Monthly Archives: December 2010
If progressive House Democrats have their way, the House will strike down the proposed deal over extending the 2001/2003 tax cuts – a deal that amounts to a second stimulus – because they think the estate tax provisions in the bill are too generous to the rich. I’m a firm believer in progressive taxation (or perhaps the European model of regressive taxation coupled with generous redistribution) because I think income has declining marginal value to society as a whole. But getting into a tizzy over the estate tax is probably wasted effort. Lowering the threshold from $5 million to $3.5 million expands the base of the tax from the top 0.25% to the top 1% of estates. And while the estate and gift taxes made up 5% of federal revenues on the eve of World War II, their contribution to federal revenues has been in decline since the oil crisis of the 1970s, with a brief reprieve during the late 1990s. This past fiscal year, the estate and gift taxes made up less than 1% of federal revenues for the first time since the 1980s.
Really, the best argument for keeping the estate tax is that it’s an effective motivator for charitable giving in the United States, which is what you’d expect when you target a tax at the subset of the population with the highest elasticities of taxable income. The impact on federal revenues and thus the deficit and debt however will likely be small.
This, by the way, is a good segue to why I think a broad-based consumption tax would obviate so much of the class conflict in America today, especially if implemented as a progressive consumption tax à la Robert Frank. Imagine if we replaced the current tax code – including the estate and gift taxes – with such a system. True, heirs wouldn’t be penalized immediately for receiving estates if they saved or invested the money or gave it to charity, but it’s mighty hard to live a life of luxury when you avoid buying luxurious things. And if they took the money and binged on an opulent buying spree, they’d bear the burden of taxation on what they bought. Since over the long-run all savings are eventually spent one way or another, we could cut straight through the income proxy and tax what I think Americans truly care about: conspicuous consumption.
Now that the Joint Committee on Taxation and the Congressional Budget Office have released an official score of the proposed White House-GOP tax deal being debated in the Senate, I’ve updated and simplified my previous chart on how the national debt fares, which was pretty back-of-the-envelope. While some of the nitty-gritty details have changed, the headline effect hasn’t: the deal as written would raise the long-term national debt by 6 percentage points of GDP over the long-term compared with a baseline where no laws currently on the books are changed. That’s $858 billion in direct costs over 10 years (per CBO and JCT) and $383 billion in added interest over the same period, bringing the total impact on the national debt to $1.24 trillion through 2020.
The key assumption here is that each component of the tax extension deal expires on schedule. So in 2012, for example, the 2001/2003 tax cuts expire for everyone, and individual income tax brackets revert back to their 2000 levels. If you think this assumption is unreasonable (and I think there’s good reason to), then the debt effect of the deal will be more than 6 percentage points of GDP in the long-run, possibly significantly more.
Is 6 percentage points big? Small? Put another way: many American and international organizations advocate stabilizing our debt at 60% of GDP. We’re currently at 62% of GDP, and if Congress sat on their hands and did absolutely nothing for 10 years then the CBO projects that we’d reach 69% of GDP in 2020. Putting aside for a moment the possible short-term economic benefits from this deal, we’re raising our national debt by a tenth in 2020 relative to the economy, which makes it that much harder to stabilize our long-term finances.
Of course, you know what else makes it hard to stabilize our finances? Weak economic growth. So deficit and debt concerns aren’t the alpha and the omega of criteria for crafting good short-term economic policy. Still, growing debt is a long-term problem (and one, lest we forget, whose consequences disproportionately harm the poor and the middle class), so until it’s under control it’s a good idea to view policy changes in that lens.
John Corgan and John Taylor argue that states simply used federal stimulus grants to reduce borrowing, leading to no net new spending and thus no stimulative effect:
So where did ARRA’s state and local grant money go? While some of it increased transfer payments to individuals in the form of welfare and Medicaid, the major part was simply used to reduce borrowing. As ARRA grants increased, net borrowing by state and local governments decreased. In the third quarter of 2010, for example, state and local governments received $132 billion in stimulus grants at an annual rate. In that quarter they borrowed $136 billion less at an annualized rate than they had in the fourth quarter of 2008, even though their revenues from all other sources were only $76 billion higher. [Emphasis mine]
There’s an implicit counterfactual underlying the Corgan-Taylor hypothesis: in recessions, state and local borrowing increases. This is, of course, so accepted by macroeconomists who study the federal level that it’s no surprise they wouldn’t question it at the state and local level.
But what if this assumption is wrong? It would undermine the Corgan-Taylor critique. So let’s look at annual net borrowing by state and local governments over the past 40 years, adjusted for inflation and with recessions shaded:
As you can see, recessions aren’t good real-time predictors of increases in state and local government debt. In fact, during the Great Recession, state and local borrowing decreased quite dramatically before the Recovery Act was even passed, then jumped back up after the Recovery Act passed. So claiming that the norm is for state and local governments to ratchet up borrowing immediately during a recession – and that by extension a decrease in borrowing must have been caused by some exogenous factor – is a weakly-support claim, especially in this recession.
