The Bush Tax Cuts

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This week, I’m writing just one long blog.  I want to discuss the Bush tax cuts.  For those of you who haven’t followed this story, tax cuts were enacted during President Bush’s tenure (2001 and 2003).  In short, the cuts lowered all tax brackets on ordinary income, lowered capital gains and dividend tax rates and eliminated the estate tax.  In order to get the cuts passed, the laws were written so that they would expire after ten years.  The Republicans don’t want the tax cuts to expire for anyone.  President Obama wants the tax cuts to be extended for all but the highest income bracket taxpayers.  He would allow the top tax bracket to increase from 35% back to 39%.


The Short Version of This Blog Entry

Since this is a long email, I want to give you the short version (and then you can read on if you’re interested).  I start with the following assumption: the Democrats and Republicans both agree that most all of the tax cuts should be extended.  Therefore, that must be the politically easy (wrong) thing to do.  I think that the tax cuts should be allowed to lapse in their entirety and here’s why:

1. Allowing tax rates to return to prior levels sends an important signal to our citizens and our creditors: we’re serious about getting our financial house in order.  It lets people know that we are willing to suffer in order to avoid a situation in which our debt spirals.




2. Even if rates return to their “pre-Bush” levels, they are not historically high.




3. We are in the middle innings of a long-term financial crisis.  We need to take action now.




4. We averaged GDP growth of 2.3% from the time the tax cuts were enacted until the recession started.  During that time, we still ran a deficit and our debt increased. There’s no evidence that low tax rates helped us.  (You are free to argue that things would be even worse with high tax rates, but one thing I know is that when something doesn’t work, continuing on won’t improve the situation.)




5. I am distrustful of many of the arguments that people are making about continuing the tax cuts.  See article below on the five tax cut myths.




6. Some of the people who have really studied this situation favor allowing the tax cuts to lapse.  Greenspan thinks we should do this.  Barry Bosworth (Brookings Institute) also thinks we should let them lapse.  Even Glen Hubbard (who helped design the tax cuts) thinks that we have made mistakes in cutting taxes while increasing spending (although he wants to keep the cuts until the next President takes office).

Below, I have summarized two interesting articles and I’ve also provided the link for Stephen Colbert’s take on the issue (see Part 3).


Part 1: Deficits Make Bush Tax Cut Fans Say There’s No Free Lunch

First, I’ve summarized a great article by Peter Coy (Bloomberg).  Here’s the link.  My quick opinion is that the issue of the tax cuts shows how difficult it is going to be to solve our long-term problems.  We don’t know what impact the sunset of these cuts will have on growth (there are too many variables for anyone to know for sure), so we just argue what we believe.  But, in my opinion, the time has arrived for us to show that we are serious about addressing our problems.  Whether we slow our growth now or later, it’s going to happen.  But, I’m not a fan of kicking the can down the road.  We need to start our painful process today.


Background Info

1. The Bush tax cuts seemed to make sense when they were enacted.  We were reducing our deficit during the Clinton years.  In addition, in late 2001, our economy was slowing.  But, it turns out that the deficit reduction during the Clinton years was misleading.  Much of this reduction came from the internet boom (and executives paying taxes on their options gains).




2. The Bush tax cuts were designed to encourage people to work and invest.  But, we can’t set tax rates without regard to our spending.




3. Growth averaged 2.3% from the end of 2001 through December 2007.  Deficits grew during this time.  (Personal comment: if we can’t balance our budget with 2.3% growth and while the baby boomers are still working, that tells you where we’re headed.)




4. The Heritage Foundation says that while projected surpluses from 2002 – 2011 swung by $11.7 trillion to deficits, only $1.7 trillion was caused by the tax cuts.   Other causes were lower economic growth ($3.8 trillion), higher spending (defense, discretionary, Medicare drug benefit, financial bailout, other)($3.7 trillion), interest costs ($1.4 trillion), 2009 stimulus ($700 billion) and other tax cuts (such as 2008 rebates) ($400 billion).




5. While deficits should shrink in the coming years (as the recession ends), the budget picture gets much worse near 2020.  (See earlier blog about the CBO’s estimates.)

The Dispute

1. The dispute between Republicans and Democrats is somewhat small: most Republicans (and some Democrats) want to extend all of Bush’s tax cuts while the President wants to extend them for everyone other than individuals earning more than $200K (or families earning $250K).




2. Macroeconomic Advisers estimates that a “full sunset” of the Bush tax cuts would lower GDP by .9% next year (from the 2.9% consensus to 2.0%).




3. The staff of the congressional Joint Economic Committee estimates that the President’s plan would forgo $2.8 trillion in tax revenue from 2010 through 2020.  The Republican version would result in a cost of another $700 billion (i.e., this is the tax revenue that is estimated to be lost by keeping the highest tax rates at their current level).




