Signs of a compromise are increasing in Washington on extending the Bush tax cuts for all income levels. The question is: Does it make good economic sense to continue them, or is this merely political expediency?
Senate Majority Leader Harry Reid (D-Nev.) said Tuesday that he's willing to consider a temporary extension of the tax cuts for all income levels. Republican leaders said such a deal might include a renewal of jobless benefits for 2 million Americans who are about to run out of unemployment checks.
If the tax cuts aren't extended, the tax rates for all Americans will increase sharply on Jan. 1. For the middle class, the increase would be about $880 a year. For those in the top 20% of income earners, it would be an average increase of $6,094. And for those with $2 million income or more, it would be an increase of $339,473.
Restore the Taxes, Trim the Deficit
James Kwak, an economist and author of the recent book about the financial crisis, 13 Bankers, is one of the few experts advocating that the tax cuts be allowed to expire. Kwak says many politicians are talking about the national debt being the most urgent problem facing the country. If that's the case, Kwak says, the best approach would be to eliminate the tax breaks, which would save $3.7 trillion over 10 years.
Over the medium term, if the tax cuts are extended permanently, by 2020 the deficit will be 5% of GDP, "which is just too large," Kwak says. Letting the tax cuts expire will remove 1.5% of GDP from the deficit going forward, he says.
While acknowledging that there would be an "anti-stimulative effect" of raising taxes now, Kwak says the bigger problem for the middle class is that Social Security and Medicare are under attack, and the programs have now reached a tipping point.
"The conventional wisdom in Washington is shifting to 'we have to do something about Social Security and Medicare,'" he says. Removing the tax cuts would reduce the pressure for entitlement reform at a time when many Americans have insufficient savings for their old age, and that would be the best policy for the middle class.
Higher Taxes Now Would Hurt the Middle Class
Augustine Faucher, director of macroeconomics at Moody's Economy.com, agrees that a smaller future deficit might be better for the country because it would lead to stronger investment and in the end, higher economic growth. But he says the hit to middle-class incomes would be too great at a time of economic uncertainty.
"The middle class has been hurt hard by the recession, and wage growth has been weak for the past 10 years," Faucher says. "So the question is: Do you want to put an additional burden on the middle class though letting these tax cuts expire?"
As a result, Faucher says he favors extending all of the tax cuts temporarily through 2011 and then raising taxes after 2011 to close the budget deficit. Even then, he doesn't see an across-the-board tax hike.
"I think raising taxes on everyone is a political nonstarter," Faucher says. "Raising taxes on just upper-income people is a good start, but that's not going to be enough to close the budget deficit and bring it down to a reasonable level. So, you need to consider either big spending cuts or further tax increases."
He said his ideal solution would be something similar to the recommendation made last week by the co-chairmen of presidential commission on the deficit, who proposed tax reforms that broaden the tax base, lower rates and bring in more revenues.
A decision on this issue is likely the biggest challenge facing the lame-duck Congress before year-end.