"Tax increases are highly contractionary…The large effect stems in considerable part from a powerful negative effect of tax increases on investment...[the finding is] strongly significant..highly robust."

 

       -Christina Romer, White Housechief economic adviser, David H. Romer, American Economic Review, June 2010   

 

Expiration of the Bush tax cutswill equate to $184 billion in reduced spending. If all of the Bush tax cutsexpire, taxpayers would have to pay $230 billion, economic growthcould be slower by five percentage points in the first half of next year, and consumers could cut as much as $184 billion out of spending, if they react quickly to the Bush tax cutsexpiring.

 

      —JPMorgan Chase   

"Why would any CEOinvest one penny in the US? There is not one reason based on the new rules of the game."--David Farr, CEO, Emerson Electric, quarterly conference call, May 2009

There’s a fiscal fundamentalism in DC when it comes to the economic impact of the regulatory vaporware coming out of DC, including the effect of  financial reform, health reform, and the expiration of the Bush tax cuts.

Most Democrats, some Republicans even, as well as the Congressional Budget Office, the Joint Committee on Taxation (JCT), and many in the business media do not understand or take into account the behavioral response to regulation and tax hikes.

For instance, there's widespread failure to question the static scoring method the government uses to assess tax changes. And that failure to question leads to a cemented hardening of the legislative arteries in DC.

At its most rudimentary, the government's static scoring method used to assess the impact of tax changes on federal revenues says a dollar tax hike equals a dollar more collected in federal revenue, or a dollar tax cutequals a dollar lost in fiscal revenue. Congressional tax analysts largely do not take into account how people and businesses react--whether they shift income into different, non-taxable investments, work more or less, or hide their income to lower their taxes.

Sort of like what the author Michael Lewis said once, that a conclusion is where the mind comes to rest.

This is habitual self deception at its worst. 

Elected officials in the Obama Administration like to argue that increased government spendingon stimulus or on unemployment benefitswill loop back into the economyand create growth because taxpayers will spend that money.

But in their blinkered concretism, they refuse to acknowledge the flip side, that tax cutsput more money in people's wallets who will then spend it, which delivers a quicker, more immediate jolt to economic growth.

 

And isn't it contradictory for the White Houseor Congress to argue that expanded child care tax credits will increase economic growthbecause taxpayers will spend that money on consumption of, say, day care services? Isn't that acknowledging the behavioral impact of tax cuts?

We see this happen with capital gains taxes. When capital gains taxes go up, as they are set to next year when the Bush tax cutsexpire, economists note that this will lock up economic activity because many investors will sit on their capital gains to take advantage of the [hopefully] lower longer term rate.  

Not much acknowledgement there from the fiscal fundamentalists on the federal revenue impact.

 

And what of the Clinton tax changes? Clinton raised income taxes dramatically in 1993. After the Republicans seized control of Congress, he then cut capital gains taxes in 1997, established a new child tax credit, increased the estate taxexemption, and launched Roth IRAs. 

 

The economyaveraged 4.2% real growth per year from 1997 to 2000--a full percentage point higher than during the expansion following the 1993 Clinton tax hike, according to government data. The Cold Warhad ended, the Internet boom was beginning, Clinton-Gore moved to pare back government, and employment increased by another 11.5 million jobs, roughly equal to the job growthin the preceding four-year period. Real wages grew at 6.5%, which was much stronger than the 0.8% growth of the preceding period, data from the Bureau of Labor Statistics show.

And the total market capitalization of the S&P 500 rose an astounding 95% versus its performance from 1993 to 1997, according to S&P.

But government analysts duffed it when it came to the federal revenues hauled in by Clinton's capital gain tax cut. When President Bill Clintonlowered the top capital gains tax rate from 28% to 20%, the Joint Committee, using static scoring, estimated that revenues would increase $7.8 billion from 1997 to 1999, then plunge another $28.8 billion over the ensuing seven years.

That didn’t happen. Far from it.

Instead, federal revenues from capital gains taxes in just the 1997 to 1999 time period was more than 10 times higher than the expected, $7.8 billion to $84 billion. And as for the projected $28.8 billion losses later on, federal revenues from capital gains soon grew to double their levels of 1996, just before the tax cut, says the American Shareholders Association, which studied the IRS data.

Look also at how unhinged the Joint Committee became when it assessed the impact of estate taxchanges in the mid ‘90s. Still using static scoring, Joint Committee estimated that total repeal would cost the federal government $70 billion a year--even though the death taxraised only $20 billion per year at that time. Huh?

The economic activity created by Clinton's curtailment of estate and capital gains taxes hauled in more federal tax revenues than his hike on the upper bracket in '93, IRS data show.

 

You can see how absurd it gets when you consider what happened in 1988, when Senator Robert Packwood, (Rep.-OR), then the ranking Republican on the Senate Finance Committee, asked the Joint Committee on Taxation (JCT) to estimate the revenue impact if the government literally confiscated all income over $200,000, notes Dan Mitchell of the Cato Institute (then at the Heritage Institute). JCT said doing so would raise $1.4 trillion over five years--utter nonsense, as Senator Packwood said, because it assumed "people will work forever and pay all of their money to the government, when clearly anyone in their right mind will not." 

Watch what happened when President George W. Bushtried to cut estate taxes in 2001. In April, 2001, JCT estimated the cut would lower federal revenue about $186 billion over a ten-year period--but a month later, JCT said the amount lost was actually $306 billion--that whopping estimate, later proved to be wrong, is why Congress forced the estate taxcut to sunset in 2011. How far off was JCT on the overall, actual impact of President Bush's 2001 tax cuts? JCT overestimated the amount of federal revenue lost due to these cuts by $568 billion--more than enough to pay for the estate taxrepeal--because JCT did not take into account the behavioral response to tax cuts, IRS data show. 

