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CBO: Extending the Bush tax cuts will hurt the economy, reduce incomes

CBO Director Doug Elmendorf testified before the Senate Budget Committee today and dropped something of a bombshell. Extending the Bush tax cuts, he said, will "probably reduce income relative to what would otherwise occur in 2020." The reason is simple: Debt.

Elmendorf doesn't deny that tax cuts stimulate the economy. But they don't stimulate it that much, he says, and over the long run, the net economic growth from the tax cuts will be quite small. The net deficit impact won't be. "Lower tax revenues increase budget
deficits and thereby government borrowing," Elmendorf said, "which crowds out investment, while lower tax rates increase people’s saving and work effort; the net effect on economic activity depends on the balance of those forces." True to form, he brought a graph:

cbotaxcutseconomy.png

As you can see, and as Elmendorf said, "Either a full or a partial extension of the tax cuts through 2012 would reduce income by much less than would a full or partial permanent extension." So the bottom line is that extending the tax cuts indefinitely would hurt the economy. The less you extend the tax cuts, the less damage you do to the economy. And this goes for both the Democrats and the Republicans, whose tax cut plans are much more similar to each other's than to a plan that doesn't extend the tax cuts, or extends them only for a couple of years.

By Ezra Klein  | September 28, 2010; 2:46 PM ET
Categories:  Budget  
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Next: CBO's case against 'Obama's middle-class tax cuts'

Comments

You know, balking on the vote for the tax cuts was the ultimate sad-sack moment for the Dems, but they were already pretty cowed by the time they circled up around a permanent extention of the middle class tax cuts. I just can't fathom how they didn't rally around a three year extention below $250k/year cuts, and that's it, or maybe a six year program where rates phase up a little more slowly so there's not a sudden jump.

Posted by: MosBen | September 28, 2010 2:55 PM | Report abuse

So let's see.

Whenever we talk about stimulus, we hear that GDP will rise in the short-term, but never mind the debt and the fact that GDP is lower in the future than it otherwise would be.

Now that we are talking tax cut extension we hear about debt in 2020 and how bad it will be. Nevermind that economic models predict GDP will be about 1.2% lower in 2012 without the tax cuts (and 0.4% lower without the tax cuts for the wealthy), and unemployment 0.6% higher (0.2% higher without the cuts for the wealthy).

http://macroadvisers.blogspot.com/2010/08/impact-of-sunset-of-tax-cuts-on-gdp.html

I'm not the type that believes much in model results (by the way, MacroAdvisers assumes the Fed hikes rates far earlier under the extension which in theory would offset some of the effects, which is a huge subjective factor given how high unemployment will be either way).

But I do think it would be fair to compare these equally.

If the tax cuts are bad because debt will increase interest rates and crowd out investment a decade from now, well then the stimulus is bad too because it also increases debt and crowds out private investment years from now.

If the stimulus is good because it increases GDP and reduces unemployment per the models, then the tax cuts are good because it increaes GDP and reduces unemployment per the models.

My own take is that spending is the problem and the true measure of the tax burden. On top of that, debt creates its own problems outside of sucking money out of the private economy.

In that most of the deficits are caused by extending the middle class tax cuts, and that lower taxes on the middle class leads to higher support for spending, I'm in favor of full sunset. After all, if the spending occurs then the taxes are collected - the only issue is timing and distribution. Making this spending surge painless will only prolong it.

People should be able to keep and spend their money as they see fit, but if they insist on taking other people's money they should experience what it is likely to have others take theirs. Hopefully, when they Americans are faced with the bill for their spending they will demand less of it.

Posted by: justin84 | September 28, 2010 3:28 PM | Report abuse

Let all the tax cuts expire, for goodness sake. Or if that's too politically difficult, then only extend the cuts for people below $250k for 3 years (so as not to have to vote on them again right before the 2012 presidential vote).

We're in massive debt, as the tea baggers are like to keep reminding everyone, after all.

Posted by: paul65 | September 28, 2010 3:30 PM | Report abuse

am i reading this correctly that a full extension for 2 years equates out to be virtually the same as a partial for those two years? So then why (OTHER THAN POLITICS) are we discussing mainly rich vs poor as opposed to short vs long?

Posted by: visionbrkr | September 28, 2010 3:31 PM | Report abuse

justin84, there are two differences I think you're missing with the objections to extending the tax cuts:

1) the tax cuts are not very stimulative as compared with other stimulus projects. If we want to stimulate the economy, there are much better ways to do it than an inefficient cut to income tax rates, especially one which extends beyond the short term economic downturn.

