Tax Policy Manipulation Won’t Fix the Economy

President Obama's tax plan is full of holes and flawed analysis; the GOP's alternative is not much better

Last week, President Obama rolled out the campaign rhetoric, calling for an end to tax cuts for “the rich” and proposing a range of new tax cuts for those making $250,000 a year and small businesses looking to grow. The Republicans have also laid out a tax plan that includes making the Bush-era tax rates permanent, fixing the Alternative Minimum Tax, and tweaking the estate tax.

While the two parties disagree over specific policies, both are stumbling into the same trap: using tax policy to manipulate the economy.

In the current debate over whether or not to extend the Bush-era tax policies there are three key questions. Would letting the tax law expire would be a return to normal or a tax hike? How would the policies impact the economy and recovery? And what’s the purpose behind letting them expire or cutting taxes?

To start, people and businesses have been working with the current tax structure when writing their yearly budgets for nearly a decade. Business plans are designed to function best in the current paradigm. So, at the very least, allowing the current tax laws to expire will feel like a tax hike to many.

A tax increase, real or perceived, would have a negative impact on economic growth. From unemployment to housing to Gross Domestic Product growth, nearly every leading economic indicator has a dismal outlook for 2011. So as the recovery process barely inches along, the last thing the economy needs is a tighter restriction of resources for consumers and businessses.

The White House wants to bump up the tax rate in order to help pay down the deficit, believing an increase will create a net increase in revenues. Conservatives argue that increasing taxes would derail the recovery by slowing economic growth and disincentivizing businesses. But both sides want to use taxes as a means of generating a recovery-which shouldn’t be the purpose of tax policy.

On the left, the idea is to use corporate taxes and income taxes on high earners to fund stimulus programs and tax credits for things like housing and green cars. Even if increasing taxes were to generate more federal revenues-which there is no guarantee they would-the desired use has proved to be a dismal failure as policy over the past two years. The stimulus, even assuming a high multiplier, hasn’t generated the economic recovery promised. Infrastructure spending has been, at best, a temporary job provider. Unemployment has only gotten worse. And both tax credits encouraging consumers to buy homes and cars have been proven to be ineffectual money wasters.

On the right, Republicans are proposing a payroll tax holiday that would cost in the neighborhood of $650 billion (from lost federal revenues). The idea here is to give individuals more cash for them to spend, having consumption lead us out of recession. But there is no guarantee individuals would increase consumption if they took home 7 percent more of their gross income. The uncertain economy would lead many individuals to save this increased income or use it to pay down debt, just as they have with the last two tax credits under Presidents Bush and Obama.

The payroll tax would give businesses 7 percent more cash to potentially employ new workers. But again, there is no guarantee businesses will go on a hiring binge, especially since the tax proposal isn’t permanent and the business would have to come up with money down the line to pay for their new employees or downsize again in one or two years.

Both sides also argue for their tax policies from a justice perspective. The GOP argues that consumers should have more of their hard earned money to spend as they will. And they are exactly right in principle. But if we can’t match a $650 billion new tax cut with equal or greater spending cuts, then we are just putting a higher tax burden on future generations by adding to the deficit and debt.

The left favors increasing taxes from the perspective that rates are too low on the wealthy. New York Times columnist Paul Krugman argues that “it’s hard to think of a less cost-effective way to help the economy than giving money to people who already have plenty, and aren’t likely to spend a windfall.” But extending the current tax rates wouldn’t be giving money to anyone. It would simply be taking less.

The language here is important, because Mr. Krugman assumes the government has some right over the earnings of Americans. This is completely backwards. We should assume everyone has a right to their income and then determine what percentage each member of society should contribute to fund the proper role of government.

And from an economic perspective, the heavier this disproportionate share of the tax load becomes, the more acute the strangling effect will be on savings and consumption. According to economist Mark Zandi, the top 3 percent of income earners in America, those targeted by Obama’s plan, account for a fourth of consumer spending.

Also consider that the top 10 percent of wage earners cover 70 percent of federal tax receipts. And perhaps more striking is that while the top 1 percent of Americans makes 22.8 percent of the wages, they also pay 40.4 percent of the overall tax bill, according to the National Taxpayers Union.

Extending the Bush-era tax rates wouldn’t be giving money to the wealthy or a tax cut for the middle class. And ending them would be a perceived tax hike that would hurt consumption and investment in the economic recovery. A 25 percent increase in capital gains taxes (by allowing the Bush tax cuts to expire) will certainly divert money away from job creation and sustainable investments. And sustainable investments are exactly what are needed.

That being said, even the GOP’s tax proposal won’t save the economy immediately. Just because people have more money doesn’t mean they will spend it in such a way that will spur a quick recovery. But through savings and investment, over time allowing individuals and businesses to direct their own resources will allow capital to be better allocated throughout the market. On the flip side, perpetuating the policies of the past two years and increasing taxes on the highest consumers and wealth creators would just continue the lethargic pace of economic growth we are experiencing now. Trying to generate more tax dollars and tax credits to direct a reallocation of capital in the economy isn’t working, it hasn’t worked, and it won’t bring about a stable recovery.