Why the Bush tax cuts should not be allowed to expire

Because I am concerned about fiscal responsibility, I am hesitant to advocate keeping taxes low. Nevertheless, as my colleague Shawn Ritenour emphasized in his blog, restoring fiscal responsibility while also promoting a prosperous economy requires cutting government spending, not raising taxes.

Raising taxes from the current level would have harmful consequences in any case, but those consequences are exacerbated by the fact that we are in a severe recession (some say depression). The main problem with raising tax rates is not that it will lead to a reduction in consumption and demand. If anything it will lead to increased consumption, though by government agencies and recipients of government transfer payments instead of the people who earned the money through their labor.

The more serious problem for the economy is how taxes influence production. When a greater share of each dollar earned is taxed away, it reduces the incentive to earn, whether through working additional hours, hiring more workers, or investing in capital. This problem is more serious for those in higher tax brackets, who are more likely to own businesses and have discretionary time and money that they could invest producing more goods and services. It is not spending that leads to economic prosperity, but greater production of what people value, which depends on entrepreneurs having confidence about the future direction of the economy and an expectation of being rewarded for taking risks. This is the key to an economic recovery that will restore prosperity while preserving freedom.

It is doubtful that raising tax rates on individuals with incomes over $200,000 ($250,000 for married couples), as proposed by the president, would lead to a reduction in tax revenue, but it will not lead to a very big increase. Thus if the big spenders currently in control of Congress really care about fiscal responsibility they will let the lower tax rates on the middle class expire as well. This would lead to an increase in revenue that is at least two or three times as large as from increasing taxes only on the those earning more than $200,000, who make up less than 5 percent of households.

Raising taxes on the middle class may actually have a less harmful effect on economic growth and prosperity in the long run than raising taxes on the wealthy, since work and investment by the middle class is likely less responsive to tax rates than that of the wealthy. Nevertheless, uncertainty about which tax rates will be allowed to increase and which will not also hinders economic recovery. Even if the president and Congress say they do not intend to raise taxes on the middle class, their unwillingness to bring spending under control leaves many of us expecting that Congress might raise those taxes out of fiscal necessity. This uncertainty discourages entrepreneurs from investing in capital to expand production of goods and services demanded by the middle class.

A clear commitment on the part of Congress and the administration to extend the Bush tax cuts across the board would remove some of the uncertainty and lead to greater investment and job creation. While such a commitment is not sufficient to address the looming fiscal problems faced by our government, it would be a step in the right direction.

An Example of Wasteful Transit Spending in Pennsylvania.

Anyone who wants to understand how the political process leads to wasteful spending on public transportation need look no further than the North Shore Connector, a 1.2 mile extension of the light rail line in Pittsburgh. Senators John McCain and Tom Coburn recently criticized this project as one of the three most offensive uses of federal stimulus funds. Recent attempts by the Pittsburgh Post-Gazette and the Port Authority of Allegheny County (PAAC) to defend this project against the Senators’ criticism reflect economic fallacies and also illustrate the process by which interest groups seek to profit from federal and state government money at the expense of taxpayers as a whole.

Defenders of the project point out that its construction provides thousands of jobs while supporting economic development on Pittsburgh’s North Shore. They ignore, however, the opportunity cost. A comparable number of jobs would have been created if the money had been spent elsewhere and much larger benefits would have resulted if the $529 million spent on the North Shore Connector were invested in a private sector project that consumers were willing to pay for.

Consumers will not be willing to pay even close to the more than six dollar per ride cost that would be required to cover the annual interest on the money invested in this project, not counting the operating cost and depreciation. The money spent on this project could be used to buy a brand new $40,000 SUV for each one of the 11,500 riders per day that are expected to use the North Shore Connector.

If it had not been for $62.5 million of economic stimulus funds, construction of the Connector would likely have been halted due to cost overruns. Not only has the cost increased from an original estimate of $363 million to $528.8 million, as noted by the Allegheny Institute (http://alleghenyinstitute.org/administrator/components/com_policy/uploads/vol10no42.pdf), but the project was scaled back in size, as PAAC dropped a planned spur to the Convention Center from the project. The PAAC website does not mention the most recent increase in costs, listing the project as costing $435 million to construct.

Why is so much money being spent on this project? Because about 80 percent of the cost was borne by the Federal Government and one sixth came from the Commonwealth of Pennsylvania, leaving only 3.33% of the cost to be paid by local taxpayers. Thus many Pittsburgh residents are strong supporters of the project. Supporters believe that if the money is not spent in Pittsburgh, it will be spent in some other city. When Uncle Sam pays for it, the cost is divided among the entire US population while the benefits accrue to a much smaller number of local transit agency employees, construction workers, and city residents who expect to use the service. It is not worth the effort of individual taxpayers to oppose this project politically because it costs only a few dollars per taxpayer, while the benefits to local groups are large enough that they are more likely to reelect their representatives in Harrisburg and Washington if projects like this are funded. When this and numerous other projects that benefit interest groups get added to the federal and state budgets, we end up with enormous government debt, which may soon be unsustainable.

Which Party will Promote Fiscal Responsibility?

Martin Wolf , writing for the Financial Times (http://blogs.ft.com/martin-wolf-exchange/2010/07/25/the-political-genius-of-supply-side-economics/) argues that if Republicans return to power, the accumulation of unsustainable government debt will continue. Wolf maintains that Republicans still promote “supply-side economics”, espousing the view that cutting taxes could balance the budget. He also points out that Bush-era tax and spending policy led to today’s extremely high deficits.

I think Wolf is onto something. Republicans are more concerned about cutting (or at least not raising) taxes than they are about fiscal responsibility. Few Republicans in Congress or the Senate are willing to propose serious spending cuts that would be necessary to bring the budget into balance (or even substantially reduce projected deficits). How many Republicans would consider cutting Medicare spending, for example? Rising Medicare costs as the baby boomers retire will be much larger than any recent economic stimulus spending.

Wolf argues further that Democrats are relatively fiscally responsible. Their support of tax increases does suggest that many of them care about fiscal responsibility. Nevertheless, just as the supply-siders exaggerate the incentive effects of tax cuts, those who believe that government can increase spending, as it will with health care reform and other progressive policy changes, and pay for it with tax increases, underestimate or ignore the negative incentive effects of tax increases.

Not only is it unlikely that the proposed tax increases will do much to bring down deficits, but it is doubtful that a big enough tax increase to make a dent in the deficit will succeed politically. And this is as it ought to be. Americans value freedom, but we cannot have the freedom to spend our money the way we want if government programs are absorbing a growing share of our income. Nevertheless, Democratic politicians play an important role in reminding Americans that tax increases will be necessary if the government is going to continue to spend as much as it has been spending recently.

The kind of fiscal responsibility that will preserve our freedom does not involve increasing taxes, particularly on the highest income groups who play such an important role in investment and entrepreneurial job creation. It does, however, require a commitment to make serious cuts in spending, including in some areas that are dear to many conservatives and Republicans, like national defense and Medicare. Keeping taxes low or reducing them without cutting spending is a recipe for a fiscal disaster that will eventually cripple the ability of government to perform even its necessary functions.