Extend the Failed Tax Cuts—For Now

09/30/2010 3:25 pm EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

Congressional Democrats have delayed a vote on whether to extend the Bush-era tax cuts beyond their January 1, 2011 expiration date.

Instead, a lame-duck Congress will try to hash it out after the midterm elections.

Republicans want to make all the cuts permanent. President Obama and many Democrats want to continue the cuts in marginal tax rates for so-called “middle-class” taxpayers and let them lapse for individuals with incomes over $200,000 and families with incomes over $250,000.

The president says letting the tax cuts on wealthier Americans expire would reduce the budget deficit by an estimated $700 billion over the next ten years. Republicans argue such a move would be dangerous during such a shaky recovery.

So, I thought it was a good time to take a broader look at the tax cuts. What did they accomplish? What would be the likely effect of letting some or all of them lapse? I’ve interviewed several experts and pored through many reports by conservative, liberal, and middle-of-the-road economists. I’ve tried hard to let the facts shape my opinions, not vice-versa.

The bottom line: I could find no evidence that the Bush tax cuts successfully stimulated the economy apart from other, more powerful factors. The cuts probably had some impact, but no economist I’ve contacted can measure it precisely.

Also, the economic recovery of the 2000s was in many ways the weakest since World War II, and the tax cuts were very expensive: at least $1 trillion in borrowed money so far, and $3 trillion more over the next decade if they’re made permanent. 

Diane Lim Rogers, chief economist of the Concord Coalition, a nonpartisan budgetary watchdog group, calls them “the single largest legislative contribution to the [deteriorating] budget outlook, because they were entirely deficit-financed.”

And because of their spotty results and high price tag, these tax cuts must be judged a failure.

Yet we’re in a recovery so slow the Federal Reserve is even contemplating more “quantitative easing”—i.e., running the printing presses. That’s why I think going cold turkey on these tax cuts now would be a mistake.

So, I’ve come to an uncomfortable, not entirely consistent, conclusion: Extend the failed tax cuts for a couple of more years, then phase out most of them over time.

The Bush tax cuts of June 2001 lowered marginal tax rates (through 2006), changed estate and gift tax laws, and allowed bigger contributions to retirement plans. The second round, signed two years later, made those marginal rate cuts retroactive to January 2003, while cutting taxes on capital gains and dividends. The 2003 law passed the Senate only when Vice-President Dick Cheney broke a  50-50 deadlock.

“The economy responded strongly to the 2003 tax cuts,” hailed the conservative Heritage Foundation. “GDP grew at an annual rate of just 1.7% in the six quarters before the 2003 tax cuts. In the six quarters following the tax cuts, the growth rate was 4.1%,” Brian Riedl wrote.

Unfortunately Riedl is confusing correlation with causation: Just because one event followed the other doesn’t mean the first event caused the second.

Other economists are more circumspect.

“There is a dearth of numbers. It is very difficult at this point to have a hard number” on the impact of the Bush tax cuts, says Alan D. Viard, resident scholar at the American Enterprise Institute.

But crediting the Bush tax cuts with even most of the gains from the last economic recovery is like saying Scottie Pippen led the Chicago Bulls to six world championships in the 1990s.

Next: The Michael Jordan of the Recovery

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The "Michael Jordan" on this team was, of course, Federal Reserve chairman Alan Greenspan--at least when it came to the economic recovery (although we've paid a big price since). He cut the federal funds rates from 3.5% before the September 11, 2001 terrorist attacks to 1% in July 2003—just in time for the second round of the Bush tax cuts.

Those rock-bottom rates coincided with the blow-out phase of what economist Robert Shiller called “the biggest national housing boom in [US] history.”

“The rise in house prices from 2002 to 2006 was a main driver of economic growth during this time period,” wrote Atif R. Mian of UC Berkeley and Amir Sufi of the University of Chicago in the Wall Street Journal’s Real Time Economics blog.

Housing-related industries “accounted for about 43.0% of the increase in private sector payrolls since the economic recovery began in November 2001,” wrote Northern Trust economist Asha Bangalore in May 2005.

And even if the Bush tax cuts were responsible for half of the economic growth that occurred, it was half of a pretty small pie. According to the Economic Policy Institute, a liberal think tank, the recovery was in many ways the weakest since World War II (see table).

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For instance, 8.3 million jobs were added from August 2003 to December 2007—a bit more than a third of the 22.7 million that came during the much longer Clinton-era recovery and about half the 16 million added during the Reagan rebound of the 1980s.

So, what do we do now?

The president says let’s go back to a top marginal tax rate of 39.6%, which high earners paid during the booming 1990s. Problem is, as Alan Viard of the AEI points out, additional taxes could push the top marginal rate to as high as 44.6%.

 “Starting in 2013, we will end up at a rate higher than under Clinton,” he says. And that doesn’t include state and local taxes.

How much could a hike in that top rate hurt the economy?

Mark Zandi, chief economist of Moody’s Analytics, estimates that letting the tax cuts lapse for top earners “would reduce real GDP by 0.4 of a percentage point in 2011 and 0.2 of a percentage point in 2012.”

Letting all the tax cuts expire, he believes, “would precipitate a double-dip recession during the first half of 2011.”

Macroeconomic Advisers projects a 0.2% decrease in GDP per year if the top rates move up and 0.6% average annual declines if all the tax cuts end.

Given the state of the economy,  “I think it’s a high-risk policy,” says economist A. Gary Shilling.

That’s why I favor keeping all the Bush tax cuts through 2012, then phasing them out over the next five years, starting with the top marginal tax rates. By then, the economy should be much improved, and we can start to address our mammoth debt problems in earnest. I would let dividend tax rates go up to 20%, but cut capital gains taxes in many instances.

There’s one big problem, though—Congress. “I really don’t believe if we extend all the Bush tax cuts for two years that we’d let them expire two years from now,” says Diane Lim Rogers. “We end up committing to a policy we can’t afford for the longer term.”

Indeed we can’t, because keeping all the cuts will cost us $3 trillion over the next ten years.

Anybody who’s sincere about dealing with the deficit will have to put all these tax cuts on the table, along with domestic and military spending and, of course, entitlement programs like Social Security, Medicare, and Medicaid. Politicians who continue to dance around it—be they Democrat, Republican, or independent—are just wasting our time and mortgaging our future, yet again.

Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.

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