With Congressional midterm elections looming, the financial debate in Washington this fall will probably be consumed by one incendiary and expensive issue: whether, and how, to extend the multitrillion-dollar Bush tax cuts.
President Obama is advocating a mixed bag of tax proposals. He wants to extend the cuts for all but the wealthiest 2 percent of Americans and offer businesses hundreds of billions in breaks and write-offs intended to encourage investment and hiring.
Republicans, and a few Democrats, assert that the Bush tax cuts should be extended for everyone, warning that a tax increase right now, even if limited to the highest income bracket, would hurt small businesses and choke off an economic recovery that is already gasping.
Given the economy’s persistent weakness and an unemployment rate hovering above 9.5 percent, those arguments have gained traction. And because another round of government stimulus spending is considered politically unviable even if it were warranted, the debate over the tax cuts will be laced with promises to spur economic activity and reduce unemployment. The concept of lower taxes is so appealing to voters that many embrace them as an economic cure-all.
But economic research suggests that tax cuts, though difficult for politicians to resist in election season, have limited ability to bolster the flagging economy because they are essentially a supply-side remedy for a problem caused by lack of demand.
The nonpartisan Congressional Budget Office this year analyzed the short-term effects of 11 policy options and found that extending the tax cuts would be the least effective way to spur the economy and reduce unemployment. The report added that tax cuts for high earners would have the smallest “bang for the buck,” because wealthy Americans were more likely to save their money than spend it.
The office gave higher marks to the proposal, now embraced by President Obama, to allow small businesses to write off 100 percent of their investment costs.
Neither of those options, though, would do as much to stimulate the economy as offering direct payments to the unemployed and Social Security recipients or reducing the payroll taxes of workers, the study found. But those proposals — as well as aid to states and municipalities — are considered politically untenable with many elected officials reluctant to even utter the word “stimulus” after the $787 billion stimulus.
So while the decision on whether to extend the tax cuts will have a lasting impact on the deficit and on how the nation’s tax burden is distributed, economists and tax experts say it is unlikely to offer much immediate relief for high unemployment and sluggish growth.
“It may have some small impact along the margins, but firms don’t hire based on tax breaks; they hire based on demand,” said Roberton Williams, a senior fellow at the nonpartisan Tax Policy Center. “So a lot of the tax breaks are likely to be rewarding people and companies for that they were going to do anyway.”
When they were signed into law in 2001 and 2003, the huge package of income and capital gains tax reductions that became known as the Bush tax cuts were hailed as a way distribute the government surplus and promote long-term economic growth. Mr. Bush was so confident in their power to generate business growth and revenue that he predicted they would enable the government to pay down $1 trillion in debt in just four years.
Those surpluses have now become crushing deficits because of a combination of factors, including the recession, the cost of the wars in Iraq and Afghanistan, the Medicare prescription drug benefit, and the $1.7 trillion in forgone revenue from the tax cuts themselves.
The specter of a ballooning national debt has led even some of the early supporters of the cuts, including the former Federal Reserve chairman Alan Greenspan, to advocate letting them expire.
Republicans, however, argue that it is essential that they be extended, because taking money out of an economy this frail would derail any hope of a robust recovery.
“We don’t think taxes ought to be increased in the middle of a recession for anyone,” Senator Mitch McConnell, the minority leader from Kentucky, said this summer.
The Obama administration dismisses that argument, saying that nearly a third of the cost of the cuts — more than $700 billion during the next decade — would go to the wealthiest 2 percent of Americans.
“They are essentially arguing that we add $700 billion to the deficit in return for $35 billion in what has been found to be the least effective means of stimulus,” said Jason Furman, a deputy assistant to the president overseeing economic policy.
Mr. Obama’s proposal would preserve the tax cuts for families that earn less than $250,000 a year (or individuals who make less than $200,000) at a cost of $2.8 trillion over the next decade.
Rather than continuing the breaks for the wealthy, however, Mr. Obama proposes an assortment of tax cuts to encourage business investment and hiring. While he has carefully avoided calling his plan a stimulus, Mr. Obama is calling for a permanent extension of the research and development tax credit for businesses and a change that would allow companies to write off 100 percent of any investments made through 2011.
The president has also called for the creation of a $50 billion infrastructure bank to improve roads, airports and railways, which would stoke business and hiring in the moribund construction industry.
Those plans have received mixed reviews from business groups and economists.
R. Glenn Hubbard, an economist who helped write the Bush tax cuts, said Mr. Obama’s proposals borrow heavily from Republican ideas but would have little impact on business activity.
“Nothing in the administration’s program is good stimulus,” said Mr. Hubbard, now dean of the Columbia Business School. “Investment incentives coupled with a tax increase are not going to get the economy moving.”
But Kevin A. Hassett, an economist at the conservative American Enterprise Institute, predicts the business tax breaks might be enough to reignite the economy and increase investment by 5 to 10 percent. Because some investors and business owners have viewed Mr. Obama’s policies as antibusiness, he said, the very fact that the president is offering the tax incentives could also help to encourage investment.
“I think at some point Americans are going to finally accept that the worst is behind us and that we’re ready to boom again,” Mr. Hassett said. “And this is the kind of proposal that could change the psychology and create the positive momentum we need to really get out of this malaise.”
One curious omission in the Obama plan is the tax cut proposal that many, including the Congressional Budget Office, believe would do the most to spur hiring: a payroll tax holiday. According to various news reports, Obama economic advisers passed on the idea because they feared it would be too expensive or would deprive Social Security and Medicare of crucial revenue. Administration officials declined to discuss their decision.
Whatever Congress and the administration ultimately decide about extending the Bush cuts, however, the narrow confines of the debate show how successful antitax groups have been in defining the terms used to discuss tax policy. Since the tax protests of the 1980s, elected officials have increasingly used tax breaks to finance social programs and business subsidies, and today the cost of those “tax expenditures” is $1.2 trillion — about 25 percent of all spending.
Edward D. Kleinbard, former chief of staff of the bipartisan Joint Committee on Taxation, said the reliance on tax expenditures had distorted the budget process because it induced the public to overlook the fact that — unless they are accompanied by spending reductions — tax cuts have the same effect on the deficit as additional spending. It also allows politicians to make unsubstantiated claims about the power of tax-cutting to accomplish other economic goals, he said.
“The thought that tax cuts pay for themselves or that tax cuts alone can turn around this economy is magical thinking,” said Mr. Kleinbard, now a law professor at the University of Southern California. “The debate has become so unrealistic it makes you want to scream.”