President Obama on the Tax Cuts He Likes and the Tax Cuts He Dislikes

Noah Glyn makes an interesting observation regarding President Obama’s latest campaign address:

At one point in his speech, President Obama said, “I don’t believe that a tax cut is more likely to create jobs than providing loans to new entrepreneurs or tax credits to small-business owners who hire veterans.”

But later in the speech he bragged about cutting taxes, “Over the last three years, I’ve cut taxes for the typical working family by $3,600.” And later, “I’ve cut taxes for small business 18 times.”

This gets at an important point: not all tax cuts are created equal. The Bush-era tax cuts were multifaceted. President Obama and congressional Democrats have endorsed most of them, having called for the expiration of only those that impact high-earners.

It turns out, however, that the tax cuts that were most conducive to growth are precisely those that the president and his allies want to end, as Alan Viard explained in 2010:

President Barack Obama has proposed that most of the tax cuts for households with incomes above roughly $200,000 for singles and $250,000 for married couples (the “high-income rate reductions”) be allowed to expire as scheduled, although he would partially extend the 2003 dividend tax cut. At the same time, he has called for the permanent extension of the Bush tax cuts for taxpayers with incomes below those thresholds (the “middle-class tax cuts”), with no spending cuts or tax increases to offset the associated revenue loss.

From the standpoint of long-run economic growth, this proposal represents the worst of both worlds. As explained below, the high-income rate reductions provide much greater incentive for investment and other economic activity, relative to revenue loss, than the middle-class tax cuts. The expiration of the former and extension of the latter therefore combine much of the disincentive effects of full expiration with much of the deficit increase of full extension.

Viard elaborates later in the piece:

Although marginal-tax-rate increases are distortionary at any income level, rate increases at the top income levels generally create the largest distortions per dollar of revenue. That partly reflects the fact that the rates at the top income levels are already high, so further increases are more damaging. But it also reflects the fact that rate increases at the top raise revenue from only some of the affected taxpayers’ income. For example, consider a proposal to increase taxes by 5 percent of the income above $250,000 (which approximates the expiration of the high-income rate reductions for a married couple with ordinary income). The resulting revenue is less than 5 percent of the affected taxpayers’ incomes because the tax applies only to the income above the $250,000 threshold; for a $400,000 couple, for example, the 5-percentage-point tax increase applies only to the last $150,000 of income, and the revenue is only $7,500. Because the disincentive effects depend upon the marginal tax rate applied to the last dollar, though, they are as severe as if the couple had to pay an extra 5 percent on their entire income (except that the disincentive will not prompt the couple to reduce their income below $250,000).

The opposite pattern holds for tax hikes in the bottom bracket, which actually leave marginal rates unchanged for most of the taxpayers from whom additional revenue is collected. For example, suppose that the 10 percent bracket, which will apply to the first $17,000 of a couple’s taxable income in 2011 if extended, reverted to 15 percent. Taxpayers in that bracket would face a 5-percentage-point increase in ¬disincentives and would pay an additional 5 percent of taxable income. At the same time, all couples in higher brackets would also pay an additional $850 in tax because the first $17,000 of their income would be taxed at 15 rather than 10 percent. These higher-bracket taxpayers would not, however, face any additional disincentives because there would be no change in their marginal last-dollar tax rates.

As Josh Barro observed in the fall of 2010, the models used by the CBO reach a very similar conclusion:

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.

This absolutely does not mean that there isn’t a case for tax cuts, or tax relief to use a more politically adept turn of phrase, for low-income and middle-income households. We might want to reduce the tax burden on these households on social justice grounds, e.g., the dispersion of market incomes might lead us to conclude that the tax code should become more progressive rather than less. Indeed, this is one reason why the share of U.S. households that are net contributors to the federal government has decreased in recent years, and I see nothing intrinsically wrong with this development, though of course there are political economy reasons to be concerned about it. 

So it seems that President Obama is operating under a very serious misapprehension regarding the core conservative case for tax cuts. He favors extending the Bush tax cuts that aren’t growth-enhancing — that were backed for a number of other reasons, e.g., to make the larger tax cut package more politically attractive, to use the tax system to redistributive ends — and he condemns those that actually are growth-enhancing.

Moreover, he has pressed for tax cuts that, like the Bush-era tax cuts he endorses, aren’t as effective at improving work incentives per dollar of revenue lost as those aimed at high-earners. I want to stress that this is obviously not a bad thing in itself if President Obama understands what he is doing, i.e., that he is backing tax cuts that are designed to give households more disposable income, etc. Given the economic climate, this may well have some economic benefit, though of course much depends on the design of the tax cuts and how different households change their spending patterns in response (see the work of Sahm, Shapiro, and Slemrod on the 2009 fiscal stimulus law). 

While President Obama has taken to condemning the Bush-era tax cuts, it seems that he should embrace those that he wants to extend, i.e., those aimed at low- and middle-income households. Then we can have a clearer debate. The right really does champion high-income rate reductions on the grounds that they are conducive to economic growth. The CBO’s weak labor response model — which could be wrong, I should stress — maintains that the high-income rate reductions are essentially an economic free lunch. So it could be that the right and the CBO are entirely wrong. 

It is the social justice tax cuts that raise interesting and important questions. For example, is the cause of social justice better served by allowing low- and middle-income households to have somewhat higher disposable incomes or is it better served by using that revenue to make public investments of various kinds? We have good reason to believe that these tax cuts aren’t the best way to jumpstart economic growth, so they have to be justified on some other grounds. 

Conservatives, naturally, are inclined to believe that the cause of social justice is better served by increasing disposable income rather than by increasing public investment levels, as private citizens (presumably) have a better sense of what their needs are and how they are likely to change over time. But I think one can make an intelligent case to the contrary, at least on the margin. That would be an interesting debate. But of course the president is uninterested in having this debate because he wants to preserve the Bush-era tax cuts for these households.

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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