Saturday, December 29, 2012

Stop Laughing at my Laffer Curve - Part 2

Real Housewives of the Beltway
How the script for the fiscal cliff melodrama was written.

The fiscal-cliff melodrama has become one of those bad cable reality shows, a sort of "Real Housewives of New Jersey" without the sincerity though not without the plastic surgery. In the latest episode on Friday, the actors met at the White House in a last-ditch attempt to avert the cliff they had created, and that they all claim would be a catastrophe to jump off, but that they hope they can blame on each other if they do.

On second thought, this script would be laughed right off cable.

It's impossible to assess any last-minute deal before it is struck. But at this point we know there will be a big tax increase of some kind, which will finance more spending but which won't come close to helping the economy grow faster or reduce America's debt. The only question is the extent of the policy damage.

House Speaker John Boehner, left, President Obama, center, and Senate Majority Leader Harry Reid, right, after debt ceiling talks in July.

So for today we thought we'd explain again how we got to this sorry pass. The mistakes are political and bipartisan. But they are also intellectual, which means there is some hope to avoid them in the future if we learn the right lessons.

The first mistake goes back to the original compromises to pass the Bush tax cuts of 2001 and 2003. Those lower tax rates are expiring now because they weren't made permanent then. The 2001 tax cut was for 10 years and the 2003 tax cuts were for five years, and later they were extended a year or two at a time, in order to satisfy arcane budget rules that didn't require 60 Senate votes.

The second mistake was the Alternative Minimum Tax, which Democrats passed in 1969 to capture a few millionaires who had used loopholes to avoid a 70% marginal tax rate. But the tax was never indexed for inflation, even when Bill Clinton raised AMT rates in 1993. Republicans also didn't index it in 2003 or 2005 because it would have "cost" too much in lost revenue under Washington's silly budget scoring rules. So now the AMT threatens to engulf 27 million Americans if it isn't patched each year.

The third and biggest blunder is the Keynesian mantra of "timely, targeted and temporary" tax cuts and spending. We thought this had been buried by the Reagan years. But it made a comeback in 2008 with Nancy Pelosi and Harvard economist Larry Summers.

The economic theory is that Congress can, in its ever-present wisdom, calculate precisely the right amount and timing of temporary tax cuts and spending increases to stimulate the economy. But the tax cut must be temporary so as not to add to the "long-term" deficit. And the tax cut must be targeted, lest it benefit someone who makes more money than Ms. Pelosi and Mr. Summers like.

So they and President Bush gave us the $168 billion temporary tax rebate of February 2008 that goosed official GDP for a quarter but did nothing to change incentives to work or invest. Then they and President Obama gave us the $830 billion spending and targeted-tax-cut stimulus of 2009, which included the temporary making-work-pay tax credit and later the temporary home buyer's tax credit.

All of this did so little for the economy that after the 2010 election even Mr. Obama agreed to a two-year extension of the Bush tax rates to avoid another recession. He also insisted on the temporary payroll tax cut of 2010 (extended in 2011), and the 2010 temporary boost in business expensing.

The problem with all of this temporary policy is that Americans aren't stupid. They know it is all going to expire. So they either don't change their behavior, or they move up investment or purchases they were likely to make anyway to take advantage of the tax break. In the end there is no permanent change in incentives and little or no change in the underlying rate of economic growth.

Oh, and when these temporary tax cuts expire, by definition they create a tax cliff like the one we are now facing. By contrast, a truly stimulative tax cut would be immediate, permanent and apply at the margin to the next dollar of income made by all taxpayers.

We should add that the one part of the cliff not to worry about are the automatic spending cuts (the "sequester") that will start to hit on January 1. The Keynesians who believe that government spending is the main source of growth are portraying this as a calamity. But when has Washington ever seriously cut spending other than after a war?

The sequester would cut a mere $109.4 billion in 2013, with half from defense and half from domestic (mostly non-entitlement) accounts. It would be smarter to decide which programs to eliminate, rather than cut across-the-board. But the size of these cuts are small in a nearly $4 trillion budget. And to the extent that they signal at least some spending restraint, they would help the economy by reducing the need for future tax increases.

The larger point here is that the fiscal cliff is an entirely made-in-Washington fiasco that is the result of bad policy choices. It reflects a dominant political class—mostly Democrats but increasingly many Republicans and conservative intellectuals—who think that growth derives from government spending and that tax rates don't matter. Until that policy fever is broken, the Beltway's cable ratings aren't likely to improve.

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