With the presidential campaign debate over domestic issues (including taxes and the economy) looming on the horizon, I decided to share some thoughts about taxes and the economy in the context of the disagreement over tax cuts that gets so much attention. My thoughts are mostly questions rather than answers.
At present, the federal government is incurring a deficit, that is, it is spending more money than it is collecting in tax and other revenue. One can argue about the measurement, because there are so many ways to classify the specific income and expenditure items and to determine the year in which they should be accounted, but no matter how that is resolved, the deficit exists, it exists for the current and past years, and it is projected to exist for future years. A key point is that no matter who is elected, the deficit will exist. No President and Congress, however aligned, is going to take the step of raising taxes to the levels to which they need to be raised to eliminate the deficit even if coupled with reduced spending. That's not the issue.
The issue is whether some portion of the deficit should (and will) be eliminated through tax changes. I say "changes" rather than "increases" because the issue is more complicated than simply setting rates.
One charge that is made is that the tax cuts enacted in June 2001 (and subsequently tweaked in March 2002 and May 2003, and extended on September 30, 2004) caused the deficit. More reasonable minds assert that the cuts caused
part of the deficit, acknowledging that the cost of the conflict in Iraq and the expansion of the Medicare prescription drug program contribute significantly to the deficits.
A recent study (
Household Expenditure and the Income Tax Rebates of 2001) suggests that the rebates received as part of the 2001 tax cuts generated more consumption expenditures on the part of households with lower liquid wealth and low income than for higher income individuals. This is not a surprising conclusions. People with less income and less wealth have a longer or much longer list of consumption items (clothing, food, medicine, etc) which they need to purchase and for which a tax rebate provides the need than do upper income taxpayers. So what? The "so what" is that in mid-2001 the economy was reeling from a recession set in motion before 2001, and was about to hurl into a deeper recession by events several months in the future. Recessions reflect, to some extent, insufficient consumption, generated by reduced income (which in turn causes businesses to spend less, causing even less income). Recession, like inflation, is spiral in effect, constrained only by the forces underway in the economy that have a countervailing effect. If the countervailing effects are few in number or strength, things get out of control. After the Great Depression (a recession gone out of control), the government enacted a variety of controls (such as the Federal Reserve Board's control of the interbank funds interest rate) so that countervailing pressure could be brought deliberately rather than in a happenstance uncontrollable manner. Thus, if the government delivers rebates to taxpayers who spend the rebates, the recession is dampened (and theoretically reversed). Accordingly, lower wealth and lower income taxpayers, make better use of rebates in this regard. So, the argument goes, if what is needed is consumption, funnel the rebates and the tax cuts to the lower wealth, lower income taxpayers because they'll spend it.
But does taxpayer use of the rebate forecast taxpayer use of the tax cuts that went into effect in 2001? Perhaps. I'll assume that the answer is probably, because even with the rebate most, if not all, lower wealth and low income households still had a long list of items which they need to purchase.
The position that tax cuts should be directed to the lower wealth and low income households in order to energize the economy encounters at least three strong and popular objections. They are related. First, it is argued that tax cuts should go to those who pay taxes, consistent with the tax burden being borne. If everyone gets a 10% tax cut, the high income taxpayer with a $100,000 tax bill will get a tax cut that is 20 times the tax cut received by the taxpayer with a $5,000 tax bill. Second, it is argued that the high income taxpayers will use their tax cuts in ways that will "trickle down" to other taxpayers. Third, to the extent the tax cuts are directed disproportionately toward low income taxpayers, the government is engaging in wealth redistribution, a policy and practice inconsistent with the philosophy of limited government and libertarian principle.
These objections raise questions. One question seeks to identify what high income taxpayers do with their tax cuts. It appears that they are not spending them to the same degree as do the low income taxpayers. That makes sense. One can eat only so much food, one can wear only so many clothes (though someone obsessed with clothes or shoes can rack it up in this category), one can take no more than 52 weeks a year of vacation, etc. Presumably, the tax cuts directed toward the high income taxpayer are invested. This is the basis of the "trickle down" argument. The investment can take the form of expanding a business owned and operated by the high income taxpayer, thus generating one or more lower-income jobs that would absorb an unemployed person (or a person employed at a lower wage whose job would then open for the unemployed person). The investment can take the form of the purchase of stock in a corporation (same scenario, simply removed one step), or in a mutual fund (same, removed two steps), or in a bank or other financial institution which in turn lends the money to someone who is either (a) starting or expanding a business (same scenario, removed so many steps I've lost count or (b) spending the money, which infuses business with more receipts, helping it to expand. The investment might also be the purchase of a capital good (home or home improvement, car, appliance) by the higher income taxpayer or by the lower income taxpayer borrowing money from the bank in which the higher income taxpayer invested, thus creating jobs for construction workers, auto workers, etc. I'm a bit convinced by this aspect of the argument, because it
truly is difficult to find a construction worker or home repair laborer (and that was
before Florida became the "winter of 2004" destination for construction workers).