4. The Congressional Budget Office has ranked the continuation of the Bush tax cuts last for effectiveness among stimulus options.  Part of their argument is that the wealthy tend to invest their tax savings (rather than spend them).  Investing does not have an immediate impact.

Opposition from Prior Supporters

1. Glenn Hubbard, who helped design the tax cuts (and now serves as Dean of Columbia’s business school) says that the tax cuts have been undermined by years of deficits.  He pointed out that “deficits are just future taxes.  You’re just talking about taxes today versus taxes tomorrow.”  (Hubbard was bothered by the fact that tax cuts were enacted and spending was increased – in particular, the Medicare prescription drug plan had a huge cost.)  With that said, he wants the tax cuts to continue until the next Presidential term.




2. Greenspan, who supported the 2001 tax cuts said that extending the cuts without making offsetting spending reductions could prove “disastrous.”  He’s quoted as saying, “I’m very much in favor of tax cuts, but not with borrowed money.”

Other Views

1. Paul Krugman (seen as the liberal’s voice) suggests that we should let the tax cuts expire and instead bail out states and local governments.  Since that is not politically possible, he favors the President’s plan, but says that the extension of the cuts should be limited.




2. Economist Alan Auerbach (Berkley) says that the tax cuts should be coupled with major spending cuts that go into force in a few years.  An example would be raising the age at which people qualify for Social Security.  (Personal note: this is very consistent with ideas in behavioral finance…commit to doing the hard thing in the future, such as saving more from your paycheck.  In other words, lock yourself in when it seems far away and easy to do.  The problem with this idea is that it furthers the political battle – people will argue that the lowest income wage earners will work longer so that there can be tax cuts for the highest wage earners.)




3. Barry Bosworth, an economist at the Brookings Institute argues that we should just let the tax cuts lapse and take the hit to growth.  (Personal note: this will never happen, but at the end of the day, I’m in Bosworth’s camp.  I think it would be painful.  But, my feeling is that we’re headed for more intense and longer pain if we put this off.)




4. Some economists believe that we should leave tax brackets where they are but lower the amount of deductions that are claimed by those who itemize.  (The idea is to get more taxes out of higher income taxpayers without raising the marginal tax rates.)

Congress Won’t Act

1. Congress doesn’t see things like Bosworth because the bond market isn’t forcing them to.  The ten-year Treasury is yielding 2.73%.  Foreign investors continue to hold our debt.   The CBO has warned that this will eventually end.

Part 2: Five Myths About the Bush Tax Cuts (by William G. Gale, Brookings Institute)

William G. Gale (Brookings Institute) wrote a piece that has received a lot of attention.  He identifies five “myths” about the Bush tax cuts.  You can read it here.  Here are the myths:

1. Extending the tax cuts would be a good way to stimulate the economy. In fact, the CBO says that we will only get a 10 – 40 cent increase in GDP for every dollar spent.  The reason is that most of the savings (in dollar terms) go to the highest earning individuals and they tend to save their tax savings rather than spend them.  (This savings could be good for the long term, but the point is that it’s not an effective stimulus measure.)




2. Allowing the high-income tax cuts to expire would hurt small businesses. He argues that less than 2% of tax returns reporting small-business income are filed by taxpayers in the top two brackets.  Also, he argues that only 40% of people in the tax bracket receive a majority of their income from small businesses.  (Personal note: I don’t find this argument compelling.  I think it will hurt the people in the highest bracket and many are small business owners.  Unfortunately, we’re not going to bring in a lot more revenue by taxing the lowest income taxpayers.)




3. Making the tax cuts permanent will lead to long-term growth. He argues that while the tax cuts can foster growth, they have also fostered debt and that could lead to higher interest rates in the long term (hurting growth).




4. The Bush tax cuts are the main cause of the budget deficit. In 2007 (many years after the tax cuts were implemented), the deficit was 1.2%.  By 2009, the deficit had reached 9.9% of GDP.  Obviously, there were other factors to blame (largely the recession…see above for Heritage Foundation’s list).




5. Continuing the tax cuts won’t doom the long-term fiscal picture; entitlements are the real problem. He argues that there is a long-term imbalance between spending and revenue that goes far beyond entitlements.  He argues that even if we return to full employment, we will have problems before considering Social Security and Medicare / Medicaid.  (While I agree that we have long-term problems with this, I think that the entitlement programs are by far our biggest problems.)

Part 3: Stephen Colbert Sums It All Up

Finally, if you want a humorous perspective, watch Stephen Colbert’s take on the tax cut issue.  Here’s the link.


Enjoy the rest of your week.

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