The Wisdom and Folly of the Bush Tax CutsBy
(Corrects headline, economic growth rate in 6th paragraph, and committee name in 9th paragraph.)
You won't find a truer believer in the big tax cuts of the George W. Bush era than Glenn Hubbard, the lanky, 51-year-old economist who is dean of Columbia Business School. The Republican academic was instrumental in designing the tax cuts, first as a Bush campaign insider and then as the President's first chief economic adviser. The idea behind the cuts, enacted in 2001 and 2003, was to encourage work, savings, and investment, thus stimulating long-term economic growth. Hubbard is especially proud of the 2003 cut in taxes on dividends and capital gains, which he calls "the most pro-growth tax reform that anybody did since Kennedy."
Now that the Bush tax cuts are coming up for renewal—they expire on Dec. 31 unless Congress acts—Hubbard has a queasy feeling about them. The cuts, he says, have been undermined by years of deficits. Until the trajectory of spending changes, he says, "deficits are just future taxes. You're just talking about taxes today vs. taxes tomorrow."
Precisely. The debate over extension of the Bush tax cuts is the opening salvo of a generation-defining fight. With Medicare and Social Security spending set to balloon as baby boomers retire and grow old, the terms of the conflict are crystallizing: What do Americans expect from their government? How much are they entitled to, how much are they willing to contribute—and what are they willing to do without?
Some people who once championed tax cuts unconditionally have a new catchphrase—or more precisely an old one that's been repurposed: There's no free lunch. Former Federal Reserve Chairman Alan Greenspan, an influential voice in favor of the first Bush tax cut in 2001, told NBC's Meet the Press on Aug. 1 that extending the cuts without making offsetting spending reductions could prove "disastrous." Said Greenspan: "I'm very much in favor of tax cuts, but not with borrowed money."
The Bush tax cuts were the product of a rare confluence of political and economic forces we may never see again. They were premised on a sturdy principle: People, both as workers and as investors, respond logically to the incentives that government sets for them. The Economic Growth and Tax Relief Reconciliation Act of 2001 lowered the highest income tax rate (on individuals earning above $200,000 and households above $250,000) from 39.6 percent to 35 percent by 2006 and cut lower brackets' rates by similar amounts—encouraging people to work more by letting them keep more of the fruits of their labor. The 2003 package accelerated the cuts and added the reductions in capital gains and dividends that Hubbard is so proud of because they reward people for saving and investing.
How did the cuts work? The long-planned 2001 tax reduction took effect during the mild 2001 recession and probably helped make it milder, says Joel Slemrod, founding director of the Office of Tax Policy Research at the University of Michigan's Ross School of Business. But the cuts weren't designed as Keynesian energy shots. They were supposed to promote long-term growth by realigning incentives. On that score their legacy is hard to measure because there's no way to know how the economy would have fared without them. Many companies instituted dividends to take advantage of the tax break, but whether that induced more investment is unclear. What's indisputable is that deficits grew while the U.S. economy rumbled along in slow gear: Growth averaged 2.7 percent a year from the end of the 2001 recession through December 2007, at which point the economy tumbled into the worst downturn since the Great Depression.
Today, high unemployment is coloring the debate over whether to extend the tax cuts. Democrats who originally opposed them on grounds that they favored the rich are open to continuing them now, figuring that the economy needs all the help it can get. Macroeconomic Advisers, a St. Louis-based economic consulting firm, estimates that a "full sunset" of the Bush tax cuts (and President Barack Obama's modest middle-class tax cut of 2009), as called for by current law, would cut 0.9 percentage points off the growth in gross domestic product next year—a big hit considering that economists surveyed by Bloomberg News expect growth of only 2.9 percent next year.
As a result, the range of options under serious consideration in Washington is remarkably narrow. Republicans want to extend the Bush tax cuts for 100 percent of taxpayers; the Obama Administration wants to limit the extension to a mere 97 percent or 98 percent, excluding individuals earning $200,000 a year or more or families earning $250,000 or more. On Aug. 4, Treasury Secretary Timothy F. Geithner said "the country can't afford" to keep the top-end reductions.
Obama's plan isn't so affordable either. According to the staff of the congressional Joint Committee on Taxation, the Obama plan would forgo revenue of $2.8 trillion from 2010 through 2020. Protecting high-income taxpayers from the tax-cut expiration as well would cost an additional $700 billion in forgone revenue over the same period, Geithner says.
The cost has economists rummaging for cheaper ways of reviving growth. The nonpartisan Congressional Budget Office ranked continuation of the Bush tax cuts last for effectiveness among stimulus options, partly because rich people tend not to go out and spend their tax cuts. They invest them, blunting the immediate impact. Princeton University economist and New York Times columnist Paul Krugman, the unofficial theoretician of the liberal wing of the Democratic Party, said in an e-mail that his preference would be to let the tax cuts expire and replace them with additional aid to state and local governments, which have been forced to lay off workers and curtail social assistance because, unlike the federal government, they are required to balance their budgets. Since, as Krugman says, that's undoable in the current political climate, his second choice is to extend the cuts, as Obama wishes, but only for a limited period.