But as a general proposition, despite the demand for construction workers, it hasn't quite worked out this way. Unemployment hasn't changed
all that much. Something is out of kilter. Could it be that the investments made by high income taxpayers of their tax cuts are being made abroad? Perhaps. And would these foreign investments be financing off-shore employment? Perhaps. Is that good for the U.S. economy? In the short run? In the long run?
Some say it is not. Return, now, to the objection that it is better to let the taxpayer decide what to do with a dollar than to let the government to take that dollar and decide what to do with it. This objection necessarily is constrained by the reality that the government will take some dollars in order to finance national defense, national parks, and other programs. In other words, taken to its extreme, this objection would put government revenue at zero and government expenditure at zero. There would be no government. There are people who advocate this extreme position but they are few in number.
When there is a surplus, because the economy is humming along and tax and other revenues increase faster than does government spending, the question of whether the surplus should be returned proportionately or directed totally or disproportionately to low income households poses an interesting question. Would the tax cuts be better used by the low income households? Recall that these households would spend the money. In this economic environment, with the economy humming along, throwing more money into the consumption bucket would increase the spiral, cause shortages of goods and services, and trigger inflation.
On the other hand, if there is a deficit, a tax cut means that the deficit is larger (no matter who gets the cuts). Then the question is whether the deficit would be reduced more quickly if the tax cuts were directed to the low income households or to the high income households. If the high income households are going to funnel their tax cuts to enterprises abroad, the tax revenue would be less than if the money were spent (by any sort of taxpayer) on domestic consumption. After all, the folks being paid to clean gutters and build home improvements, etc., now have higher income and thus will pay more taxes.
Here is the conundrum. The tax cuts were enacted when it appeared that (a) there was and would be a surplus and (b) the economy was in recession and needed a boost. Though the cuts were not directed as disproportionately to the low income households as some may have desired, there was some sort of positive impact. And then a mostly unnoticed declared war went hot in very visible places and life, including economic life, changed. Permanently, but that's another posting someday.
The need for increases in government spending (even aside from the Medicare prescription drug program expansion) quickly became apparent to some and eventually to most. The conditions which had justified a tax cut evaporated. The tax cuts should have been delayed, at least for higher income taxpayers. After all, during war, taxes increase. When I tell my students the marginal rates during the Second World War (which I know from research and not first-hand experience), they gasp. Vietnam brought a tax "surcharge" (a tax increase by any other name is a tax increase). So what happened? Not only were the tax cuts not delayed or discarded, they were subsequently extended.
Why?
Begin with a President who refuses to take away a tax cut, having seen first-hand the adverse effect similar decision making had on his father's re-election bid in 1992. Even Ronald Reagan had to scale back his initial tax cut, but he was gifted with a personality, charm, demeanor, wit, and private meeting persuasion skill that does not exist in any of today's political headliners. In other words, Ronald Reagan could "get away" with raising taxes (and the timing was such that it did not adversely affect him).
Then add in a Congress controlled by the tax-cutting wing of the Republican Party. Having promised constituents that they would go to Washington to cut back the size and intrusiveness of government, including taxation, they are not in a position to go back on that promise so long as they value re-election over economic necessity.
Yet with all the accusations being tossed about concerning the deficit and the horror of the tax cut, the
Congress extended the tax cuts in a bill signed into law a few days ago. The vote?
In the House, 339-65. in the Senate, 92-3. Surely the tax-cut Republicans don't hold
that sort of majority. No, this was a bipartisan effort. Politicians of all parties (431 to 68) had something in common: the need to trumpet to the voters back home that they had voted to extend a tax cut. "Aren't we nice?"
It's like giving candy to a diabetic child. What the nation needs is fiscal discipline. If the nation is going to provide all that it has promised, the nation needs to pay for it. One can argue the merits of what should be spent on prescription drugs, social security benefits, homeland security, national defense, and the tens of thousands of other expenditures in the federal budget or waiting to be added (no matter who is elected). Tax revenue must equal expenditures. Raise one or cut the other. One can debate how the tax burden should be allocated, and I am not going to reinvent that wheel. Suffice it to say that the worst thing that can be done is to increase spending (something both candidates propose to do, because votes come more easily that way) without raising taxes (something one candidate promises not to do and something the other candidate seems to support though with campaign trail words very different from the realities of the plan).
Yet that is where we are. One last piece needs attention. If government expenditures exceed revenues, how is cash flow managed? Is there a huge Federal credit card? No, there is something better. The government borrows money. From whom? From two sources. Remember the question about the high income taxpayers and what they're doing with their tax cuts? They're investing in U.S. Treasury bonds (and other obligations). And foreign governments (especially China), awash in U.S. dollars because of the trade deficit, are also buying U.S. Treasury obligations.
So, instead of the Congress directing tax cuts to people who would spend the money because they have no choice, the Congress directed most of the tax cuts to the high income taxpayers who then loaned the money back to the government so that it could spend it. When the smoke clears, the government (us) is indebted to the high income taxpayers (and to China, if that makes anyone feel any better).
My next-to-last question: so how is this all that different from a feudal economy, in which the low income serfs were beholden to the high income nobles and royalty (and, tossing in some theology and annoying a few folks, the very high income church)?
Someday, we will wake up and the creditors will be at the door. My last question: Who is going to pay?
