CBO Head: Raising Taxes on the Rich Will Shrink the Economy

Congressional Budget Office Director Doug Elmendorf testified before the Senate Budget Committee today on long-term effects from extending the Bush tax cuts. The headline claim in his testimony is that an extension, whether full or partial, will reduce national income in 2020. While lower tax rates grow the economy, increased government borrowing shrinks it; in CBO’s estimation, the latter will more than offset the former.

Less noticed, though, is a key implication of this presentation. In the CBO’s strong labor response model, a full extension of the tax cuts knocks 0.6 percentage points off of GNP, whereas a partial extension as proposed by President Obama (which would raise earned and unearned income tax rates on most filers making over $250,000 per year) would cost 1.2 points of GNP. That is, a partial tax cut extension is worse for the economy than a full extension, even though the full extension grows the national debt by more.

The implication is that the extending the portion of the tax cuts that principally benefits high earners would grow GNP by 0.6 points, despite such an extension’s effects on the deficit. It is the rest of the tax cuts (lower marginal rates in the bottom four brackets, marriage penalty relief, the higher per child tax credit, etc.) that do not stimulate enough economic activity to offset the added debt burden.

Even if you prefer CBO’s weak labor response model (which assumes workers have low sensitivity to tax treatment), the presentation shows equal economic damage from a partial or full extension, despite the fact that a full extension grows the deficit by about a third more than a partial extension. With this assumption, tax cuts for the rich aren’t an economic boon, but they are at least a free lunch.

So, this is more evidence to support what I like to call the Barro-Orszag-Feldstein position: we should have a temporary extension of the tax cuts that does not prejudice our permanent decision about tax reform in favor of retaining a specific part of the current tax cuts, especially the part favored by Obama that has the fewest dynamic benefits for the economy. Instead, it is important to structure the coming fiscal adjustment in a way that avoids, to the extent possible, marginal rate increases on taxpayers whose behavior is highly sensitive to tax policy changes—which is mostly to say, rich people and owners of capital.

If I were a Republican member of Congress, I would be asking CBO to model certain tax policies ten years out to defend the idea that higher marginal tax rates on capital and high-income people are destructive to the economy. This, not effects on “small business,” is the real reason that these components of the Bush tax cuts were important. I strongly suspect that this CBO model would show that keeping the capital gains tax rate at 15 percent for all filers grows the economy compared to taking the rate to 20 percent for high earners, even despite deficit effects.

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