The Bush Tax Cuts and Uncertainty

-- Posted by Neil H. Buchanan

The imminent expiration of the 2001 tax cuts has continued to dominate the political debate this week. In a post on this blog on Tuesday, Professor Dorf nicely described the political dynamics of the debate; so when I sat down to write my FindLaw column for the week (published yesterday here), I thought I would discuss the economic arguments in favor of the Republicans' desire to extend the tax breaks for people with incomes over $250,000 per year. (I had also discussed the extension of the Bush tax cuts earlier this month in a radio interview, which is available here.) As some people have finally started to point out, extending the cuts for the lower 98% also helps the highest 2%, because the extension of the tax cuts will apply to the first $250,000 for everyone, even the rich. Therefore, the real argument is about extending the considerable tax advantages in the 2001 bill that benefit only the richest taxpayers.

Perhaps unsurprisingly, the economic arguments in favor of this position are so weak that the discussion ultimately returned to politics. The non-political arguments to extend the high-end cuts boil down to hoary trickle-down economics (taxes on rich people and businesses should never go up, because those groups always respond to taxes negatively) and its variants (taxing rich people will cause them to stop spending and/or shrink their small businesses). None of those arguments withstands even the most passing scrutiny.

One of the arguments that I discuss in the column is contained in a letter from some "red-district Democrats" to House Speaker Pelosi, who argued that "in times of economic recovery it makes good sense to maintain things as they are in the short term, to provide families and businesses the certainty required to plan and make sound budget decisions." As I point out, the best way to provide certainty is simply to make a decision as soon as possible, whether that involves extending all, some, or none of the tax cuts. Because people currently know only that the default is unacceptable to everyone, only political gridlock can result in the tax cuts simply expiring. If the Obama plan were enacted today, it would remove that uncertainty no less than enacting the Republicans' plan. The real argument, therefore, is not about uncertainty but about the merits of allowing taxes to increase on the top two percent of earners.

This general theme, that it is uncertainty that is killing the recovery, has become a constant refrain from those who oppose Obama's policies. For example, in a blog post over the summer, I discussed a David Brooks NYT op-ed in which he claimed that small business owners in Yakima and Racine are so scared about possible new taxes and a fiscal crisis that they are refusing to hire new workers. Similarly, in July I discussed a claim in a Washington Post editorial that businesses are too shaken up by real or proposed changes in health care, financial regulation, and energy law to be confident about the future. Again, it seems obvious that these are merely excuses, because a failure by Congress to address problems in health care, financial regulation, and energy law could also have been blamed for businesses' uncertainty about the future.

Earlier this week, an economist at Harvard published an op-ed in the Wall Street Journal, in which he claimed to have demonstrated empirically that spending cuts -- not Keynesian spending increases -- are expansionary. The op-ed is rather poorly written, to be honest, making it difficult to follow whether he is against spending increases or tax increases, or some combination of spending and tax changes, under some ever-shifting set of economic circumstances. Even after sorting that out, however, at least two problems remain: (1) As pointed out here, the empirical analysis (based on fiscal policy changes in the 21 OECD countries from the 1970s onward) simply doesn't support the conclusion that a country in a deep recession with near-zero interest rates (like the U.S. today) can expand by contracting; or as Paul Krugman put it: "Here’s a comprehensive list of [cases where austerity led to growth]: Ireland 1987"; and (2) The claimed theoretical basis for this claim is once again either trickle-down ("Consumers and especially investors are more willing to spend if they expect that spending and taxes will remain limited over a sustained period of time.") or based on businesses' need for certainty ("[American businesses'] uncertainty over regulation and taxes discourages them from risk-taking, investment and consumption.")

As a Keynesian, and thus a believer in the importance of "animal spirits" in determining business investment, I cannot simply dismiss the idea that businesses might worry about future changes in economic policies. Even so, there is nothing about a cut in government spending that would create greater certainty for businesses. They would know, after all, that if spending cuts do not succeed in helping the economy, then policy could be changed later. (For that matter, they know that policy can be changed later for any reason.) They also know that spending increases could later be cut back if the economy begins to recover. Indeed, even if businesses do not expect government spending increases ever to be repealed, standard conservative economics tells us that businesses will accurately forecast an increase in future taxes to pay for that spending. That is why they are supposedly scared of spending increases today, even though those spending increases will result in more customers for those businesses immediately.

It is, therefore, not a matter of uncertainty, but a fear of higher taxes that drives this explanation. In other words, "Spending cuts will help by making future tax increases unnecessary and by reducing uncertainty," really means, "Spending cuts will make future tax increases unnecessary." And now we're back to trickle-down theory: cut taxes for the rich and for businesses, and they will make us all rich.

This is not the place to replay the weakness of trickle-down economics, except to say that it has no stopping point. Even zero rates are not enough, because it is always possible to subsidize businesses (giving them negative tax rates), financed by taxes on working people. It is worth pointing out, however, that there is a role for uncertainty in the explanation of the business cycle: Businesses are not willing to invest or hire when they see no reason to expect more customers. Blaming free-floating uncertainty about possible future policy changes, however, proves too much -- and therefore nothing at all.