2) Other stimulative projects are one time purchases or short term costs. If we have a payroll tax holiday, the cost is (mostly) incurred during the holiday. If we build a highway then we spend the money to build it. A permanent extension of the tax cuts has long term effects that other stimulative projects don't because won't end like other stimulus does.

Posted by: MosBen | September 28, 2010 3:45 PM | Report abuse

The tax cuts already didn't work the first time they were tried.

None of this matters if we can't rein in spending.

Don't extend a single cut, start to gnaw off some mortgage interest type deductions, and cap spending, then we can spend a lot less of our money on payments on the debt.

Posted by: staticvars | September 28, 2010 4:08 PM | Report abuse

"if we have a payroll tax holiday" ....

I'd love it if we had a payroll tax holiday. That would add up to about $15,000 a year in my household's pocket.

Then we can have a debate on making the holiday permanent.

Posted by: NoVAHockey | September 28, 2010 4:33 PM | Report abuse

maybe we have a quasi government agency, call it Fannie Mae, and somehow, even though it is losing billions of dollars,
it somehow has enough "profits" to make over $72 Million in campaign donations,
to members of the Democrats controlling
congress, and everyone yawns, and says,
"well, the republicans got their's, it's time for Us to get ours!!!"

thanks for the change, barrack'

Posted by: simonsays1 | September 28, 2010 4:44 PM | Report abuse

MosBen,

All I tried to highlight is that when an allegedly stimulative policy is proposed that Ezra likes, he cites an economic model showing higher GDP and lower unemployment. When its a policy he doesn't like, we see how the debt burden makes us worse off in 2020.

Ezra could have had a post titled: "Stimulus: will hurt the economy, reduce incomes" and provided a chart showing how GDP will be lower in 2020 due to the debt which financed the stimulus, or "Charts and graphs that will finally make it clear that the tax cuts work" and show how GDP is larger with a tax cut extension.

http://voices.washingtonpost.com/ezra-klein/2009/11/charts_and_graphs_that_will_fi_2.html

The relative magnitudes may be different, but the meme being presented here is that tax cuts will "shrink the economy", stimulus "creates or saves jobs", whereas the balanced approach would be "I think both tax cuts and stimulus grow the economy now and shrink it later, but I think that stimulus will be the more cost effective option".

As I said, I don't buy the models either way. The economy is far too complex to model with several variables. After all, they used economic forecasting models to produce the embarrassing chart which suggested unemployment would be lower today without stimulus. The defense used here is that the downturn was worse than we thought, and my counterargument there is that the model couldn't even get the real time weakness of the economy right within any reasonable degree of accuracy.

Stimulus is just money taken from points A and B and shuffled around to points C and D. Food stamps, for example, may be spent quickly, but someone else must forgo spending in order to buy the treasury notes issued to pay for the food stamps. The chain of spending which began with the food stamps prevents another chain of spending from ever starting.

Can one chain of spending lead to higher GDP? Sure, but it's hard to know for sure without knowing what both chains would look like.

What's worse, is that the stimulus may be offset by the Fed's reaction function. Let's say that the stimulus actually does increase GDP by 2% in 2009 and 2010., ceteris paribus. Had there been no stimulus, the weaker economy might well have prompted the Fed into aggressive QE action. While printing money can have very real side effects, it is pretty clear that it can boost GDP in the short term because the money is generated out of thin air, rather than shuffled around.

Posted by: justin84 | September 28, 2010 4:47 PM | Report abuse

Why does this chart make the partial extension look worse than the full extension? Does this mean that the CBO projects any stimulus now would have a negative impact on GNP in 2020? I find that very hard to beleive, and contradictory to a lot of the views usually found on WonkBook.

Posted by: alevy02 | September 28, 2010 5:06 PM | Report abuse

How about we just start paying down the debt. Cut spending and tax people an adequate amount to get the job done.

Posted by: RobMc1 | September 28, 2010 5:15 PM | Report abuse

Many economists, and most liberal ones, just the ones who would most be against the tax cuts, don't believe in the concept of crowding out. Especially in an economy operating well below capacity.

