The ‘Misoverestimated’ Surpluses and the Tax-Cuts Debate

One of the most stunning statements in George W Bush’s recent memoir, “Decision Points”, is his response to accusations that he squandered the budget surplus he inherited from the Clinton administration. According to an MSNBC report, Bush writes:

“Much of the surplus was an illusion, based on the mistaken assumption that the 1990s boom would continue. Once the recession and 9/11 hit, there was little surplus left.”

The irony runs deep: Back in 2001, the projected “surpluses” had been the very premise underlying the Bush tax cuts, which, supporters argued, would serve to refund to Americans the over-charge on their taxes.

But with the surplus premise now defunct even by the tax cuts’ own creator (let alone by the glaring misery of America’s fiscal outlook), are there any arguments left to support their extension beyond their scheduled expiry at year-end?

Obviously, the #1 argument made by frightened policymakers from both the right and the left is that the economic recovery is still at too fragile a stage to engage in contractionary fiscal policies such as the repeal of the Bush tax cuts. But the argument is misplaced. First, because the stimulative effect of the Bush tax cuts—as designed—is not as obvious as their multi-billion dollar cost would suggest; and second, because the alternative does not have to be the absence of any other stimulus measure.

Expanding on the first point, it is useful to consider the arguments made by William Gale and Peter Orszag in a 2004 paper, which assessed the impact of the Bush tax cuts, including as a stimulus against the 2001 recession.

The authors argued that the tax cuts were poorly designed as a stimulus measure for a number of reasons, many of which continue to apply today: First, they had a regressive nature—i.e. they were not primarily targeted to the (lower-income) households with the highest marginal propensity to consume.

Second, some of the provisions (e.g. estate tax repeal, and increases in tax-free savings allowances) were designed to increase saving, not consumption.

Third, by contributing to a large fiscal hole (to the extent they are not offset by spending cuts), they generate uncertainty about the government’s finances, which could undermine future investment by increasing volatility in capital markets.

Finally, the authors cite research by that estimated that the measures with the highest “bang for the buck” (always from a stimulus perspective) were the extension of unemployment benefits, the aid to state governments and measures that targeted low- and moderate- income households, including the child tax credit rebate and the acceleration of the 10% bracket.

In short, the call to keep the Bush tax cuts out of fear of undermining the economic recovery has shaky economic foundations, and certainly does not stand when made by those who consider a fiscal “stimulus” as anathema. Further government support to the economy (to the extent it is politically desired) can be provided by alternative measures that are better targeted, temporary and cheaper (ie with a bigger bang for the buck).

A second argument for maintaining the Bush tax cuts is that lower revenues encourage spending restraint. Well… if only! In fact, not only is this argument disproved by the spending track record of the previous administration; steps to reduce spending can be made politically difficult by the fact that the prime beneficiaries of the tax cuts are not the same as those affected by the potential spending cuts. In other words, the bargaining game on how to restore fiscal discipline is easier when spending cuts can be “traded” for selected tax increases.

A final argument has to do with efficiency: lower taxes tend to foster incentives to increase labor supply, saving and investment. But, as argued by Gale and Orszak, the Bush tax cuts, as designed, were not ideal from an efficiency perspective. Labor supply incentives tend to increase with decreases in a worker’s marginal tax rate and, per the authors estimations, this did not change for some 40% of taxpayers. The latter is partly because the nominal cuts in the tax rates are irrelevant for households subject to the alternative minimum tax (AMT).

In addition, the Bush tax cuts have not provided a stepping stone for a true, fundamental reform of the tax system—one that is geared towards a consumption (rather than income) tax, one that broadens the tax base, one that addresses the “double taxation” on corporate profits, one that treats the interest income and expense equally, and so on. Such reform will have to wait until Congress is ready for a constructive debate on the tax code. It has little to do with the Bush tax-cut extension.

In light of the above, it is pretty baffling that voices from both the right (who supposedly care about tax efficiency, fiscal discipline, etc) and the left (who supposedly care about equity, progressive taxation, social spending, etc) have been “terrorized” into maintaining a set of measures that is faithful to none of their respective “credos”. And it will be unfortunate (and potentially explosive) if the debate on government finances does not manage to graduate into a cooler, economics-driven discussion in the months ahead.

Originally published at Models & Agents and reproduced here with permission.