A number of readers have commented on my most recent yearend commentary. In it, I argued that regardless of what additional policy moves may be made, next year’s economic performance is largely baked in the cake. Furthermore, because of the lags in policy, we would be well into next year and the start of election season before we can begin to assess the impacts of the passage of the tax bill and the Fed’s QE2. Consequently, public focus will be dominated by continuing uncertainties and by concerns about employment, neither of which can be materially affected by additional policy moves in the short run.
The comments that have flowed in suggest that one point in the commentary may have been misinterpreted. That was the aside that the budget cost of the tax-stimulus package is estimated at $800 billion or more. This was not my estimate, but rather one that was widely cited in news reports.
Most of the respondents argued that the tax package might have little or no cost because it would stimulate growth, which would increase revenues. I didn’t think to go into the tax/cost issue at the time, but here are my thoughts on it.
First, the $800-billion estimate in the press was essentially a comparative static estimate. That means it was arrived at by comparing revenues from the current marginal tax rates (which are now extended for two years) with how much additional revenue would have been collected from the new marginal tax rates had the tax cuts not been extended and nothing else had changed. No attempts were made to take into account the fact that, faced with higher marginal tax rates, tax avoidance activities would take place, especially by the “rich” and would reduce revenues that would be collected. For an interesting view on the relationship between taxing the rich and implications for revenues, see the attached chart. The chart shows that historically there is no significant relationship between marginal tax rates on the highest earners and tax revenues collected, even with the Alternative Minimum Tax. Interestingly, revenues collected average about 19% of GDP, hence the flat tax proposal.
At the same time, those who suggested that economic growth would be stimulated by extending the cuts ignored the research that suggests permanent tax cuts are what matter, not temporary tax cuts. Ricardian equivalence (a term attributed to the late-18th-century British economist David Ricardo who was also the father of the theory of comparative advantage) tells us that, faced with temporary tax cuts, rational taxpayers realize that their tax bills will have to go up in the future. Therefore, instead of increasing spending and consumption, they increase savings and pay down debt in anticipation of higher tax bills. A similar argument applies to temporary fiscal stimuli like the 2008 tax rebate. Studies of the impacts vary significantly, but surveys and related evidence suggest that most consumers spent a little of the rebate (about 1/3), then paid down debt and/or increased savings with the remainder. The bang was not big for the buck.
In truth, it is uncertain what the impacts will be or might have been when it comes to trying to evaluate the tax policies, especially over this next year. Clearly, no one believes that extension of the tax cuts is permanent. The budget uncertainty that results only exacerbates the other sources of uncertainty that I believe will be important in 2011.