Posted by: famattjr | September 28, 2010 5:26 PM | Report abuse

alvy02, not all stimulus would necessaryily make the GNP smaller in 2020. A permanent extension of the tax cuts has a lot longer effects than a temporary stimulus measure during an economic downturn.

justin84, you may feel that Ezra isn't fair in arguing about tax cuts versus stimulus, but I don't see the connection in this post. A temporary stimulative measure, whether tax cuts or spending projects, will increase the deficit. The government borrows money. A permanent tax cut also increases the deficit (assuming that it's not tied to lower spending), and leads to government borrowing. The difference, as I understand it, is this: a permanent tax cut means that the government is going to be borrowing even after the economy picks back up. That means that private entities that might want to borrow can't because they're being crowded out by the government tying up all the available credit. With stimulus, however, there's little or no private entities looking to borrow, or they can't qualify to do so, so the government isn't crowding them out.

And Ezra has for a long time argued that the debt incurred by stimulus isn't insignificant, but it is less important than the temporary stimulative effect needed in times of economic crisis. I don't think he's ignored the debt aspect of stimulus, and he's had posts about how stimulus probably doesn't pay for itself, but has argued that it's just a better value than President Bush's tax cuts. This is especially true of a permanent extension of those cuts, which cause a huge increase in the deficit, especially in the long term, but aren't that stimulative to begin with.

Posted by: MosBen | September 28, 2010 5:30 PM | Report abuse

An awful lot of people rely on those "rich" people to provide them with work. Some of the jobs I've done for them: Cutting grass, washing windows, cleaning pools, trimming trees, busing tables. I have friends in these businesses, and a some of them have told me, based on what their customers have said, that they expect to lose a good chunk of their business when the tax cuts expire.

But, hey... maybe they'll put some of that tax money to work, creating some jobs.

Posted by: MrTracker | September 28, 2010 5:34 PM | Report abuse

Let the tax cuts expire all the way if that is what is required. But if the Republicans want to cooperate, we can allow everyone including the rich to keep the Bush era cuts for the first 200K/250K. Probably that should be cut to 100K/125K since you can live fairly good on wages that good. That is for most Americans. I understand that if you live in the heart of NYC cost of living might be higher, so let them have a tax credit.

Another thing we can do is to include the cost of basic food into cost of living calculations. Foods especially such as WIC and basic foods; grits, dry beans, low sugar cereals, milk, brown rice, etc. should be used in these calculations. Maybe some other foods also, except high cost foods such as organic.

I say this, because very basic foods have risen considerable over the past year, but they are not used in the governments calculation of the cost of living. If I heard right.

Posted by: LL314 | September 28, 2010 5:46 PM | Report abuse

Echoing famattjr, crowding out is completely irrelevant when you're in a liquidity trap, as we are now. The CBO analysis seems to be erroneously based on a model with full employment.

That's good for putting supply-siders in their place, since their own models show that the (dubious) positive effects of low marginal tax rates are dominated by the negative effects of exploding debt.

The only way to justify the tax cuts on economic grounds is to include short term demand-side effects. Permanent extension is baseless, and even temporary extension doesn't give as much bang for its buck as other forms of stimulus.

Posted by: csmith932 | September 28, 2010 5:48 PM | Report abuse

"Lower tax revenues increase budget
deficits and thereby government borrowing"

This is not necessarily true. Lower tax revenues along with adequate spending cuts can actually decrease deficits and borrowing. This would increase private sector investment, which could boost the GDP. Elmendorf presents a false dilemma. His argument is not valid and thus neither are the conclusions of Klein.


Posted by: phraseturner | September 28, 2010 5:56 PM | Report abuse

It is too bad we went to war and cut taxes. People thought the price of houses would always go up. So, many people bought over sized houses, took out their equity and bought a few houses on speculation. At the same time, maxed out their credit cards. That made it seem like the economy was booming but itwas just waiting to fall.

I suspect it will take 4 or 5 years to pay off credit cards and get all those foreclosed homes occupied again.

It is obvious we should never have cut those taxes particularily when Bill Clinton had the right idea.


Posted by: LL314 | September 28, 2010 5:58 PM | Report abuse

"justin84, you may feel that Ezra isn't fair in arguing about tax cuts versus stimulus, but I don't see the connection in this post."

