The Tax Deal

We knew that there had to be some kind of deal on those Bush tax increases. Nobody wanted to be responsible for the planned tax hike going into effect, especially while the economy is still sluggish. So, despite all the silly posturing, a deal was always the most likely outcome. The question now becomes: is this particular deal any good?

As usual the answer is muddled.

I find it sad that we cannot legislate transparently sensible things such as extended unemployment assistance without a behind the scenes political brawl over making sure the wealthy folks get some benefits as well. Quite what our horde of unemployed fellow citizens and Wall Street bankers have in common I am not sure. Nonetheless it became necessary to lavish gifts on the rich in order to secure their support for the needy. We are incapable of doing the right thing for its own sake. We have to bargain away at everything. Oh well.

So the Bush tax increase was averted for a couple of years. Big deal. According to the Congressional Budget Office that will pump up GDP growth by all of 0.1% in 2001 and 2012. OK, let me be honest: the CBO gave a range of 0.1% to 0.3% for the boost to GDP. Frankly that’s not much of a boost at all, especially considering all the huffing and puffing needed to acquire it. Then again, as I have said many times here, tax cuts are not very good at generating economic growth. Especially when people are still paying down debt. I have a suspicion that the average family will not notice any change. Why not? Because there isn’t any. We seem to forget that this entire discussion has been about avoiding a tax increase, not about getting an actual tax cut. That’s why the terminology was wrong. The projected boost to GDP is more theoretical than actual. Since analytical models had to take into account the existing law, which had the Bush tax increase coming into effect, the postponement of that increase alters the models more than it alters actual cash flows in the economy.

Thus far: no big deal.

However, the compromise worked out does have some real stimulative content. It includes three such components: a modest change in business tax deductions for investment; an extension of unemployment payments; and a temporary 2% cut in employee payroll taxes.

The first of these, the business investment tax credit, will have minimal effect. At least I don’t see how it can. With businesses awash with profits and cash, this $40 billion or so credit will hardly encourage investment. Besides, the economy is knee deep in excess capacity making additional investment foolhardy at best.

The other two pieces of the deal make more sense and are truly stimulative. Keeping a flow of cash into unemployed worker’s pockets will be expansionary. They need the cash and are likely to spend it. So the economy benefits from this. Similarly, the cut in payroll taxes gets extra money into worker paychecks and is also likely to get spent. While most right wing politicians want to deny it, money given to the average or below average household is much more likely to be spent than the same money given to the more affluent. This is not only intuitive it is proven. So these two parts of the deal will provide a boost to growth next year. Depending on your view of the “multiplier” or knock-on effect, this boost will be between 0.5% and 0.7% of GDP. Not a whole lot, but better than nothing.

So overall the deal will have a modest benefit next year before tapering off during 2012. Which is odd, since this implies the boost declines just as we are cranking up for yet another election. By the way, that increase in GDP will lower unemployment only by a small amount. A good rule of thumb is to look for a reduction in the unemployment rate of about half the addition to the GDP growth rate. So, taking the entire deal as a whole, we can expect extra growth of between 0.6% and 1.0% next year, thus cutting unemployment down by about 0.5% at best. Not a huge return on such a vast output of political effort.

One last thing. Nowhere in the brouhaha about this deal have I seen anyone ask what it means for the deficit of the debt. I can only wonder why this is. Up until now we have been bombarded by right wing stories of gloom and doom based upon apocalyptic visions of the wave of debt supposedly about to wash away the republic. Apparently maintaining the tax reductions that caused over 50% of our current deficit is not a problem to the deficit hawks. Which makes them either liars or hypocrites. Maybe both. It’s easy to see where this is now headed. With the tax cuts for the rich safely protected we will all be asked to sacrifice the safety net in order to balance the books.

But that’s after the New Year. When the hawks will be hawks once more.