How Much Would the Fiscal Cliff Raise Taxes?

by Veronique de Rugy

A lot. The Tax Policy Center’s Roberton William, Eric Toder, Hang Nguyen, and Donald Marron did the math in a new study, and find the following:

Taxes would rise by more than $500 billion in 2013—an average of almost $3,500 per household—as almost every tax cut enacted since 2001 would expire. Middle-income households would see an average increase of almost $2,000.

They also look at who will be affected the most and by what increases of which taxes:

Almost 90 percent of Americans would see their taxes rise if we topple off the cliff. For most households, the two biggest increases would be the expiration of the temporary cut in Social Security taxes and the expiration of the 2001/2003 tax cuts. Households with low incomes would be particularly affected by the expiration of tax credits expanded or created by the 2009 stimulus. And households with high incomes would be hit hard by the expiration of the 2001/2003 tax cuts that apply at upper income levels and the start of the new health reform taxes. Taken together, the scheduled changes would significantly increase the marginal tax rates that can influence behavior. Average marginal tax rates would increase by 5 percentage points on labor income, by 7 points on capital gains, and by more than 20 points on dividends.

When economists have looked into the impact of changes in taxes that occur independent of changes in the economy — such is the case with the fiscal cliff — they have found that the impact of tax hikes are rather negative. Take the work of former Obama CEA chairman Christina Romer and her economist husband, David Romer. They show how increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.

So we can expect some significant impact on economic growth. What about the impact of tax increases on labor supply? Interestingly, the microeconomics literature finds that labor supply — especially for men or primary earners — is relatively inelastic to changes in net tax, meaning that employees don’t really seem to react much (e.g., by shifting their hours) in response to higher taxes.

Does that mean that the fiscal cliff’s tax hikes wouldn’t affect the labor supply? Yes and no. #more#In the short term, studies suggest that increases in rates likely won’t have much of an effect on the labor supply of the typical full-time employed man aged 30 to 50 (roughly), but this finding doesn’t hold for secondary earners.

It also doesn’t hold in the long run. In recent years, labor economists have been focusing a lot of attention on what they call the extensive margin — in this case, employees’ movement in and out of the labor force, particularly at both ends of life cycle. Economists such as Nobel-prize winner Edward Prescott have concluded that looking at “extensive margins” allows us to understand questions like why Europeans work fewer hours over their lives than Americans do.

In other words, changes in tax rates may not matter much for typical workers, but they do have an effect on younger workers and older ones. Moreover, employees may not change their labor supply at the time of the tax increase, but they are likely to adjust in later years. When looking at tax effects on labor supply, it’s lifetime hours that matter, and the effects are there. That may be an important factor in explaining the strong negative economic-growth effects of tax increases, which is identified by the Romers.

Interestingly, women could be the ones affected most by the fiscal cliff. As my colleague Matt Mitchell recently noted:

Increasingly, however, the literature has identified another margin that matters: lifetime decisions about schooling, fertility, and work experience. If taxes affect these things, then they still affect labor supply, even if they don’t seem to affect short-term decisions about how much labor to supply. As Michael Keane’s recent piece illustrates, taxes have a very pronounced effect along this margin, especially among women.

Matt also has a list of relevant economic articles about the question of the fiscal cliff and its impact, and an excellent response to the recent CRS report by Thomas Hungerford that claim that taxes, in particular the individual income and capital-gains rate, do not affect economic growth.

My take on all this is that letting the tax cuts expire as part of the fiscal cliff would have a large negative impact on the economy; hence we shouldn’t.

That said, if Congress continues refusing to cut spending significantly or reform Social Security and Medicare, I would argue that we should let all the tax cuts expire and deal with the painful and dramatic consequences of our irresponsible spending.