Can you ever see Ezra publishing a post titled "Stimulus: will hurt the economy, reduces income"? Because it will - again, the magnitudes are a bit different but its the same causal mechanism that would cause the tax cuts to hurt the economy:

Deficit spending -> Debt -> Lower Capital Stock -> Lower GDP in future

And it's not like the CBO never mentioned this either:

"In contrast to its positive near-term macroeconomic effects, the Senate legislation would reduce output slightly in the long run, CBO estimates, as would other similar proposals. The principal channel for this effect is that the legislation would result in an increase in government debt."

http://www.cbo.gov/ftpdocs/96xx/doc9619/Gregg.pdf

An interesting thing to note (per alevy02) is that extending tax cuts from just the middle class to everyone reduces the GDP drag assuming a strong labor response, suggesting that keeping the Bush tax rates for ONLY for the highest earners (and not for the middle class) seems to be positive for GDP in 2020. The middle class tax cuts and the stimulus are both negatives.

To his credit, I do see Ezra posted another piece about the CBO case against the middle class tax cuts.

So extending tax cuts only for the rich leads to a far smaller deficit than extending the Bush tax cuts to everyone, might increase GDP relative to baseline, and will certainly damper demands for more spending by the majority of voters who have seen their tax bills increase.

Posted by: justin84 | September 28, 2010 6:05 PM | Report abuse

"Hopefully, when they Americans are faced with the bill for their spending they will demand less of it." posted by justin84

Yep.

Posted by: bgmma50 | September 28, 2010 10:16 PM | Report abuse

"If the 2% crowd had followed through on the promises of trickle down and invested their tax cut in American industry as was predicted, we wouldn’t be where we are today. The middle class would be much stronger and putting money back into the system, they would have probably gotten more kickbacks in tax breaks and we wouldn’t be having this discussion.

They only have their own greed to blame."

Posted by: seaduck2001 | September 28, 2010 10:21 PM | Report abuse

Germany, France, Italy cut spending, confidence & growth soar

US: no cuts to spending, confidence & growth tanks.

US plan to cut spending: "Got no plan, let's wing it"

"Got pledge?"

Posted by: betterdays1 | September 29, 2010 5:22 AM | Report abuse

justin84, but magnitude matters. If a stimulative policy has major positive impacts in the short term and is a slight drag on GNP in the long term, why would you title a post to highlight the slight long term effects? Similarly if a tax cut policy has moderately stimulative effects in the short term but is a major drag in the long term, why would you focus your headline on the short term effects? It'd be one thing if the short and long term effects in either case were roughly comparable, but I haven't seen anything supporting that.

Posted by: MosBen | September 29, 2010 10:54 AM | Report abuse

MosBen,

You make a good point. Magnitude matters.

So consider partial extension. It hurts the economy in 2020 by as much as ARRA (0.2% of GDP). GDP is raised by 0.9% in 2011 and 1.2% in 2012 per earlier cites. Unemployment is expected to be about 0.6% lower. That isn't all too far off of the low estimate for ARRA of +1.7% GDP at peak and -0.7% unemployment.

Not too different, and plus, tax cuts are often better politics (in fact, the only large stimulus measure still in play). Who knows, with the Bush tax cuts on the line you might have been able to get unemployment insurance extensions too.

http://www.calculatedriskblog.com/2010/08/cbo-stimulus-raised-gdp-17-to-45-in-q2.html

Now, if we must pick between the two, and we buy all the numbers, ARRA seems the better choice. It is either a little better or a lot better for the same long term cost (abstracting away from any distributional concerns on either side).

However, is it difference enough (particularly if one has a track record of asking for more stimulus in the recent past) to put up multiple posts on the benefit of stimulus, and none on the long term costs? Or to put up a post saying tax cuts reduce GDP, incomes (a decade from now), and not have a post showing the near-term GDP gains?

At any rate, I'd expect a nonpartisan (outside of being pro-stimulus/pro-model)analysis to suggest extending the Bush tax cuts through 2012 and trying to get perhaps some other stimulus measure through Republican obstructionism using the Bush tax cuts as the vehicle.

I don't see how one can support ARRA on stimulus grounds and not support a 2 year extension of the Bush tax cuts (remember, the only stimulus-type measure on the table is extension).

Since ending the Bush tax cuts offsets between 1/3rd as much as 6/7ths of the effect of ARRA on unemployment, opposition to extension casts doubt on the motivation for supporting ARRA - was it GDP/unemployment, or was it to spend a whole lot on Democratic priorities, and use the extra debt to help block Republican priorities?

Posted by: justin84 | September 29, 2010 2:01 PM | Report abuse

Why does Congress bother holding these testimonies? Or, maybe, I should ask - why do people bother accepting their invitations to testify in front of Congress? At the end of the day, the Republicans are still going to follow through with their agenda, and likewise the Democrats with theirs. The Republicans are going to use the same argument to defend their objectives (tax cuts stimulate the economy, etc.), and I don't expect the Dems to incorporate Mr. Elmendorf's arguments either.

