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     Aug 11, 2010
The US tax debate
By Hossein Askari and Noureddine Krichene

The closer it gets to the expiration of the George W Bush tax cuts (January 1, 2011), the hotter becomes the debate in Washington - whether to let the Bush tax cuts expire, extend them all or to come up with a compromise in between.

Those who favor the extension of the complete Bush tax cuts claim that because the US economy seems stuck with a high unemployment rate, a significant increase in the tax would reduce private-sector investment, decelerate economic growth, in turn exacerbating the already high unemployment rate; and that

raising taxes on the richest 1% of American households, to address income inequities and voter anger, may in fact reduce tax receipts and worsen the outlook for the federal budget deficit.

The Barack Obama administration and its supporters claim that a tax increase and tax reform was a main theme of Obama's presidential campaign; a tax increase is needed on the richest 1% of Americans to reduce record fiscal deficits and achieve higher social and income equality, and they reject the notion that a tax increase on the rich will impede economic growth, reduce tax receipts and exacerbate the longer-term outlook for the federal budget deficit.

The tax issue will, in all likelihood, be a key, if not the key, point of contention between Democrats and Republicans in the upcoming November elections for all House and a third of the senate seats. Although the Obama administration may have a better chance of getting its measure through the current congress because of its large majorities in both the House and the senate, politicians being politicians are unlikely to take a decision before the November elections. They will just adopt a position that is supportive of their election, which many, true to form, will change after the elections are over and done with.

First, the facts
As to budgetary deficits and National Debt, the US is facing record peacetime budget deficits because of the recession and federal expenditures for unprecedented bailouts and stimuli. These deficits are in turn increasing the US national debt at a rapid pace.

There are two definitions of budgetary deficit (and in turn national debt); the difference between the two is the inclusion of intra-government obligations, primarily the Social Security Trust Fund. The measure of national debt that includes Social Security obligations is commonly referred to as the gross debt and the other as the debt held by the public. Although the US gross debt is lower than that of most other industrial countries and stands at 90.5% of GDP, it has increased significantly because of the recession and monumental government stimuli and bailouts.

It is projected to increase to 101% of GDP in 2011 before declining ever so slightly thereafter, then if nothing is done it is expected to grow relentlessly to 200% of GDP by 2035. Such levels of debt are damaging to economic growth as they take resources away from the private sector, the engine of growth. In fact, Rinehart and Rogoff, in a recent landmark study, have argued that a debt a level of 90% or more has historically spelled trouble for all countries; the US is already in the danger zone. [1]

As to rising income and wealth inequality in the US, the country has the most unequal income distribution among industrial countries. Emmanuel Saez provides what is arguably seen by academics as the most respected analysis of the changing income distribution in the US. Briefly taking from a popularized version of his results:
In 2008, the top decile [10% of income earners] includes all families with market income above $109,000. The overall pattern of the top decile share over the century is u-shaped. The share of the top decile is around 45% from the mid-1920s to 1940. It declines substantially to just above 32.5% in four years during World War II and stays fairly stable around 33% until the 1970s. ... After decades of stability in the post-war period, the top decile share has increased dramatically over the last twenty-five years and has now regained its pre-war level. Indeed, the top decile share in 2007 is equal to 49.7%, a level higher than any other year since 1917 and even surpasses 1928, the peak of stock market bubble in the "roaring" 1920s. In 2008, the top decile share fell to 48.2% , approximately, its 2005 level, and is still higher than any other year before 2005 (except for 1928). ... the top percentile has gone through enormous fluctuations along the course of the twentieth century, from about 18% before WWI, to a peak almost 24% in the late 1920s, to only about 9% during the 1960s-1970s, and back to almost 23.5% by 2007, and then to 20.9% in 2008. Those at the very top of the income distribution therefore play a central role in the evolution of US inequality over the course of the twentieth century.

Figures on wealth concentration are even more alarming. In 2007, the richest 1% of Americans owned about 35% of its wealth and the richest 20% owned more that 85% of its wealth, meaning that the bottom 80% of Americans owned about 15% while 1% owned 35%. [2] Similarly figure show that most of the inheritance of large estates is received by 1% of Americans; namely, estate taxes are paid by the richest I%. Their wealth is still passed from generation to generation.

The Bush tax cuts at issue are: the highest marginal tax rate on incomes, the tax rate on capital gains and dividends, and the inheritance tax. (Some Americans, not realizing that over 95% of estates do not pay the estate or inheritance tax, inaccurately labelled as the death tax; a death tax would be paid by all).

So the debate is what would be the impact of reversion in these tax rates to their pre-Bush levels; more precisely the impact on (i) economic activity and employment, (ii) federal budget deficits and debt, and (iii) concentrations of income and wealth?

This is the last year of the tax rates adopted under president Bush, and with no estate tax at all. Because of the sunset clause, if congress fails to take action, the tax rates will go back to where they were before the tax cuts.

There is no doubt that maintaining the income tax structure (including capital gains and dividends tax rates) as they are (as opposed to increasing the marginal tax rates and the other tax rates) would increase disposable income, economic activity and thus increase employment in the short run. On this almost all economists agree. The issue is what would it mean for the budget deficit and the national debt in the longer run?