One problem with extending the cuts is that it doesn't send much of a signal about fiscal fortitude. That's why economist Alan Auerbach of the University of California at Berkeley argues for coupling the extension with a major deficit-reducing measure that would kick in a couple of years from now—say, an increase in the Social Security retirement age. Barry Bosworth, an economist at the Brookings Institution, takes an even harder line. He would let the cuts expire on Dec. 31, stimulus be damned. "We've gotten so deep in the muck that we're going to have to pay the short-run cost" of a hit to growth from rising taxes, says Bosworth.
Congress doesn't see things Bosworth's way because, in part, the bond market isn't forcing it to. The U.S. Treasury is able to borrow for 10 years at an interest rate of just 2.9 percent, vs. 10.2 percent for comparable Greek bonds. Foreign investors, who held 57 percent of U.S. Treasuries at last count, are tolerating minuscule returns because they're confident the U.S. won't default or try to lighten its debt via inflation. The bond vigilantes who terrorized the Clinton Administration into good fiscal behavior have become enablers. Says economist Ed Yardeni, who coined the term bond vigilantes: "This Administration has got to be saying, 'What's all the commotion about? Party on, dude.' "
Party on, that is, until the bond enablers wake up one day and decide that the U.S. has dug itself into a hole it can't get out of. On July 27, the CBO warned of a nightmare scenario in which "investors would lose confidence abruptly and interest rates on government debt would rise sharply." It added: "The exact point at which such a crisis might occur for the U.S. is unknown."
Big tax cuts seemed quite reasonable in 1999 and 2000, when Bush was campaigning for his first term as President and talking up cuts to fend off challenges from fellow Republican Steve Forbes and, later, Democrat Al Gore. The U.S. was running budget surpluses and paying down the national debt. It's hard to believe now, but Greenspan, who was running the Fed, worried that if the U.S. paid off all its debts, conducting monetary policy through the purchase and sale of Treasury bonds would be impossible.
On the stump, Bush made an argument with obvious appeal: If the government was taking in more money than it needed, it should let Americans keep more of what they earned. And if tax cuts kept government from growing, so much the better. Hubbard recalls devising the 2001 tax cut in huddles with fellow advisers Lawrence B. Lindsey, who went on to head the National Economic Council, and Hoover Institution scholars John Cogan and John Taylor. So confident was Bush in his tax cut, which he signed that June, that he predicted that even after reducing rates the U.S. would be able to pay off nearly $1 trillion in debt over the coming four years. That August, at his ranch in Crawford, Tex., first-termer Bush called the shrinkage of the surplus "incredibly positive news" because it would create "a fiscal straitjacket for Congress."
What Bush and others failed to see was that the Clinton surplus had been a fluke. Capital-gains tax receipts had grown because of the short-lived dot-com boom. A stalemated government was living within its means: Clinton couldn't get spending programs past the Republican-controlled House and Senate and the GOP couldn't get tax cuts past Clinton. And the vigilantes were vigilant: Investors demanded an inflation-adjusted yield on 10-year Treasuries averaging 2 percent or 3 percent then, vs. less than 1 percent now.
After the 2001 cuts were enacted, deficit hawks such as Clinton Treasury Secretary Robert Rubin grumbled that they were unaffordable, but most of the controversy was over whether the cuts were tilted too much toward top earners, who would get the lion's share of the dollar savings. (The same law cut the estate tax to zero by 2010.)
Then came Bush's second big tax cut, the Jobs and Growth Tax Relief Reconciliation Act of 2003. Once again the biggest debating point was who got the largest share of benefits, not the deficit impact. Quietly, though, deficits were mounting.
Hubbard, who returned to Columbia to become dean in early 2003, was dismayed by the red ink. The Bush tax cuts on investment income were supposed to induce people to invest more, which would stimulate growth, make workers more productive, and ultimately raise wages. But if investors suspected that the move would have to be reversed to cover the growing budget gap, they wouldn't be willing to open their wallets—and the cuts would be of little value. "The spending during the Bush years was a huge problem," says Hubbard, citing the Medicare prescription drug benefit, which is projected to cost $400 billion from 2004 through 2013 and to keep growing.
Indeed, the Heritage Foundation says that spending growth contributed more to the deficits than tax cuts did. Using CBO figures, it calculates that the 2001 and 2003 tax acts were responsible for just (!) $1.7 trillion of the $11.7 trillion swing from projected surpluses to huge deficits from fiscal 2002 through 2011. The other reasons: poorer-than-expected economic growth and stock market performance, $3.8 trillion; higher-than-expected defense spending, discretionary domestic spending, the Medicare drug benefit, financial bailouts, and other spending, $3.7 trillion; interest costs, $1.4 trillion; the 2009 stimulus, $700 billion; other tax cuts such as the 2008 rebates, $400 billion.
