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  • A Tax Report in Search of the Economy

    On May 25, the Fiscal Analysis Initiative of Pew’s Economic Policy Group published an overview of what might happen to the federal government’s annual deficits should the tax relief of 2001 and 2003 be allowed to expire, be extended through 2012, or be made permanent. As readers may know, all of the tax relief currently in force will disappear by law at the end of this year.

    Unfortunately, Pew’s report does little to inform policy makers on the awesome economic decisions they are about to make. Had it focused as much on the economic implications of the expiring tax relief (which is all gone on January 1, 2011), it easily could have moved this important tax debate forward. Instead, it is almost entirely derivative of an earlier analysis by the Congressional Budget Office (January 2010). It proves once again, as the CBO study did a few months ago, that introducing economics into the discussion of tax policy change is absolutely critical. By leaving out the economy, Pew may have actually moved this momentous tax debate back.

    Why is economics important in the analysis of tax change? Taxes affect economic activity.

    As the economy changes so does the pool of income from which tax revenues are drawn. An analysis that ignores the effects of tax policy on the formation of income is a woefully deficient analysis, indeed.

    What the Pew analysts do tell policy makers is that extending the Bush era tax relief will worsen  our fiscal position: “Making the tax cuts permanent for all taxpayers, regardless of income, would cost $3.1 trillion over the next 10 years and inflate the national debt to 82 percent of GDP.” Allowing them to expire would “cost” nothing, and extending them for, say, two year would be relatively affordable, according to this report.

    However, this clearly is only half of the equation. What’s lacking is the economy. If you’re a business owner, an investor, or a consumer (and who’s not one of these three), you may be thinking that allowing tax relief to expire means an increase in taxes. After all, tax rates on wages and salaries will go up, taxes on dividends and capital gains could increase, death taxes reappear after a year off; and, certain deductions, credits, and exemptions shrink in value.

    If taxes go up, you, the taxpayer, may react by sheltering your income from taxation. Then again a tax increase might just slow the economy, as investors require higher returns on their money to pay for the higher taxes on capital and workers decide it just isn’t worth their time to work harder and pay higher taxes. Either way something is happening in the economy that affects the base of income from which the federal government gets its taxes.

    So, it’s curious that Pew and CBO don’t provide an analysis of how this substantial increase in tax rates and revenues may affect the tax base. It’s not that Pew and CBO fail to see the importance of analyzing the economic effects of tax change Its just too hard to do in their opinion.  Both organizations argue that estimating these effects requires too many questionable assumptions in their economic models.  OK, let’s think about that.

    Imagine two models of the economy that inform policy makers on how raising taxes will affect the economy. One model assumes that an increase in tax rates will leave taxpayers unfazed: they will work, save, and consume just as much after taxes rose as before. The other model assumes that tax rate increases will produce changes in the way taxpayers behave: higher taxes reduce labor effort, investment, and, thereby, overall economic activity.

    Now, which of these two models makes the more questionable assumption? Which of these two models do you believe is based on economic theory?

    It often surprises otherwise good analysts to learn that they are making bold and perhaps questionable assumptions about taxpayers when they avoid thinking about taxpayer reactions to tax policy change. It also surprises them to learn that they may be doing serious damage to the economy by presenting their analysis as based in economics.

    Policy makers, most of whom are untrained in economics, assume that analysts from such groups as CBO and Pew are engaged in good economics. If the only “economic analysis” these policy makers get is the accounting exercise of multiplying tax rates by changes in the tax base, then tax policy can be enacted that temporarily fattens the Treasury at the expense of long-run economic prosperity.

    Posted in Economics [slideshow_deploy]

    7 Responses to A Tax Report in Search of the Economy

    1. DreadGazebo, San Die says:

      You're omitting that the positive economic effects of cutting taxes will be mitigated by the fact that at some point, the tax cuts will have to be paid for, either by raising taxes, cutting spending, or, most likely of all, some combination of two. To their credit, Pew makes this crystal clear in their section about dynamic analysis: "The stimulative effect… depends on how and when

      the tax cut is ?nanced. Financing tax cuts with de?cits can crowd out capital investment in plants and equipment and ultimately work to dampen the economy over time… In some economic models [according to the CBO], dynamic effects could reduce the costs of a tax cut by as much as 32 percent; in other models, dynamic effects could actually increase the costs of such a tax cut by 5 percent. Another study by the Department of the Treasury in 2006 also found ambiguous results."

      So now which analyst is making the bolder statement? The one who assumes that tax cuts are a free lunch and that we can keep growing our national debt without consequence? Or the one who acknowledges the issue but, in light of empirical studies which can even agree on the *sign* of the economic effect of a tax cut after it's paid for, focuses instead on static fiscal costs?

    2. MN says:

      Cut spending! Stop running deficits! Stop borrowing money!

      "Dave Ramsey: Greece Needs To 'Break The Orbital Pull Of Stupid'"

      http://www.npr.org/blogs/money/2010/05/dave_ramse

    3. J.D. Foster, Ph.D. JD Foster, Washingto says:

      DreadGazebo makes a very common mistake in arguing that tax cuts have to be paid for. This is only true if spending is already too high. This point of view takes the current level and projections of spending as absorbing of all tax revenues and as normal and proper, as opposed to bloated and abnormal as we see today. Further, it's curious that this argument only arises when tax cuts are discussed, but never when spending is raised. No one says then that deficit-expanding spending increases will have to be "paid for" by future spending reductions. Insteady, the new level of spending is assumed to go on forever and will just have to force up taxes. This is called the "glut the beast" strategy that Obama pursues, and it will fail.

      Advocating low and lower taxes is not a free lunch policy. The free lunch policy comes from those who think the money really belongs to the government in the first place, and allowing us to keep some of it somehow pays for our lunch.

    4. Dean, Lititz says:

      Historically across the board tax cuts produce growth in the economy and in tax revenues.While no growth equals no increase in tax revenues.

    5. Tim Az says:

      DreadGazebo has demonstrated the reason the state of California is financially bankrupt. They just can't grasp an understanding of basic economics. I suppose there's no need for economics in a socialist republic in the first place.

    6. Lynn Bryant DeSpain says:

      Odd, isn't it, that those who raise and increase taxes, are not the ones who pay those taxes.

      Perhaps all Federal tax increases and all State Tax increase, levys, tarrif, et al. should be put to public vote? That way, the people working for us, would have an actual budget to work within!

    7. Pingback: A Tax Report in Search of the Economy | The Foundry: Conservative … | The Daily News

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