So I return to my question - what's the point of this hearing? Sure, it's informative, and provides a well reasoned perspective regarding the Bush tax debate, but... I don't think this will have swung any Congressional votes. Not because the argument is unconvincing, but because it's difficult to convince anything to any member of Congress.

Posted by: sanchk | September 29, 2010 3:29 PM | Report abuse

All the GOP conservatives want a balanced budget, until someone tells them they have to help pay the taxes that balance that budget. That said, getting rid of the wars in the ME and stopping outsourcing would go a lot further and quicker to balancing the budget than a few % differences in the averages persons taxes.

Posted by: masonxhamilton | September 29, 2010 5:20 PM | Report abuse

I saw the testimony on TV and the guy said tax cuts at all levels were good for the economy. He followed up by saying that if the government fails to reduce spending and keeps adding to the deficit it will have a very negative impact on the economy for obvious reasons. Taxes and deficits are not directly linked. The idea that tax cuts increase the deficit is extremely misleading because it's actually spending that increases the deficit and our gov't spends money recklessly and irresponsibly. They need to bring spending to a responsible level first and then we can talk about how much taxes people should pay. I'm not paying higher taxes for this BS and I sure as hell don't think any other person should no matter how much they make. Ezra like every other liberal of his ilk is part of the "Rules for Radicals" crowd. They have no problem lying to or misleading you because in the end they believe they will be part of the elites while the rest of us fools wallow in serfdom.

Posted by: peterg73 | September 30, 2010 8:41 AM | Report abuse

peterg73- Yes, you can have tax cuts and not increase the deficit if you reduce spending by an amount equal to the lower tax revenue. The issue, of course, is what spending do we reduce? This is the question that Republicans apparently refuse to answer. There is not enough discretionary spending in the federal government to cover the reduced tax revenues coming from a renewal of the Bush tax cuts. The only way to do it is to reduce "entitlements" - Medicare, Medicaid and Social Security. If and when the Republicans admit that there will have to be cuts in those programs to fund their tax cuts, then I'll hold out some hope that we can have real dialogue in Congress, and a real understanding of the issue outside the Beltway.

Posted by: PaDem1 | September 30, 2010 9:28 AM | Report abuse

PaDem1 - What spending do we cut? What entitlements do we keep? Dude it is over. They spent twice as much money as they took in last year and greatly expanded entitlements with Obamacare at the same time. Things weren't sustainable before Obama was elected. You had better start saving some money. Social security, medicare, medicaid are over. As bad as the economy is right now, these are good times compared to what is coming. I'm talking about doing a massive course correction right so that maybe our kids or grandkids will start to see some benefit. Very hard times are ahead for us regardless.

Posted by: peterg73 | September 30, 2010 10:36 AM | Report abuse

Peterg73 - Dude, answer the question. "They" were both the Democrats AND Republicans. The bailouts began in the Bush administration, and the stimulus is a one-time boost in government spending. The Health Care Reform ("I'll call it Obamacare if you call the wars in Iraq and Afghanistan the "Bush Wars")is projected to lower, not increase, the deficit. So answer the question. What spending do you decrease to make up for the loss in tax revenue from the tax cuts first enacted under President GW Bush? Or are you suggesting that we just stop funding Social Security, Medicare and Medicaid, since they're "over" anyway? I just want to be clear on how you (and the Republicans) propose to fund our government, or conversely, dismantle it.

Posted by: PaDem1 | September 30, 2010 10:50 AM | Report abuse

The problem is not that our leadship does not know how to balance the budget, the problem is that they are afraid to.

This means that any solution to balance the budget must also preserve the careers of those who vote for it.

The only solution that meets that criteria is autobalance.

Autobalance automatically adjusts tax rates based upon a percentage of the previous year's deficit or surplus

For example , if the budget was 4 trillion and the deficit was 1 trillion, ther percentage deficit would be 33 percent. If the percentage adjustment that autobalance implemented was 10 percent, taxes would rise by 10% of 33%.

The net effect would be a constantly diminishing deficit or surplus. This would be profoundly reassuring to markets. If tax rates became too high it would lead to pressure to cut programs. If there were a surplus, taxes would automatically drop.

The benefits are many and it is a process which will work for a long time.

Avraam Jack Dectis

Posted by: avraamjack | October 4, 2010 11:10 AM | Report abuse

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