Magazine | November 29, 2010, Issue

Tax Extension

Letting rate cuts on top earners expire would cost more than it’s worth

The 2001 and 2003 tax cuts are set to expire on December 31. In the months before the election, the White House pressed the case for permanently extending tax cuts for households earning $250,000 or less, while congressional Republicans insisted on extending all of the tax cuts, including those for high-income households. Dozens of congressional Democrats, many of them facing tough reelection battles, came to embrace the Republican stance, forcing the Democratic leadership to punt on the issue until the lame-duck session.

As Princeton political scientist Larry Bartels recently argued, the politics of the tax cuts rests on the influence of an energized minority. According to a YouGov/Polimetrix survey conducted in late October, only 28 percent of the public favors permanent extension of all of the 2001 and 2003 tax cuts. Yet this slice of the population was far more committed to its position, and far more likely to vote, than the 42 percent who prefer the president’s stance. And so, Bartels concludes, “candidate Obama’s skillful-looking proposal to allow the tax cuts to expire only for the richest 2 percent of taxpayers has turned out to be very costly for President Obama and his party, despite its overall popularity.”

Regardless of the political consequences, the president remains committed to some version of his original stance. Recognizing that raising taxes by allowing the expiration of tax cuts for high-earners is a non-starter, the White House has suggested “decoupling” the 2001 and 2003 tax cuts. In a recent weekly address, the president emphasized the importance of permanently extending the tax cuts for middle-income households, yet insisted that the country could not “afford to borrow an additional $700 billion from other countries to make all the Bush tax cuts permanent, even for the wealthiest 2 percent of Americans.”

The president is characterizing his stance as evidence of his commitment to fiscal restraint. But strikingly, he failed to note that the middle-income tax cuts will cost $3 trillion over the same ten-year period that he’s using to yield $700 billion as the cost of the high-income rate reductions. One assumes that the $3 trillion will also have to be borrowed from other countries.

Congressional Democrats attempted to paper over this question in February when they approved an extraordinary exception to the “pay as you go” (PAYGO) rule. As conventionally understood, PAYGO means that all proposed changes to the budget, whether spending increases or tax cuts, will have to be balanced by tax increases or spending cuts. Defying logic, the Democratic leadership decided that the $3 trillion in middle-income tax cuts would be exempt from PAYGO. But this, of course, doesn’t change the fact that the $3 trillion will still have to be borrowed.

One could argue, in the president’s defense, that the middle-income tax cuts will generate enough economic activity to justify the revenue loss. Yet it appears that the high-income rate reductions were the most economically beneficial component of the 2001 and 2003 tax cuts, as Alan Viard of the American Enterprise Institute argued in September. In Viard’s view, allowing only the high-income rate reductions to expire would “combine much of the disincentive effects of full expiration with much of the deficit increase of full extension.”

Viard is far from alone in reaching this conclusion. His argument is consistent with the findings of the Congressional Budget Office, led by the well-regarded Democratic appointee Douglas Elmendorf. Josh Barro of the Manhattan Institute, writing at National Review Online’s blog “The Agenda,” observed that the CBO’s strong labor-response model finds that a partial tax-cut extension as proposed by the president would reduce real GNP by 1.2 points — the growth effects of the tax cuts would not be sufficient to offset the lost government revenue. A full extension, in contrast, would reduce real GNP by only 0.6 points, suggesting that the addition of the high-income rate reductions would actually increase GNP by 0.6 points, despite the revenue loss. The weak labor-response model finds that partial and full extension have the same impact on GNP.

#page#It’s worth stressing that the CBO’s model could be entirely off-base. For example, new empirical evidence from researchers at the University of Michigan suggests that the CBO overestimated the economic impact of the Making Work Pay tax credit. But for a president who insists that he pays careful attention to the real-world implications of his policy choices, the CBO’s findings ought to force a serious reexamination. There is a real danger that the president’s favored approach is the economic equivalent of cutting off your nose to spite your face. And if, as Bartels argues, his approach doesn’t even have the virtue of being politically expedient, one can’t help but wonder why the president is so committed to it.

There is a way out of this impasse, and it was first proposed by Peter Orszag, the president’s former budget director, in an op-ed published in the New York Times. Orszag, to his great credit, acknowledged that the president’s call for permanent extension of the middle-class tax cuts is a budget-buster. As a compromise measure, he proposed a temporary extension of all of the 2001 and 2003 tax cuts. Barro has also embraced this approach, and Howard Gleckman of the Tax Policy Center thinks it is the most likely outcome. Having fallen short of a majority in the Senate, Republicans don’t have the leverage they’d need to push through a permanent extension of all the cuts. Yet Republicans in the House understand that the president’s “decoupling” strategy will place them in a very weak position when it comes time to debate the tax cuts in two years. Despite the president’s unpromising rhetoric, it looks as though the White House might be willing to cut a deal.

The question for conservatives is whether this is a deal worth accepting. Many will insist that only a full and permanent extension of the 2001 and 2003 tax cuts is an acceptable outcome. Intriguingly, Bartels observes that only 8 percent of the voters who favor permanent extension of all of the tax cuts have household incomes of $150,000 or more, while half earn less than $50,000. Tax-cut supporters appear to be voting on the basis of their values and aspirations rather than their narrow pocketbook interests. Or it could be that these voters, often ridiculed by left-of-center critics for voting against their own economic interests, are convinced that tax increases will create strong work disincentives at the top of the income spectrum that will have baleful consequences for the broader economy.

Rather than focus on preserving the 2001 and 2003 tax cuts, conservatives should embrace a temporary extension and think seriously about how to overhaul our destructive and inefficient tax code. A comprehensive reform agenda could dramatically lighten the economic burden of taxation, including the 3.5 billion hours U.S. firms and households spend on tax preparation. And fortunately, congressional conservatives already have an excellent model for comprehensive reform in the Growth and Investment Tax Plan proposed by Pres. George W. Bush’s 2005 advisory panel on federal tax reform. Among other things, the plan reduces the highest marginal tax rate and cuts in half the number of tax brackets, thus improving work incentives. It slashes the tax rate on dividends, capital gains, and interest. And most important, it eliminates or simplifies a panoply of costly tax deductions aimed at micromanaging Americans’ economic lives.

There are, of course, many other worthy approaches, including a flat tax or a progressive consumption tax, or the politically attractive, family-friendly tax plan advanced by Ramesh Ponnuru in National Review and Rob Stein in the pages of National Affairs, which dramatically increases the child tax credit. Regardless of which approach the Right eventually embraces, a temporary extension of the 2001 and 2003 tax cuts will buy conservatives the time they need to make the case for a durable, pro-growth reform.

– Mr. Salam is a policy adviser at Economics21.

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

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