On the one hand, some economists argue that high tax rates are detrimental to budget balance. This is largely based on the so-called Laffer curve, that high tax rates could turn out to be regressive and bring lower tax revenues. Laffer gave an update earlier this month [3]. Namely, tax collection is dependent on the tax rate as well as on the level of income. It is the combination of the two that determines the government's tax collection. Imposing income taxes at very high rates would create disincentives to invest and work and that this negative effect on income would have a larger effect on tax collection, through lower incomes, than the higher tax rate. These economists present a number of historical precedents to support their case.

On the other hand, other economists argue that this simply is not the case. Incentives are not so adversely affected by a slight increase in tax rates. An increase in the marginal tax rate of say 5% does not kill incentives, when the highest federal marginal federal tax rate would still be about 40%. Looking at the same facts, they reach a different conclusion. And they note that the so-called historic precedents were not only due to a reduction in tax rates as there were other special factors simultaneously at work.

Frankly, the two present writers, friends and colleagues for over 25 years, do not agree as to how the deficit will be affected in the longer run. For this reason we have presented both sides of the argument.

Many economists would argue that a properly constructed consumption tax (or value added tax) that exempted most necessities, such as food, drugs and the like, would be better than an income tax because it would increase savings (as in Europe) and thus the prospects for longer-term growth and be supportive of budgetary balance. Still other economists would argue that a VAT is in practice regressive. Most economists would agree that an increase in the tax rate on capital gains and dividends would be detrimental to savings. But they differ on the extent.

When it comes to the tax rate on estates, or the inheritance tax, there is less technical dispute. The differences are more on moral and social grounds. Clearly, the abolition of the estate tax would reduce government tax receipts, as there can be no offsetting items. That is in the absence of the estate tax (remembering a tax that is paid by the top 5% and largely by the top 1% of Americans), the rich are unlikely to save more in order to pass it on to their survivors. However, they may give less to charities (deductible from the estate).

Some argue that it is wrong to double-tax individual incomes (when earned and when left in an estate); but the double taxation is not quite true because under the current system, although estate taxes are due on estates above a certain level, other taxes, such as capital gains no longer apply. Others argue that it is morally indefensible to have increasing concentration of wealth, that it would increase social tensions and could even threaten the very fabric of the republic. Ironically, the two richest Americans (Bill Gates and Warren Buffet), for these latter reasons, are strongly against the abolition of the estate tax.

In short, a change in tax structure can be used to improve income and wealth distribution. Specifically, a well-conceived increase in the marginal tax rates for the rich and the continuation of some form of the estate tax on large estates can be used to address the income and wealth-distribution issues. There a some who feel that a government has no business in addressing income disparities. Although tinkering with the tax structure can address distributional issues, no matter what, changes in tax structure and in tax rates are unlikely to be enough to restore budgetary balance anytime soon and without extraordinary damage to overall economic prosperity.

The US needs to also cut expenditures. There are two candidates that can make a significant difference in the budgetary outlook. These are cuts in entitlements and defense, two hot potatoes for any congress, and something that all US politicians try to avoid if at all possible.

What is the likely outcome of the increasingly heated debate in Washington and what will it mean for taxpayers and the US economy going forward?

On the one hand, the Obama administration and the democrats have floated the following ideas on taxes: restoring the pre-Bush tax rates for those earning more than $250,000 per year; by restoring the higher marginal rate for the rich only, the budgetary implications (as compared to adopting the tax cut for all income earners) would be improved by about 35% .

On the other hand, the Republicans favor extending the lower rates for everyone. Most politicians seem to agree that extending the tax cuts are helpful to economic activity in the short run and that if the cuts, in part or as a whole, are continued, then congress has to find a way to pay for them with higher taxes elsewhere or lower expenditures (Ben Bernanke and Alan Greenspan both recently endorsed the need to find an alternative to pay for the continuation of any of the Bush tax cuts). This is an absolute necessity if the US is to avoid more serious fiscal problems in the future. But when asked for details on what higher taxes or expenditures cuts, there is usually silence or a lot of talking without saying anything.

As to the estate tax, the administration and the Democrats are looking for a compromise that would increase the estate exclusion to a figure around $5 million and maintain estate taxes on estates that are larger. The Republicans, while vowing to eliminate estate taxes altogether, appear to be bargaining for the highest exclusion figure and the lowest tax rate on larger estates.

While compromise is always the way forward, it may be tougher now than before. Even before, the reason for adopting the sunset clause on the Bush tax cuts was that congress could not agree to a permanent tax cut before. Congress has to agree on a number of tax rates going forward: the highest marginal tax rate and for whom, capital gains tax, dividend tax, estate tax, and the AMT (Alternative Minimum Tax - originally designed to catch the rich who paid no taxes, this has in recent years become an annual problem as thanks to inflation it applies to middle-class Americans). But what makes it even more difficult now is a combination of a number of other unusual factors: the persistent high unemployment rate, budgetary predictions that look disastrous if not addressed, and voter anger at the financial collapse and the bailouts for banks and their wealthy employees. With elections around the corner, all these issues loom large.