But that begs the question: why is state and local government borrowing behavior so different from the federal government’s? The obvious answer is that almost all states are constrained to either propose or approve balanced budgets, so the federal norm of directly financing deficits using debt is closed off to states (though there are back-door ways of doing this). Two further answers are less obvious: 1) states, unlike the federal government, often have significant rainy day funds that allow recession-induced borrowing to be lagged until well after the recession itself is over; and 2) states use debt primarily to finance capital projects, and states may be reluctant to start new capital projects during a recession.
The bottom line though is that a decrease in state and government borrowing is not dispositive of anything, and saying that it is says more, I think, about the clumsiness with which federal-minded economists sometimes try to weigh in on state and local issues even though there’s a different dynamic at work.
Buttonwood at The Economist is worried that the recently-announced tax extension deal is making the bond market nervous:
The vigilantes certainly sounded the alarm yesterday, pushing the yield on the 10-year Treasury from 2.95% to 3.11%…The market moves were triggered by an agreement between Congressional Republicans and President Obama to extend the Bush tax cuts for two years. Democrats did not want the rich to benefit from this largesse. But the President traded that concession for a cut in the payroll tax and an extension of the unemployment benefits, measures that are classic examples of a Keynesian stimulus.
Perhaps Mr. Buttonwood’s telepathic mastery explains why my Economist subscription is so damn expensive?
The “market reaction to policy events” is one of the laziest tropes in economic journalism. Logically, if you accept Buttonwood’s interpretation, you also must believe a) markets are confident in the cost of the deal, even though no scoring has been done on it yet; b) markets are confident the deal will pass both houses of Congress, even there’s nary a whip count and clearly many lawmakers on both sides of the aisle who are skeptical of the deal; c) markets are acting out of heightened concerns of default risk (a bad thing) rather than heightened GDP and inflation expectations (a good thing); and, d) markets aren’t acting based on other influences, such as QE2 and events in Europe.
On that last point, Treasury yields have been rising for a few months now, after reaching near-historic lows:
The tax deal may be wielding some influence over the bond markets, but given the great uncertainty surrounding it, plus the fact that its effect would likely be in the same direction as QE2, we’ll never be able to disentangle the “Obama-McConnell” portion from the “Bernanke” portion. Plus, it’s worth reminding ourselves that rising bond yields are a biproduct of economic recovery and shouldn’t be cause for instant panic or hand-wringing.
I really have nothing original to add about politics surrounding the deal over extending the 2001/2003 tax cuts announced today. I find myself broadly agreeing with Ezra Klein that this was a better outcome than most thought possible, though Kevin Drum makes a sharp point that’s it’s moronic to kick the can down the road to 2012, a presidential election year. I also don’t think the Left is doing itself any favors by acting as if raising taxes on the rich was the cornerstone of its short-term economic recovery plan. As disappointed as they are, this deal has probably done more to raise the probability of Obama’s reelection than any action in the past year, possibly since the Recovery Act passed.
Substantively, what gives me pause is the dependence on temporary tax cuts. I’m on board with the idea of short-term fiscal stimulus, and I get that there are limited options to do so with a GOP-controlled House. But most of this isn’t net new stimulus, it’s preventing anti-stimulus (or, if you prefer, it’s anti-anti-stimulus). Also, in the long-run I’m a deficit-hawk, and if the past few months, to say nothing of the past 10 years, have taught us anything about the political economy of temporary tax cuts, it’s that they’re seldom “temporary” at all.
To illustrate, here’s America’s debt-to-GDP ratio over the next 10 years if this deal is enacted and all the temporary provisions expire as planned, relative to the Congressional Budget Office’s baseline of debt under current law:
Notice that the Y-axis starts at 60% debt-to-GDP, which is where most organizations (somewhat arbitrarily) recommend we stabilize the debt in the long-run. The Obama-GOP deal basically shifts our debt up by 6 percentage points of GDP if everything expires as planned. That’s significant but not disastrous, and in fact would be quite beneficial on net if this deal delivered real economic results in the short-term and were followed up with deficit reduction in the long-term.
But “expired as planned” is a major assumption. For the 2001/2003 tax cuts, for example, that means either a) in a presidential election year, a GOP-led House would have to capitulate to letting taxes go up for everyone; b) Congress becomes gridlocked, does nothing, and the tax cuts expire; or, c) Congress agrees to fundamental tax reform that, when all is said and done, raises as much additional revenue as letting the 2001/2003 tax cuts expire. None of these strike me as very likely.
So let’s say instead that, under duress of the “tax-and-spend-liberal” label sticking, Obama and Congressional Democrats acquiesce to making almost the whole deal permanent in 2012. Here’s how our 10-year debt outlook would change:
The scale on the Y-axis changed, so here’s a third graph without all the component parts:
In other words, if history repeats itself and all tax cuts are made permanent, with no offseting spending cuts or revenue increases, then the national debt will reach about 105% of GDP in 2020: almost reaching our nation’s historic high of 109% of GDP in the aftermath of World War II.
We shouldn’t let long-run debt and deficit fears prevent us from taking well-planned and prudent short-term recovery measures. But I’m not sure this deal is well-planned at all. And it’s certainly not prudent if there’s no fiscal escape route once the recovery is full-steam.