Thursday, December 9, 2010

The tax-cut stimulus

President Obama's slide continues. In the desperation to secure Congressional approval for an extension of unemployment insurance (UI) (whose extension was expiring on December 31, 2010), the Obama administration agreed for a two-year $900 bn tax-cuts only stimulus plan. The stated objective is to mitigate the sufferings of the long-term unemployed and boost aggregate demand. However, the odds are that it may well return to haunt him when he seeks re-election in 2012.

The major component is the extension of the Bush-era cut in marginal tax rates from 36% and 39.6% to 33% and 35% respectively for two more years. After strongly opposing its extension for those with incomes above $250,000 (which amounted to $60 bn in tax revenues for a year), the President finally abandoned this in return for Republican support for UI extension. The UI extension allows jobless workers in states with high levels of unemployment to collect insurance for up to 99 weeks (as against the regular 52 week period). See reactions to the tax cuts here. Mark Thoma says that it is neither targeted nor timely nor temporary.

The other components include protection of estates up to $5,000,000 from the estate tax for next two years (cost $10 bn in revenues); extension of all refundable tax-credits made in ARRA for two more years (cost $40 bn); extend UI for 13 months (56 bn); a 2% cut in the 6.2% Social Security payroll tax paid by employees (not employers) for one year (cost of $120 bn); and 100% tax cuts on business investments over the next two years (so as to shift investment forward to 2011 and 2012). The top rate of 15% on capital gains and dividends would remain in place for two years.

Ezra Klein puts the stimulus measure in perspective,

"There's some new stimulus in the form of the payroll-tax cut and the expensing proposals. The older stimulus programs that are getting extended -- notably the unemployment insurance and the tax credits -- probably would've expired outside of this deal. The tax cuts for income over $250,000 are a bad way to spend $100 billion or so, and the estate tax deal is really noxious... Most of the money just keeps programs that are currently in effect from expiring, so in some ways, it would be more accurate to say that this money is anti-contractionary rather than stimulative."


In view of the unsustainable fiscal deficit and public debt, it was important that any fiscal stimulus focus on areas that provide the biggest bang for the buck. But by relying exclusively on tax cuts - all of which except the UI extension will have a multiplier less than one - the stimulus measure will have limited impact on the aggregate demand. In fact, the CBO has estimated that its impact on the unemployment rate will be marginal. Economix points to a study by Center for American Progress which estimates that the stimulus will save or create about 2.2 million jobs over the two years. This overlooks the fact that a large proportion of these tax cuts will end up being saved than being spent, all the more so given the anemic economic environment. See also Mark Zandi's assessment here.



There are two dangers for the White House with this round of stimulus, similar to what happened with the ARRA. It is now widely acknowledged that the White House over-promised with the ARRA, despite clear evidence that it was not large enough to meet the requirements of the time. Subsequently as economy stagnated and unemployment rate rose beyond the initial estimates (as was inevitable), opponents jumped on it as evidence of the stimulus having failed. This in turn made further stimulus measures anathema.

This time too, the same story is being repeated. President Obama has already promised that "It will spur our private sector to create millions of new jobs". Since the "millions" of jobs will expectedly never arrive, this round of stimulus too will remain vulnerable to being criticised later for not delivering on its promises.

Second, the compromise is only kicking the political economy can down the road. The two year extension of tax-cuts means that they will come up for renewal once again in 2012, in the midst of the presidential elections. In light of the present conditions and medium-term prospects, the economy is likely to be no better then. The debate is likely to follow much the same script as now. The two-year extension may therefore end up playing into the hands of the Republicans. In fact, after their recent Congressional election success, the GoP would now have the opportunity to use the same agenda to win two elections.

This debate surrounding the tax cuts extension draws attention to one of the most challenging public policy issues - tax cuts are rarely ever rolled back. Temporary tax cuts, especially direct taxes, have a habit of becoming permanent. Not only are the Bush tax cuts likely to become permanent, the newer tax cuts too will become difficult to roll-back after the two year period. As Mark Thoma says, this assumes greater significance with the payroll tax, which is critical to sustaining the already bleeding Social Security. He suggests that instead of payroll tax cut, the administration could have proposed a 2% rebate on pay-roll taxes, to be paid out of general revenues.

Update 1 (26/6/2011)

Robert H Frank points to the high unemployment rate (14 million unemployed, 9 million part-timers looking for full time jobs, 28 million in jobs they would have quit under normal conditions, and 2.2 m who had dropped out of labor force) and advocates a temporary payroll tax cut for both employees and employers. The payroll tax was originally meant to pay for Social Security, and in recent years, employees and employers have each contributed 6.2 percent of total salary — with no additional levies on salaries beyond $106,800. Last December, Congress approved cutting the employee’s contribution to the payroll tax to 4.2 percent of salary for the 2011 calendar year.

He argues that tax holiday for employees will boost disposable incomes and spending (estimated to lower unemployment rate by one percentage point by 2012 end), and holiday for employers on new hirings can generate atleast 5 m new hirings.

2 comments:

Scoremore said...

If the concern is that a lot of the wealthy may cut or prevent job hires then why not provide a tax incentive for the business they are in charge of rather than boost their income? How many of those making 250K+ are directly responsible for hiring employees? I’d guess (I know I shouldn’t) that some proportion of these wealthy either inherited it, or or are responsible for a minimum (and not negotiable) number of jobs like doctors, lawyers, actors and sports players (the latter of course to a possibly negligible degree. It seems like a crude way to ensure job growth to just give them all tax reductions. I know there are already business incentives but proposing more to compromise would be much more helpful than flat out giving money to the wealthy. Of course there’s nothing wrong w/ giving money to anyone, except when there are people trying to make ends meet, with no purchasing power on their own to afford necessities like food and health care, which are by the way much more efficient for productivity than luxury cars and 4-star dinners. Something’s off here. Is it just that democrats are completely inept at explaining things or am I not understanding the message?

gulzar said...

completely agree with you scoremore. a baffling inability, even unwillingness by the Democrats to take the bull by the horns!