Things get worse from here, though not right away. Over the next few years, deficits will likely shrink as the economy recovers. Then, starting around 2020, the CBO projects that rising health-care and retirement outlays will push the national debt steadily higher despite projected tax increases. In the CBO's more favorable scenario, federal debt held by the public (excluding interagency obligations like the Social Security trust fund) grows from 62 percent of GDP now to 80 percent in 2035. In its unfavorable scenario—so bad that investors would probably revolt before it occurred—debt balloons to 185 percent of GDP.
The political riddle of the moment is how to convince the American people that something's gotta give. They can't have low taxes and high spending and stay solvent all at the same time. Everyone in Washington knows it, yet the courage to act is lacking. Late this year, after the midterm elections, Obama's bipartisan deficit-reduction commission headed by Democrat Erskine Bowles and Republican Alan Simpson will release its ideas. But Obama's political capital has been largely spent on health-care reform and bailouts. It's hard to imagine he will use the last two years of his term banging his head against the brick wall of deficit reduction. Hubbard thinks there won't be any serious action on deficits until the next Presidential term of office—and he wants the Bush cuts to stay in place at least until then. "There's no reason to open up the tax code," he says, "until we're ready to have a real conversation."
Let's hope it turns out to be a conversation and not a shouting match. There's a lot of good thinking on the economics of taxation that could be trampled in the coming political free-for-all. One concept embedded in the Bush policy that deserves to survive is the importance of maintaining low marginal tax rates—i.e., the rates paid on the last dollar of income. Remember, a person in the highest tax bracket, which is now 35 percent, doesn't pay 35 percent of his or her entire income in taxes. Most of the income is taxed at lower rates. Only the last bit earned suffers the biggest haircut. But that last bit matters a lot, because someone who's deciding whether to put in the extra hours and effort to earn an extra $1,000—or whether to kick back in front of the TV instead—will be influenced by the 35 percent marginal rate, not the average rate. Hubbard considers the reduction in the marginal rate on the highest earners, formerly 39.6 percent, to be one of the most growth-inducing aspects of the Bush tax reductions.
Liberal economists like Krugman who favor letting the top-bracket rates rise aren't overly impressed by the marginal-rate argument, saying the disincentives aren't severe enough to discourage people from making the effort. To many Democrats, the focus on lowering tax rates for the rich smacks of trickle-down economics. However, there is a way to preserve the low marginal rates that Hubbard favors while extracting more tax revenue from the well-to-do. That's to shrink the deductions and exemptions that are available to high-income households. Subjecting more of their income to taxes would increase tax payments without higher rates.
Will broadening the income tax base be enough, or is even more drastic action required? Some economists say an income tax, even an improved one, is simply incapable of generating the necessary amount of revenue without rates going so high that they would discourage work, saving, and investing.
One bold idea is to replace the complicated, loophole-riddled income tax with a value-added tax—a sort of national sales tax. The virtue of a value-added tax, widely used in Europe and elsewhere, is that it encourages frugality and saving by taxing spending rather than work and investing. Former Fed Chairman Paul Volcker has advocated consideration of a VAT, as has Senate Budget Committee Chairman Kent Conrad (D-N.D.). Politically, though, the VAT is stuck between tax-hating Republicans like Senator John McCain, who fear it will become an additional tax rather than a substitute, and liberal Democrats, who worry it will fall most heavily on poor people who must spend every dollar they earn (even though a VAT can be designed to protect the poor). In April the Senate voted 85-13 for a nonbinding amendment introduced by McCain that opposed a VAT.
The Bush tax cuts of 2001 and 2003 embodied both wisdom and folly. The wise part was cutting rates in a way that increased incentives to work, save, and invest. The cuts came straight out of the economists' cookbook for achieving stronger economic growth. But setting tax rates without taking spending into consideration was pure folly. Washington lowered taxes while raising spending—an unsustainable combination in the long run.
For business, perpetuating Bush's legacy by extending the tax cuts is highly appealing. Business executives also realize that—no matter what optimistic lawmakers claim—low tax rates can't last if the government continues to spend more than it takes in. "We need certainty. We need to know what those rates are going to be," Daniel Clifton, head of policy research at Strategas Research Partners in Washington, told Bloomberg Radio on Aug. 2.
In June 2001, when the U.S. embarked on the first of the historic Bush tax cuts, the ink was running black and all things seemed possible. Now fear predominates—fear that if the cuts aren't extended, the economy could fall back into recession. In the long run, the U.S. needs a fiscal policy that's based on neither hope nor fear, but on a realistic assessment of what the country needs from its government and what it can afford.