and reduce payroll taxes without offsetting cuts in federal spending.

President Obama's Making Work Pay refundable tax credit of $400 for workers earning under $75,000 would be replaced by a cut in workers' share of the payroll tax. Taxes would decline by two percentage points, from 6.2% to 4.2%, on the first $106,800 of annual earnings, putting more money in consumers' pockets.

This bipartisan compromise isn't perfect, but it's better than allowing all taxes to rise on January 1, potentially sending the economy into another recession, according to White House economic director Larry Summers.

How could the plan be improved?

A permanent tax plan would have given consumers and businesses more confidence. The late Milton Friedman won a Nobel Prize for his permanent income hypothesis, which argued that consumers were more likely to save rather than spend temporary tax cuts, such as the reduction in the payroll tax.

The plan expands the deficit, and should be offset by spending cuts. Mr. Obama complained about the cost of extending upper-income tax rates, $79 billion over two years, but this is dwarfed by the cost of the payroll tax cut, $120 billion for one year. Extending unemployment insurance benefits for 13 months clocks in at another $56 billion.

That's why Vice President Biden distributed charts to House Democrats on Wednesday showing that "what we got" was twice the size of "what they got."

The 100% first-year write-offs of investment, or "expensing" of plant and equipment outlays, combined with the 2007-2009 increases in the minimum wage from $5.15 an hour to $7.25, encourages firms to substitute equipment for labor, hurting unskilled workers. Much of the equipment receiving the credit will be made in China, helping Chinese workers.

And the White House confuses tax cuts and redistributionary spending programs for low-income Americans. In its description of the tax package, the White House states that "a working family with three children making $20,000 will continue to receive a tax cut of more than $2,000 as a result of the Earned Income Tax Credit and Child Tax Credit expansions in this framework agreement."

But this family pays no income taxes, so they cannot receive tax cuts. They do pay payroll taxes, which amount to $1,240, substantially less than $2,000. These payroll taxes would decline to $840 in 2011 if the tax deal becomes law. If the administration wants to increase subsidies to low-income Americans, it should do so transparently, and not disguise them as tax cuts.

Mr. Obama does not recognize the value to the economy of extending upper-income tax rates-or, if he does, he does not want to admit it.

Based on his Tuesday press conference, the President appears to think that extending these tax rates will yield no benefit to the economy. This error is troubling.

Mr. Obama said, "And economists from all across the political spectrum agree that giving tax cuts to millionaires and billionaires does very little to actually grow our economy. " He went on to explain that extending the current top tax rate, 35%, will not be good for the economy because it comes at the expense of government services for veterans and low-income people.

In Mr. Obama's world, those who earn over $250,000 per year don't use their money for the benefit of others (unless they give it away). So the president assumes that the government can tax the most productive people in the economy, those with the highest incomes, without negative consequences for the others, and that the actions of the top income groups don't affect the well-being of people making less.

Top income filers purchase goods and services, own or manage businesses that employ other Americans, and have capital investments that fund businesses that create jobs.

Treasury data show that 48% of income on individual returns accrues to unincorporated business owners making over $250,000 a year. If these businesses' taxes rise by five percentage points, some may close or curtail expansion plans, shrinking their payrolls.

The economics literature clearly shows that tax cuts lead to more economic growth than do spending increases.

Even a Democrat, like Christina Romer, who headed Obama's Council of Economic Advisers, agrees. She and her husband, David Romer, both professors at the University of California (Berkeley), in a 2010 paper in the American Economic Review on postwar tax policy, found that $1 of lower taxes boosted national income over the next 3 years by $3.

And Harvard economists Alberto Alesina and Silvia Ardagna, in an analysis of OECD countries from 1970 to 2007, concluded that "Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases." With $1 trillion of spending stimulus over the past two years, and no tax cuts, the U.S. unemployment rate is over two percentage points higher now than it was in January 2009.

President Obama is trying to save the economy from the massive fiscal contraction that would occur in January if taxes were allowed to rise. The deal could be better targeted, and less costly, but it's better than the alternative. Let's hope he succeeds.

Diana Furchtgott-Roth, former chief economist at the U.S. Department of Labor, is senior fellow and director of Economics21 at the Manhattan Institute. Follow her on Twitter: @FurchtgottRoth.   

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