The Tax Compromise and the Erosion of Public Accountability

blitt chandan 22 11 The Tax Compromise and the Erosion of Public Accountability

To the consternation of his Democratic base, President Obama reached a compromise with Republicans early last week that will see expiring tax cuts extended temporarily for Americans at all income levels. Among the many other provisions of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, employee payroll taxes will be reduced by 2 percent for the duration of 2011. For the unemployed, emergency unemployment benefits will be extended at their current levels for another 13 months. And in an effort to encourage business spending on capital and equipment, firms will be able to expense their 2011 investments in full.

There is something in the legislation for everyone, whether one is seeking an opportunity to claim victory in a perceived presidential concession or to bemoan the sorry state of political discourse in our great republic. In either case, the Senate was poised as of press time to pass the legislation over objections of more steadfast elements in both parties.


Extend and Pretend

Once the legislation has become law, current arguments over the fairness of the tax plan will be rendered academic. But within the academic realm, economics is better suited to addressing questions of efficiency rather than equity.

As for the latter point of disagreement, the estimation of fairness is a subjective question that we will now have to revisit in the lead-up to the 2012 election as the tax cuts reach their new expiration. Regrettably, and if the past few weeks are any indication, this means a presidential election debate that focuses inordinately on the issue of marginal tax rates and an abandonment of the principled commitment to fiscal responsibility.

Losing out will be the more important debate about how to bring government revenues and expenditures in line, so as to finally address our gaping deficit and its threat to our nation’s long-term prosperity. On this issue, both parties have shown a willingness to capitulate in recent weeks. Barring a radical shift in elected officials’ sense of accountability on this issue, both high-mindedness and hard decisions risk giving way to the sometimes base dialogue that has characterized the lame-duck session.


Revise Your Near-Term Projection

Many economists that have sounded warnings on the deficit and called for a measure of austerity are now responding positively to the tax compromise. The upside of a focus on the immediate future is a legislative package that will deliver a temporary but observable boost to economic activity, through an increase in personal consumption and the potential for accelerated business investment.

According to a Dec. 10 analysis by the Congressional Budget Office, the tax legislation will add $374 billion to the deficit in the current fiscal year and $423 billion in the next. Over the 10-year projection time frame, the net impact is to increase the deficit by $858 billion. Some of this total relates to new spending, but the vast majority relates to reduced income and estate tax revenues, the payroll tax holiday and the cost of the business investment incentive.

By putting money back into earners’ pockets, and by doing so in a manner that is more impactful for income-constrained households, overall consumption activity will trend higher. The multiplier effect of the unemployment benefits extension should prove very high since this income will be spent on necessities and will not drive higher gross savings. The payroll tax holiday will have a stronger multiplier for lower-income households than their higher-income peers.

In each case, the effect of the policy will be to temporarily increase households’ after-tax income, driving some measure of personal consumption. One danger is that state and local governments, many of which are facing large budgetary shortfalls, will seize upon favorable federal tax policies to enact revenue-enhancing increases of their own.

By design, the income and payroll tax adjustments do not lower directly the cost of hiring new employees. Wages are sticky, and these lower taxes will not mean a fully compensating adjustment in prevailing wages. As a result, the impact on overall employment will be indirect and on the margins.

There are other provisions that are helpful for business, however. The expense adjustment for business investment is well intentioned, in part because firms are holding record amounts of cash. As of the third quarter, cash as percent of corporate assets had hit 7.4 percent, its highest level since 1959, according to the Federal Reserve’s Flow of Funds report. If some of that $1.9 trillion is channeled into investment spending, it could help to reaccelerate the recovery. The risk is that in the event that firms do not see a change in the underlying drags on the long-term outlook, they will not respond to the incentive but will continue to hoard cash and other highly liquid, low-risk assets. This risk is real given the degree of slack in the economy’s productive capacity, which is prompting stimulative tax policy in the first place.



In the near term, and holding all else equal, the tax compromise will support consumer activity and, by extension, the real economy. Businesses may invest more as well. But we achieve these results at a cost that is captured only in part by the Congressional Budget Office estimates of a wider federal deficit. Ultimately, consumer and business confidence is tempered by the perception of a political system that cannot resolve intractable fiscal issues with solutions that exhibit a degree of permanence. If our deficits exceed our rate of growth, the weight of our borrowing obligations on our economy is increasing. In choosing to delay any truly difficult choices and in calling that delay a compromise, we have opted to pay forward an even greater weight on our economy’s potential.


Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.

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