As the United States enters its mid-term election period, one of the major issues being discussed in Washington D.C. is whether or not the “Bush Tax Cuts” of 2001 and 2003 should be extended. In essence, the tax cuts under the previous president lowered America’s marginal tax rates at all income brackets. From the Wikipedia article on the “Bush tax cuts”:

• a new 10% bracket was created for single filers with taxable income up to $6,000, joint filers up to $12,000, and heads of households up to $10,000.
• the 15% bracket’s lower threshold was indexed to the new 10% bracket
• the 28% bracket would be lowered to 25% by 2006.
• the 31% bracket would be lowered to 28% by 2006
• the 36% bracket would be lowered to 33% by 2006
• the 39.6% bracket would be lowered to 35% by 2006

To be clear, the White House and president Obama do not want to repeal all of the tax cuts above, only those enjoyed by those in the highest income bracket. The 35% marginal tax rate only applies to households earning above $250,000 in the United States. This bracket includes less than 2% of American households. So what Obama wants to do is raise the marginal tax rate by 4% on income earned above and beyond $250,000. Only a couple of million Americans will be affected by this tax increase, while more than 98% of American households will experience no increase in income taxes.

The backlash against Obama has been fierce. The main argument against raising taxes on the richest Americans comes from the Republican party, who argue that higher taxes on the rich will decrease the incentive for workers to produce more output and increase productivity to earn higher incomes. In addition, say the Republicans, it is the rich who are the investors, the capitalists, the firm owners in an economy. Increasing income taxes on the rich will decrease their incentive to invest and thus decrease the overall demand for labor in the nation, leading to lower overall levels of employment and national output. This supply-side argument claims that higher taxes may in fact lead to less taxable income, thus lower tax revenues for the government.

The Economist’s Free Exchange Blog wrote a piece last year on supply-side economics and the Laffer Curve, a popular graphic used by the supply-side to argue against increases in taxes.

“The basic reasoning behind the so-called “Laffer curve” is plain, uncontroversial, and by no means was discovered by Arthur Laffer. There is nothing to tax if no one produces anything. But taxes affect the return and therefore the motive to supply labour to economic production. An increase in the tax rate can reduce the pool of wealth to tax — the tax base — by reducing the supply of labour. No taxes, no revenue. Also, 100 percent tax rates, no revenue. Somewhere in between — exactly where depends on, among other things, the responsiveness of labour supply to after-tax wages — there will be a point at which an increase in rates delivers a decrease in revenue. If the tax rate is already past that point, a tax cut delivers more revenue.

…labour supply is just one of many ways in which an increase in tax rates may reduce the effective tax base. In addition to working less, individuals may alter their savings and investment patterns, bargain to shift more of their labour compensation to untaxable perks and benefits, move to a different tax jurisdiction, consume more tax-deductible goods, or simply hide income from the tax authorities.”

As Laffer’s model shows, at certain tax rates, a tax cut will lead to an increase in tax revenue. So how can policy makers be sure whether the United States is currently at a point on its Laffer curve that an increase in taxes won’t result in a decrease in tax revenue?

“Supply-siders” who oppose Obama’s plan to repeal the tax cut, and even argue further tax cuts would benefit the US economy, need to look more carefully at where America is on the Laffer curve.

Republican politicians of late have exhibited a dismaying lack of respect for basic science, and it is not much of a surprise that many are also cavalier about fiscal economics. At current tax rates, new cuts will not “pay for themselves” in the short run. Emphasizing this point, however, does not begin to imply that raising tax rates is smart or harmless.

In a separate piece on the Economist’s blog, the relationship between tax rates and long-run economic growth is further analyzed.  The blog presents the main point of the supply-side argument:

Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.

On the other hand…

…we find that a tax cut of one percent of GDP increases real output by approximately three percent over the next three years.

So do tax cuts “pay for themselves” as some politicians in the United States have argued in opposition to Obama’s desire to let Bush’s tax cuts expire?

Tax cuts don’t exactly “pay for themselves”, but they also don’t diminish revenue after about two years. That is, after about two years, the government receives revenues equal to what it would have received at the higher rate, but taxpayers enjoy a lower burden. It is an important advance to discover that because cuts do lead to an immediate dip in revenue, they often inspire offsetting tax increases that retard the growth effect of the origina cut. Nevertheless, the effect of cuts on output is generally strong enough to bring revenue back to where it would have been otherwise.

So it’s possible that keeping taxes lower may indeed lead to higher growth and more taxable income down the road in the United States. But all the above analysis neglects to take into account one other VERY important consideration that the US government must consider at this point in time. In a year in which several European nations, most notably Greece, have encountered debt crises, the need to generate tax revenues to finance government spending is as important as ever.