Congressional tax officials were also way off on the revenue impact of the Bush tax cuts. The paper says that during the period 2003 to 2007, The Wall Street Journalreports. “In each year total federal revenues came in substantially higher than Joint Tax predicted--$434 billion higher than forecast over the five years,” and not all of it was due to the housing bubble, the paper adds. The budget deficits under the Bush Administrationwas due to rampant spending, spending that arose due to two wars, a recession, and the expansion of the Medicareprogram to increase coverage for drugbenefits.

The Congressional Budget Office, launched in 1974, and the Joint Committee on Taxation have taken baby steps toward adopting some types of dynamic scoring which would take into behavior responses to tax changes. Both still remain to resistant to changing their standard methodology, because it takes a lot of elbow grease to figure it out.

“Sometimes, resistance to change is just an excuse to avoid doing real work,” Bruce Bartlett, Treasury official under President George H.W. Bushand domestic policy advisor to President Ronald Reagan, once wrote. “It is a lot easier just to assume that nothing changes in the economywhen a major tax change is enacted than to figure out all the ways in which it will…there is a systematic bias in the revenue-scoring process that encourages tax increases and discourages tax cuts."

The Minneapolis Federal Reserve Bankrecently released a study that said the tax hikes in the ‘30s, during the Great Depression, caused a large drop in business capital spending, which creates jobs.

Same is happening here — companies have gone on a spending freeze due to regulatory and tax hike fears, when ironically it’s the US Congress and the administration that needs to stop. In financial reformalone, some 350 new rules will need to be written, taking up 20,000 pages, estimates Barclays Capital. Rules written in pencil, not pen — and that doesn’t count health reform.

Likely why two-thirds of the drop in jobs comes from lack of job creation. 

But the White Housewill tell you that a gain of a percentage point of GDPcreates 979,000 jobs, and that government spendingcan do that.

Even though economists Carmen Reinhartand Kenneth Rogoff says that government debt above 90% of GDPcuts a percentage point out of GDP growth, and we’re fast approaching that level. The fiscal antenna fell off the roof of the Capitol dome decades ago, and fiscally responsible politicians are an extinct species in D.C.

Moody’s Investors Service already says that interest on the federal debt will 14% of tax revenues by 2015 — its Maginot line before it downgrades.

Moody’s is saying the U.S. simply cannot be put on a hamster wheel of taxing and borrowing money to pay interest to the country’s debt holders — meaning China, the UK, and Japan — without a downgrade of its Triple A status, which it’s held since 1913. It would be sort of like paying your Visa bill by running up your Mastercardbill.

The US faces either a downgrade or a currency devaluation--the central printers will print our way out of a crisis, so the latter is in store, down the road as deflationis more the danger now.

And there’s a bigger problem. The Federal Reserveis estimating GDP growthwill be 2.8% for some time into the future.

Federal Open Market Committee meeting minutes released last week show the Fedsaying it will take another five to six years to get back to full “convergence” in the economy, meaning, trend lines pre-crisis.

But economists uniformly say we need at minimum 3% GDP growthfor job growth. That’s what economists call the economy’s Mendoza line, nicknamed after Pittsburgh Pirate’s batter Mario Mendoza, who could never seem to crack his bat above the 200 average.

So the question is: Will the policies of this Administration and this Congress keep the US economysubmerged below the economic Mendoza line?

Listen to what business executives are saying:

"The interaction between government and business will change forever…. [T]he government will be… an industry policy champion; a financier; and a key partner."--Jeffrey Immelt, CEO, GE, GE’s 2008 annual report

“People are in a really bad mood [in the US]…we [the US] are a pathetic exporter...we have to become an industrial powerhouse again but you don’t do this when government and entrepreneursare not in synch,” also “expressing concern that over-regulation in response to the global financial crisiswould damp a ‘tepid’ US economic recovery.”--Jeffrey Immelt, CEO, GEto the Financial Times, July 1, 2010

I fear that Americans have been provided a false choice between a little more and a lot more regulation and taxes. We keep hearing more ideas to create jobs and generate growth that almost exclusively require more government spending. Jobs can come from government, but those jobs get paid for by taking money from the private sector, reducing the private sector’s ability to provide jobs…there are many who believe that less regulation, less government interference, less arbitrary regulation when it does exist, and lower government spendingwill generate more growth and more jobs. I agree with those views."--Edward S. Lampert, CEOof Sears HoldingsCorp., 2009 annual report

"Today, manufacturing employment in the U.S. computerindustry is about 166,000, lower than it was when the first personal computer… was assembled in 1975…You could say, as many do, that shipping jobs overseasis no big deal because high-value work–and much of the profits–remain in the U.S. But what kind of society are we going to have if it consists of highly paid people doing high-value-added work, and masses of unemployed?"--Andy Grove, co-founder and past chairman of IntelCorp., Bloomberg News, July 1, 2010

"A new semiconductor factory built from scratch costs about $4.5 billion–in the United States. If I build that factory in almost any other country in the world, where they have significant incentive programs, I could save $1 billion [due to tax breaks]."--Paul Otellino, current CEOof Intel, recent speech

“The Obama administration has created an increasingly hostile environmentfor investment and job creation. The U.S. corporate tax structure is a major impediment to international competitiveness. The government should ‘stop trying to micromanage industries.’"--Ivan Seidenberg, CEOof Verizon, speech before the Economic Club of Washington, June 22, 2010 (president of the Business Roundtable)

Footnote: Farr, Lampert Grove, Otellino, Immelt quotes first reported by Frederick Sheehan,  author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession(McGraw-Hill, 2009), blog at www.aucontrarian.com