The tax compromise that the president, after protracted bargaining with Congress, signed into law Friday represents the worst of each party’s principles. Democrats agreed to forgo their insistence on raising taxes to narrow the widening budget deficit. Republicans forgot (again) that they are supposedly the party of smaller government.
In effect, each party stuck to the portion of its principles that will be popular with the electorate right now -- and dismissed the part that would be unpopular. The Washington compromise is symptomatic of the disease infecting government at many levels. It is known as short-termism.
The better course would have been the simplest one: Let the Bush tax cuts -- on every income group -- expire. Democrats (I am one) have generally supported raising tax rates only on the rich. I never liked that approach because it’s an attempt to curry favor with the majority of the public by saying, “The deficit is not your problem; it’s only the problem of wealthy people.” It sends a misleading, as well as divisive, message that, for the majority of Americans, incremental government services, such as stimulus spending or rising health-care expenditures, are free.
No Free Lunch
To make serious inroads on the deficit, we should restore Clinton-era tax rates on every income group. The wealthy would suffer by far the largest incremental burden -- which is proper -- but the middle class wouldn’t get a free lunch. The Republican Party has opposed restoring the old rates because, as it has repeatedly demonstrated, it is allergic to all taxes. Since it isn’t opposed to government spending, only to revenue, it is hypocritical and exceptionally short-term focused.
Republicans claim that higher taxes translate to lower growth. Recent evidence is to the contrary. In the 1990s, the top tax rate was 39.6 percent. The U.S. enjoyed a booming economy, warmed by the balmy breezes of a balanced budget. In the 2000s, George W. Bush cut the top rate to 35 percent. Deficits ballooned, and the economy was mostly lousy.
Going back further, the connection is murky at best. In the 1960s, marginal tax rates were extremely high -- 70 percent and in some years even more. The economy roared. In the 1970s, taxes remained high and the economy slumped. In the 1980s, President Ronald Reagan slashed taxes: By 1988, the marginal rate was only 28 percent and the tax code was greatly simplified. Clearly, those giant tax cuts, plus the elimination of many loopholes, stimulated a boom.
Though that decade-by-decade synopsis inevitably simplifies, the evidence suggests tax rates should be as low as possible subject to the constraint that the budget IS roughly in balance in good times, and even in bad times avoids the risk of runaway deficits. But with the government borrowing equal to 9 percent of gross domestic product, and with large entitlement- spending increases looming, we are well into runaway territory already.
The evidence also shows that small changes in tax rates don’t depress the economy, especially when the outlook for tax rates is consistent and when tax policy is straightforward.
Current policy fails on inconsistency grounds -- given the deficit, tax rates are unsustainable. The most serious quarrel with raising rates now is that we are still emerging from a recession. But this isn’t Herbert Hooverism -- the U.S. economy has grown in every quarter since mid-2009.
It is true that, given the weakness of the recovery, the timing isn’t ideal. However, Congress has been passing off the bad coin of the Bush tax cuts for almost a decade. Why should we think that Congress or President Barack Obama will show more courage in 2012 -- a presidential election year?
For obvious humanitarian reasons, I support the extension of unemployment benefits. Obama could have proposed an additional extension in return for the lower estate-tax levels so hotly pursued by Republicans. Unlike cutting taxes on people with jobs, extending benefits to those without jobs is truly part of the safety net -- one that, if properly explained, the electorate would get.
Finally, lowering the payroll tax, which will drain funds from Social Security, is incredibly shortsighted. It is only weeks since Obama’s panel on the deficit highlighted the need to strengthen entitlement budgets.
Punishment for Savers
I suspect the Federal Reserve has contracted the same disease -- pushing ultra-low short-term interest rates. This encourages consumer spending and the credit-card mentality of the pre-crash years, and it punishes people who save.
The Fed is responding to today’s sluggish economy, though the signs for tomorrow are bullish. Rising long-term interest rates suggest that if the Fed had a little patience, the recovery would continue without further easing.
Another example of short-term thinking is the maintenance of the government’s role in propping up mortgages -- chiefly through the failed Fannie Mae and Freddie Mac. Wouldn’t it be more prudent to let home prices fall to whatever level the market would support? Then, private mortgage financing would return, leading to a sustainable housing recovery based on real- market prices.
Short-termism is also alarming at the level of state governments, which are facing massive budget shortfalls even as they refuse to adequately fund their pension plans. It isn’t inconceivable that the federal government will be faced with another too-big-to-fail entitlement -- that of a bankrupt local government.
With the private sector recovering, albeit slowly, and public finances worsening, the time to restore our public finances to health is now. And if doing so delays the economy’s return to full and robust growth, then let the recovery come more slowly -- and let it be built on sound financing and not on a new pyramid of debt.
(Roger Lowenstein, author of “The End of Wall Street,” is a Bloomberg News columnist. The opinions expressed are his own.)
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