Ironically, some of the same people who oppose ending the Bush tax cuts on the rich also oppose deficit financed fiscal stimulus. People like Niall Ferguson argue that continued deficits threaten to “bring down the US bond market” as foreign and domestic investors lose faith in the US government’s ability to pay off its ever growing national debt. These “deficit hawks” argue that the US should take drastic steps to balance its federal budget, much as several European governments have begun to do, to reduce the likelihood that investors will begin demand higher interest rates for investing in government bonds, which in turn could drive up interest rates for the private sector, crowding out private investment and plunging the US economy into another recession.

The tradeoff may come down to this. Higher taxes now, or higher interest rates AND higher taxes  in the future. Raising taxes on the rich now will allow the US to achieve a more balanced budget in the future. This means less government borrowing, less government debt, and lower interest rates on government bonds and in the private sector. It also means that there will be less debt to pay interest on, which makes debt repayment (currently almost 10% of the government’s non-discretionary budget),  less of a burden in the future. A more balanced budget now (achievable if we repeal the tax cuts for the riches Americans) means less debt in the future, lower taxes in the future, and lower interest rates in the future.

I’ve always said that humans are (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run creatures living in a long-run world. I think Americans epitomize this reality. American voters can always be convinced to vote against new taxes, or vote for the guy who promises to lower their taxes. But in this case, over 98% of Americans will not even be affected in the short-run, however in the long-run the majority stands to gain from tax increases on the rich in the form of less debt to be repaid and more private investment as government borrowing and the resulting crowding-out of interest sensitive spending by the private sector is reduced.

By the way, one of the most prominent supply-side economists of the last half century agrees with me on this one. Here’s former Chairman of the Federal Reserve Alan Greenspan arguing for a repeal of the Bush tax cuts:

Discussion questions:

1. Under what circumstances would a tax increase harm not only workers and firms, but reduce government tax revenue as well?
2. What would a Keynesian say about the wisdom of raising taxes at a time when unemployment is as high as it is in the United States right now?
3. How does achieving a more balanced budget now assure that Americans will have to pay less in taxes in the future?
4. Do you believe that asking the riches Americans to pay 4% more in marginal taxes now will lead to more unemployment in America? Why or why not?

This is a follow up to a recent post to this blog, Hey, what are you Laffing at? The relationship between tax rate and tax revenue

The unbearable lightness of being Martin Feldstein | Free exchange | Economist.com

Supply-side economics, advocated by most Republican politicians, including presidential candidate John McCain, places great emphasis on the idea that investment is the main engine of economic growth, price level stability, and low unemployment. To encourage firms to invest, government should play a minimal role in the economy; taxes should be sufficiently low to incentivize firms to invest, while at the same time government spending should be reduced to avoid crowding-out of private investment.

Without a healthy level of investment, a country’s capital stock wears out and is not replaced, raising costs of production and shifting (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run (and maybe even long-run) aggregate supply leftward. If investment remains sufficiently low, over time an economy’s output could even begin to shrink.

In the article below, The Economist’s Free Exchange explores the relationship between tax rates and long-run economic growth. The Economist takes the position of “supply-siders” who study the impact of tax rates on the level of output. The idea of supply-side economics is that lower taxes encourage more investment and thus higher growth rates.

Here’s the gist of the supply-side argument:

Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.

On the other hand…

…we find that a tax cut of one percent of GDP increases real output by approximately three percent over the next three years.

In the case of the Laffer Curve, which shows the relationship between tax rates and tax revenue, the article concludes that:

Tax cuts don’t exactly “pay for themselves”, but they also don’t diminish revenue after about two years. That is, after about two years, the government receives revenues equal to what it would have received at the higher rate, but taxpayers enjoy a lower burden. It is an important advance to discover that because cuts do lead to an immediate dip in revenue, they often inspire offsetting tax increases that retard the growth effect of the origina cut. Nevertheless, the effect of cuts on output is generally strong enough to bring revenue back to where it would have been otherwise.

Supply-side economics, folks. Understanding the effects of fiscal and monetary policies on not only aggregate demand, but on aggregate supply (both short-run and long-run) is a crucial skill in  answering AP free response questions.

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Shanghai American School Economics Student Blog » You Hate Taxes, I Hate Taxes… Let’s Hug- by Alice Su

I’m repeatedly amazed at the intelligence and maturity of the young economists here at Shanghai American School. After only nine months of econ instruction, these students already know more about sound economic policy than politicians of 40 years! Case in point: SAS senior Alice Su offers an stinging critique of John McCain’s proposed tax plan over at the SAS Economists Blog. Read below…

It’s easy to see how politics and sound economic policy may not mix very well; in fact, trying to put the two together usually ends up in contradiction and confusion that puts economically concerned voters in great distress. (Example: Remember that one econ class when Welker was talking about taxes, trying to decide if he was more liberal or conservative, and then got so agitated that Jeff said “You’re having a midlife crisis” and Welker threw a smartboard marker at him yelling “I’M 29!!”? Case in point. )

In this case, McCain’s speech about his economic policies on Tuesday contains so many contradictions, both with classroom economic theory and various parts of his own policy platform, that I find myself questioning whether he is taking a solid stance on the economy at all, or is simply trying to say whatever will appeal to his audience the most.

