The Wisdom and Folly of the Bush Tax Cuts

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The political riddle of the moment is how to convince the American people that something's gotta give. They can't have low taxes and high spending and stay solvent all at the same time. Everyone in Washington knows it, yet the courage to act is lacking. Late this year, after the midterm elections, Obama's bipartisan deficit-reduction commission headed by Democrat Erskine Bowles and Republican Alan Simpson will release its ideas. But Obama's political capital has been largely spent on health-care reform and bailouts. It's hard to imagine he will use the last two years of his term banging his head against the brick wall of deficit reduction. Hubbard thinks there won't be any serious action on deficits until the next Presidential term of office—and he wants the Bush cuts to stay in place at least until then. "There's no reason to open up the tax code," he says, "until we're ready to have a real conversation."

Let's hope it turns out to be a conversation and not a shouting match. There's a lot of good thinking on the economics of taxation that could be trampled in the coming political free-for-all. One concept embedded in the Bush policy that deserves to survive is the importance of maintaining low marginal tax rates—i.e., the rates paid on the last dollar of income. Remember, a person in the highest tax bracket, which is now 35 percent, doesn't pay 35 percent of his or her entire income in taxes. Most of the income is taxed at lower rates. Only the last bit earned suffers the biggest haircut. But that last bit matters a lot, because someone who's deciding whether to put in the extra hours and effort to earn an extra $1,000—or whether to kick back in front of the TV instead—will be influenced by the 35 percent marginal rate, not the average rate. Hubbard considers the reduction in the marginal rate on the highest earners, formerly 39.6 percent, to be one of the most growth-inducing aspects of the Bush tax reductions.

Liberal economists like Krugman who favor letting the top-bracket rates rise aren't overly impressed by the marginal-rate argument, saying the disincentives aren't severe enough to discourage people from making the effort. To many Democrats, the focus on lowering tax rates for the rich smacks of trickle-down economics. However, there is a way to preserve the low marginal rates that Hubbard favors while extracting more tax revenue from the well-to-do. That's to shrink the deductions and exemptions that are available to high-income households. Subjecting more of their income to taxes would increase tax payments without higher rates.

Will broadening the income tax base be enough, or is even more drastic action required? Some economists say an income tax, even an improved one, is simply incapable of generating the necessary amount of revenue without rates going so high that they would discourage work, saving, and investing.

One bold idea is to replace the complicated, loophole-riddled income tax with a value-added tax—a sort of national sales tax. The virtue of a value-added tax, widely used in Europe and elsewhere, is that it encourages frugality and saving by taxing spending rather than work and investing. Former Fed Chairman Paul Volcker has advocated consideration of a VAT, as has Senate Budget Committee Chairman Kent Conrad (D-N.D.). Politically, though, the VAT is stuck between tax-hating Republicans like Senator John McCain, who fear it will become an additional tax rather than a substitute, and liberal Democrats, who worry it will fall most heavily on poor people who must spend every dollar they earn (even though a VAT can be designed to protect the poor). In April the Senate voted 85-13 for a nonbinding amendment introduced by McCain that opposed a VAT.

The Bush tax cuts of 2001 and 2003 embodied both wisdom and folly. The wise part was cutting rates in a way that increased incentives to work, save, and invest. The cuts came straight out of the economists' cookbook for achieving stronger economic growth. But setting tax rates without taking spending into consideration was pure folly. Washington lowered taxes while raising spending—an unsustainable combination in the long run.

For business, perpetuating Bush's legacy by extending the tax cuts is highly appealing. Business executives also realize that—no matter what optimistic lawmakers claim—low tax rates can't last if the government continues to spend more than it takes in. "We need certainty. We need to know what those rates are going to be," Daniel Clifton, head of policy research at Strategas Research Partners in Washington, told Bloomberg Radio on Aug. 2.

In June 2001, when the U.S. embarked on the first of the historic Bush tax cuts, the ink was running black and all things seemed possible. Now fear predominates—fear that if the cuts aren't extended, the economy could fall back into recession. In the long run, the U.S. needs a fiscal policy that's based on neither hope nor fear, but on a realistic assessment of what the country needs from its government and what it can afford.

Coy is the economics editor for Bloomberg Businessweek. With Tom Keene in New York and Ryan J. Donmoyer in Washington D.C.

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