Can congress reach a compromise that addresses all the issues? The answer is a "no". It is unlikely that congress can reach a compromise before the November elections. After the elections they will play a high stakes game of poker and reach a terrible compromise that addresses the immediate need without addressing the longer-term budgetary issues. What is the likely form of the compromise?

The outlines of the compromise are: continuing the Bush cuts for those earning less than $250,000-$300,000; abolishing the tax cuts for the higher income earners but not by the full amount; continuing the Bush cuts for capital gains and dividends; increasing the estate tax exclusion to $5 million to $7 million and restoring the estate tax on larger estates, possibly at a slightly lower rate; and promising to find a more complete solution in 2011 to pay for these tax cuts and address other aspects of the gloomy budgetary outlook when the economy recovers and tax collection goes up.

There are a number of points that have been wrongly, but maybe strategically, excluded from the debate. First and foremost, tax increases are insufficient to address the dire budgetary outlook. The reality is that, absent double-digit, Chinese-style economic growth in the US, the US must cut Social Security and Medicare benefits and/or increase Social Security and Medicare taxes, and the US must begin to trim its defense budget.

Second, and looking more towards the future, government expenditure efficiency and its balance between productive and unproductive expenditures are of paramount importance. Government expenditures are not all the same and should not be always lumped together.

Taxes that finance infrastructure, education, research and development, health, and reduce social inequities have high social and economic returns. Taxpayers are more willing to pay for social and economic capital than for expenditures that bring no overall benefits to the economy whatsoever. Efficient government spending generates high economic growth and in the long run alleviates the burden of taxation. A higher share of productive expenditures allows countries to achieve high long-term economic growth.

In contrast, higher shares of unproductive government spending have bankrupted countries and eroded economic growth. In this regard, we should note that the various subsidies for housing do not lead to new technology, innovation, and other benefits; or in other words, houses don't lay baby houses. Similarly, while some defense expenditures may be necessary, tanks don't lay baby tanks.

Third, and as a follow-up to the previous point, the complete US tax structure needs debate and overhaul; it is suboptimal to look at taxes one component at a time. For instance, are the various subsidies for housing (mortgage interest deduction and elimination of capital gains for most taxpayers) in the best national long-term interest? Would American be better off if these subsidies were reduced or eliminated in favor of other incentives?

Fourth, economic mismanagement and imprudent monetary policy by the US Federal Reserve during 2002-2010 have brought on distortions and inflicted damage to public finances. The financial crisis has compounded the deleterious effect on the US budget; through unproductive expenditures to bail out bankrupt financial institutions, large subsidies to homeowners, and gigantic stimuli packages; and all the while with substantially reduced tax revenues because of the Great Recession. Most of the additional federal expenditures will have little positive effect on economic growth. While the financial reform bill recently signed by President Obama was touted to address all of these issues, it does not go far enough. This needs to be taken up as a part of the future debate.

Undoubtedly, President Obama inherited the worst post-World War II economic and financial crisis. However, a failure to address the underlying economic crisis would make the crisis his liability going forward. Recent record fiscal deficits could be attributed to Obama's own deliberate policy. Adding $0.5 trillion in homeowner's subsidies to preserve high property prices might not have been a sound policy when home prices were highly overvalued. Low-cost housing programs for eligible low-income families, not monumental housing bailouts, could have promoted socially desirable housing.

Hence, a homeowners' bailout may not improve social equity and could simply subsidize the "have and have not" at the same time. Had the government allowed housing prices to adjust, price discovery would have been restored, and the housing crisis might have been long gone without its adverse fiscal incidence. Over-spending by government or private sector might not be a solution to mass unemployment. Instead the restoration of full employment should be through orderly fiscal and monetary policies and removing excesses and distortions that pushed the economy away from full-employment.

In our opinion, a dramatic increase in taxes at this time to pay for inefficient government spending would harm economic growth and would not be prudent. The recent debt crises in Europe illustrated the overburdening inefficiency of government expenditures. European countries interested in long-term economic growth decided to cut expenditures instead of increasing borrowing or raising taxes. In other words, the policies that brought about large fiscal deficits, economic recession, and financial chaos are not the policies to get us back to prosperity!

At the same time, we must also emphasize that uncertainty regarding taxes is harmful for savings, investment and growth. The delay in congressional tax legislation should have been avoided. It is now a matter of national urgency.

The debate before the November elections in the US is only the preamble for years of contentious debate on ways to fire up economic growth and how to divide up the economic pie. Thirty years of financialization, or the increasing domination of the financial sector over the real sector, has exposed how Wall Street has enriched itself at the expense of ordinary Americans and the overall health of the US economy while the White House, the Congress, the Treasury and the Fed gave them a helping hand.

The ongoing debate is truly just the preamble. Politicians will only address contentious policies when and if there is no choice. Radical fiscal change will come to the US, but not in 2010. For now it will be the smallest bandage that will stop the bleeding.

1. Carmen Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009.
2. http://sociology.ucsc.edu/whorulesamerica/power/wealth.html3. 3. For the Laffer update, click here.

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.

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