First, McCain’s economic plan, dripping with supply-side sentiment, is centered around a series of tax cuts. In addition to making Bush’s tax cuts permanent, he also calls for cutting corporate taxes, phasing out the alternative minimum tax, doubling the value of exemptions for each dependent to $7,000 from $3,500, and giving people the option of using a simpler, shorter tax form. As a finishing tax-cut touch,

One of Mr. McCain’s tax proposals would take effect even before the Republican Convention: he called on Congress to suspend the 18.4 cent a gallon federal gas tax from Memorial Day until Labor Day. Mr. McCain said that doing so would provide “an immediate economic stimulus,” but some environmentalists said that the change might encourage more people to use their cars, while Mr. McCain has made combating global warming central to his campaign.

Hmm. Here’s where the first hints of contradiction kick in. Besides the conflict between wanting to end global warming and yet encouraging more cars on the road, we’ve all studied the Laffer Curve, and I think I can speak for all the SAS Economists when I say that the U.S. Economy is not at a place where further tax cuts will lead to an increase in tax revenue or benefit the economy. Furthermore, what about the enormous budget deficit that Mr. Bush has so graciously left us with? As the author of this article discreetly points out, McCain seems to have forgotten that he previously promised to balance the budget by the end of the first term; rather than offer the economic stimulus that McCain is claiming it will, the tax cuts would probably just plunge the nation deeper into debt.

What answers do McCain’s economic policy have to offer these questions? Well, he also proposes a one-year freeze on most “increases in discretionary spending” while he reviews every federal program, department, and agency… with the exception of spending on the military. Supposedly, the money saved from eliminating earmarks as well as getting rid of unnecessary “discretionary spending” will add up to $100 billion annually, and that is how McCain says he will pay for the lowered business taxes. However, he neglected to address the issue of all the money being spent on the wars in Iraq and Afghanistan, and whether any of that might be categorized as unnecessary “discretionary spending”, or whether we should be spending anything over there in the first place.

An analysis by the Center for American Progress Action Fund, a liberal think tank, estimated that the overall cost of Mr. McCain’s tax cuts would be three times as much as the $100 billion he estimates that he can save. And they questioned whether his programs would really save $100 billion a year.

While I’m not saying anything in support of Obama or Clinton’s economic policies, McCain’s plan seems so shaky that I would think twice before buying into how he’s going to save our country. Personally- especially since this tax-cut-focused speech was given on the day of the deadline for filing taxes- it looks to me like another plan designed for the purpose of politics, and not with sound economic policy in mind.

Wednesday’s class this week was one of my favorite of the year. Why? We got to talk taxes. Oh my goodness, you say, what’s wrong with Welker? How could he actually enjoy talking about taxes? As I said at the beginning of class, there are only two certainties in life: death and taxes.

For most people, taxes are a dismal subject, to say the least. But for teachers of economics, especially in this presidential election year, taxes make for an exciting economic, political and philosophical debate.

The premise of our discussion in class was the idea put forth by Arthur Laffer nearly 30 years ago towards the beginning of the Regan administration: that if the government would cut taxes on businesses and households, the incentive to invest and work would increase so much that gains in total output and income would be such that the government’s tax revenue might actually increase, despite the tax cut! Cutting taxes on the wealthy would have the greatest positive effect, however, since it’s the wealthy who do most of the investing and much of the spending in the economy.

This basic philosophy underpinned the tax cuts the wealthy enjoyed during Regan’s presidency, and again during George W. Bush’s term in 2001 and 2003. The debate about whether taxes cuts made by the current president is one at the heart of the Democratic/Republican divide today.

Watch the videos below, then answer the questions that follow:

First, the Democratic view:

Then the Republican view:

Discussion questions:

1. Why do Obama and Clinton promise that if they’re elected we’ll “go back to the tax rates we had before President Bush”?
2. What is McCain’s criticism of Obama’s view on taxes?
3. What do you think about the “supply-side” argument that lower taxes will stimulate spending, growth, employment, and possibly even the amount of tax revenue collected by the government? Do you buy it?
4. Are you a “supply-sider” or more of a Keynesian when it comes to the role of government in the economy? What’s the difference?

What McCain Could Do About Taxes – New York Times

McFlation?

John McCain admits that economics is not his strongest suit. He recently claimed that he  wished “interest rates were zero.” Perhaps the fallacy of this policy position is over his head, but I think there are at least 74 AP Econ students here in Shanghai who could explain to Mr. McCain the inflationary impact zero percent interest rates would have.

Regardless, the article above is not about interest rates (thankfully, interest rate and monetary policy decisions will never be his to make even if he does end up in the White House, granted Fed independence remains intact!), rather, tax policy, which would be within McCain’s powers as the designer of the US federal budget. Ben Stein, economist, actor, and humorist, writes a letter to Mr McCain offering his advice on tax policy. Continue Reading »