Posted by: Jeff | August 2, 2010

Time to Let the Bush Tax Cuts Die

In 2001 and 2003, George W. Bush and the Republicans in Congress (along with the help of some centrists Democrats) enacted a massive package of tax cuts. The legislation was actually passed via reconciliation — the same process used to pass portions of health care reform — and because of that methodology the cuts are set to expire at the end of this year. As a result, a major debate is starting to brew over what, if anything, should be done about their impending departure. Opinions seem to break down into two broad camps — liberals would like to allow the cuts to expire for the two top income brackets, but extend them for everyone else, and conservatives would like to extend them for everyone across the board.

On that note, William Gale had a very good Sunday piece debunking a lot of patently false notions being tossed around about the Bush tax cuts. Among these myths is the conservative assurance that extending the cuts will stimulate the economy (they won’t); that allowing the cuts to expire for the two top income brackets would hurt small business (98 percent of small-business income filers do not make it into the top two brackets); that making the cuts permanent would lead to long-term economic growth (the economic and historical evidence for this is extremely sketchy); and that we should be focused solely on cutting entitlements into order to balance the budget (that’s just blinkered anti-tax ideology talking). My one quibble is with his last remaining point, that the tax cuts are not the main cause of the budget deficit:

Although the cuts were large and drove revenue down sharply, they are not the main cause of the sizable deficit that exists today. In 2007, well after the tax cuts took effect, the budget deficit stood at 1.2 percent of GDP. By 2009, it had increased to 9.9 percent of the economy. The Bush tax cuts didn’t change between 2007 and 2009, so clearly something else is to blame.

The main culprit was the recession — and the responses it inspired. As the economy shrank, tax revenue plummeted. The cost of the bank bailouts and stimulus packages further added to the deficit.

This is all true so far as it goes, but I think it’s the wrong way of looking at the issue. As Joe and I have discussed before, there’s a difference between deficits and debt. Which one is more pertinent depends on what you’re discussing, and mixing the two up can cloud the larger issue.

The deficit is the shortfall of revenue with respect to spending for any one particular year, while the debt is the cumulative result of all the deficits the country has run. (In other words, all the year-to-year borrowing we haven’t yet paid off.) So deficits can actually fluctuate dramatically from year to year, depending on how policy shakes out. Which means that 2009’s deficit of 9.9 percent of GDP is kind of meaningless when it’s just taken on its own. As Gale notes, it was much smaller in 2007, and could very well be much smaller again next year or the year after that. And, as it turns out, that’s precisely what’s going to happen:

That big spike in the middle (with the blue arrow saying “major short term gap”) is our expenditures in response to the recession — the stimulus, the bailouts, etc. At the same time, the dark blue line has a mirroring dip, representing the loss in federal revenue caused by the recession. The resulting gap between the two peaks is 2009’s gargantuan budget deficit, and as you can see, it disappears by 2012.

The point being, an enormous budget deficit is really not a big deal, provided that it’s temporary. It’s when you start getting big deficits year after year that you get a real problem, because that means your debt is growing at an unsustainable rate — and that means higher interest rates and all the other problems that will drag an economy down to an early grave. As you can also see from the graph above, if we stick with business as usual, in the next decade our expenditures will start to outpace our revenue by a continuous and dramatic amount. That’s our long-term debt/deficit problem.

Getting back to the Bush tax cuts, if you really want to judge their fiscal impact, look at their cumulative impact on our fiscal situation, not just their impact for one particular year. (Remember, the tax cuts have been in place for ten years running, while the stimulus and the bailouts were one-time events.) What you’ll find is that the Bush tax cuts have added $2.5 trillion to the debt in the ten years they have been in effect — over twice the combined cost of the wars in Afghanistan and Iraq, and at least $500 billion more than the one-off expenditure of the bailout and stimulus together.

Take a look at the graph to the right, which predicts our deficit spending over the next decade, assuming all the Bush tax cuts stay in place. The tax cuts would be the dark orange slice — by far the biggest contributor to the problem. And the really depressing part is that if we go with the preferred solution of Obama and the Democrats — and only allow the cuts for the top income earners to expire — that would only reduce the dark orange portion by a quarter. So you get a sense of the scale of the problem.

While I’m sympathetic to the argument for keeping the tax cuts in place for lower earners, I think Fareed Zakaria is right here: The tax cuts in their entirety were irresponsible and destructive, and they need to go. Extending the cuts for lower earners for another year or two — until the worst of the recession is (hopefully) over — certainly wouldn’t be crazy. But that, it seems to me, is the absolute limit of what we can reasonably afford. And then there’s the issue of political inertia: The longer the cuts are in place, the more Americans will likely come to see them as normal, and the harder it will be for politicians to dislodge them, especially in a tough economic environment. Overall, it’s a real nasty dilemma.

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