Tax Folly

by Douglas Holtz-Eakin

The U.S. economic recovery stumbles along. In June, payroll employment remained below the number of jobs at the end of 2008. And for those with jobs, the experience is not much better. Over the period 2008 to 2011, real disposable income grew at the paltry rate of 0.1 percent annually. More recently, we have seen economic growth downshift from a 2 percent annual rate to 1.5 percent in the second quarter of 2012, with most recent economic indicators painting a picture that is steadily weaker.

In these circumstances, it would seem that the first rule would be “do no harm.” In particular, the U.S. faces a $600 billion “fiscal cliff” at the end of 2012 that is dominated by an enormous $440 billion tax increase. A top priority should be to avoid these increases that are a guarantee of another recession. In particular, failing to extend the 2001–2003 tax cuts would increase taxes on every single taxpayer in the country, put millions of lower-middle-class households who are not currently paying taxes back on the tax rolls at a rate of 15 percent, and restore the marriage penalty.

The administration argues that these detrimental effects can be avoided while still raising taxes on those making more than $250,000. This wishful thinking ignores the reality that for workers and small businesses in the top tax brackets, the effective marginal tax rate for many — if not most — of these would spike to above and beyond 50 percent of their income in taxes. 

Research shows that this has striking impacts on the activities of entrepreneurs and small business that are taxed as so-called “pass-through” entities. An increase in the top effective rate from 35 percent to 42 percent, would lower the probability that a small-business entrepreneur would add to payrolls by roughly 17 percent. For those that do manage to hire, the growth in payrolls would be diminished by over 5 percent. That is, at a time when job growth struggles to crack the 100,000 barrier monthly, the proposed tax increases would harm small-business job creation even further. #more#

Similarly, the increase in tax rates would reduce the probability that a small business undertakes expansion by 14 percent, and reduce the capital outlays of those who do expand by almost 20 percent. Again, at a time when businesses are the only sector with the financial wherewithal — households and governments are a sea of red ink — to power the recovery, the tax policy would further damage businesses’ ability to pursue pro-growth investments.

In sum, the weak state of economic growth dictates that Congress and the administration should quickly agree to keep taxes low. But does that mean that the current tax code should be made permanent? 

No. It is widely understood that the federal tax code is in desperate need of reform. Both the Bowles-Simpson and Domenici-Rivlin fiscal-reform commissions proposed real tax reform as part of the comprehensive solution to the daunting fiscal outlook. In reform, rates would be made lower, the tax bases broadened, the corporation income-tax code made more internationally competitive, and the broken Alternative Minimum Tax (AMT) eliminated. Keeping current taxes low should be tied to a commitment to tax reform. That is, the current tax rates are simply a bridge over the fiscal cliff to the opportunity for real reform.

Real reform would have dramatic benefits, especially for small businesses. Consider the reform of lowering the top marginal rate to 28 percent — the tax rate that existed after the last comprehensive reform in 1986. The decline in the top effective rate would raise the probability that a small-business entrepreneur would add to payrolls by roughly 48 percent — a significant impact. Similarly, for those firms that do manage to hire, the growth in payrolls would be enhanced by over 14 percent. That means that tax reform that is in principle directed at higher-income taxpayers would benefit workers by resulting in more hiring and higher pay.

In the same way, tax reform would affect incentives for growth, raising the probability that a small business undertakes expansion by nearly 40 percent, and augmenting the capital outlays of those that do by 54 percent. As these expansionary incentives are put in place, the demand for capital goods will rise — a fundamental of strong economic growth.

The White House and Congress should put aside the folly of higher taxes and join in a commitment to temporarily extend current taxes and undertake real tax reform. The former would get the U.S. across the fiscal cliff, while the latter would undergird desperately needed faster growth.

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