Two months ago, the Congressional Budget Office issued a stark warning to Congress over the fiscal impact of “Taxmageddon,” the upcoming expiration of the Bush-era tax rates at the end of this year. Allowing all of the tax rates to rise would push the US into recession:
Tax hikes and spending cuts set to take effect in January would suck $607 billion out of the economy next year, plunging the nation at least briefly back into recession, the nonpartisan Congressional Budget Office said Tuesday.
Unless lawmakers act, the economy is likely to contract in the first half of 2013 at an annualized rate of 1.3 percent, the CBO said, before returning to 2.3 percent growth later in the year.
Canceling those tax and spending policies would protect the recovery in the short run and encourage more vibrant growth, around 4.4 percent, in 2013, the CBO said. However, unless lawmakers adopt policies that would reduce budget deficits by a comparable amount down the road, the CBO said, the national debt would continue to climb, imperiling future economic growth.
Republicans want to follow the CBO’s advice and cancel the tax hikes, while looking for other ways to reduce spending rather than the sequestration policies set to take effect in January. Democrats want to hold both hostage to force the GOP to agree to Obama’s proposal to raise taxes on earners over $250,000 — or $1 million, depending on which Democrats one asks, and when. Will the economic impact of those tax hikes be much different than that of the full fiscal cliff? According to a new study by Ernst and Young … no:
With the combination of these tax changes at the beginning of 2013 the top tax rate on ordinary income will rise from 35% in 2012 to 40.9%, the top tax rate on dividends will rise from 15% to 44.7% and the top tax rate on capital gains will rise from 15% to 24.7%.
These higher tax rates result in a significant increase in the average marginal tax rates (AMTR) on business, wage, and investment income, as well as the marginal effective tax rate (METR) on new business investment. This report finds that the AMTR increases significantly for wages (5.0%), flow-through business income (6.4%), interest (16.5%), dividends (157.1%) and capital gains (39.3%). The METR on new business investment increases by 15.8% for the corporate sector and 15.6% for flow-through businesses.
This report finds that these higher marginal tax rates result in a smaller economy, fewer jobs, less investment, and lower wages. Specifically, this report finds that the higher tax rates will have significant adverse economic effects in the long-run: lowering output, employment, investment, the capital stock, and real after-tax wages when the resulting revenue is used to finance additional government spending.
Through lower after-tax rewards to work, the higher tax rates on wages reduce work effort and labor force participation. The higher tax rates on capital gains and dividend increase the cost of equity capital, which discourages savings and reduces investment. Capital investment falls, which reduces labor productivity and means lower output and living standards in the long-run.
- Output in the long-run would fall by 1.3%, or $200 billion, in today‟s economy.
- Employment in the long-run would fall by 0.5% or, roughly 710,000 fewer jobs, in today‟s economy.
- Capital stock and investment in the long-run would fall by 1.4% and 2.4%, respectively.
- Real after-tax wages would fall by 1.8%, reflecting a decline in workers‟ living standards relative to what would have occurred otherwise.
John Merline at Investors Business Daily also points out that the effects will be felt more in the very states that support Obama the most:
Connecticut, New York, New Jersey, Massachusetts and California — all blue states — would suffer the most, according to a Tax Foundation report.
The reason, the study notes, is that these states have higher shares of wealthy taxpayers than the rest of the country. In each of them, those making more than $200,000 — the taxpayers targeted by Obama’s hikes — account for more than 56% of all federal income taxes paid in those states. The U.S. average, the report notes, is 50%.
“As a result, a higher proportion of new tax dollars will come from these states,” noted the Tax Foundation’s Ed Gerrish, “likely impacting local economies.”
IBD also notes in a separate editorial that the Obama proposal fails Fed chair Ben Bernanke’s test on policy:
Fed Chairman Ben Bernanke warned Congress Tuesday to “do no harm” to our fragile economy. …
“Economic activity appears to have decelerated” from the tepid first quarter, he said, and “available indicators point to a still smaller gain in the second quarter.”
Bernanke talked about a “loss of momentum in job creation” and slower household spending growth for Q2.
Manufacturing, he said, “has slowed in recent months.” The rise in spending on equipment and software “appears to have decelerated.” Indicators of future investment “suggest further weakness ahead.”
In this context, Bernanke encouraged lawmakers to adopt the Hippocratic Oath and “do no harm.”
“Fiscal decisions,” he said, “should take into account the fragility of the economy.”
Clearly, Obama has prioritized re-election over the fragile economy. Why else would he talk about raising taxes as the economy slides toward recession, and the fiscal cliff guarantees one? In my column for The Fiscal Times, I write that the “you didn’t build it” comment relates directly to Obama’s view of the role of government in dictating economic outcomes, but mostly he just needs to fight Mitt Romney with good, old-fashioned class warfare more than he needs to position the US for recovery in 2013:
Once again, Obama wants to make this an issue of “fairness.” By arguing that it takes a village for anyone to succeed in a market, the President can argue for greater confiscation in tax policy, claiming that it will fuel a new level of success. …How bad will it be? In the long run, Ernst & Young concludes, the tax hikes will cost more than 700,000 jobs and reduce economic output by 1.3 percent if the cuts go to fuel more government spending, using today’s economy as a measure. Wages would fall by 1.8 percent, and investment would decline by 2.4 percent. If the proceeds of the confiscatory policies get used to fund a broader reduction in tax rates below current levels – which is not part of Obama’s proposal – output still falls by 0.4 percent.
This demonstrates the problem with excessive government interventions in markets, which always suppress growth to some degree. That is a rational trade-off, however, for a smoothly operating economy. However, we do not have a smoothly operating economy nor have we had one for the last several years, thanks to a crash created by government manipulation of the lending and securities markets to achieve favored social-policy outcomes, and an economic plan afterward that consisted of short-term gimmicks and escalating ambiguity in tax, regulatory, and monetary policy.
We need to find ways to stimulate growth, not suppress it. Obama’s argument that the village needs to confiscate more from those who invest and take risks to provide that growth is exactly the worst prescription possible for our ailing economy – and yet another demonstration that the President has learned nothing about small business or the economy after four years in office.
I wrote this earlier today, but it’s worth repeating: Small businesses and markets fund the government, not the other way around. The reason why we have the capital to seize for building roads, bridges, and other infrastructure is because of the wealth created by free markets. Without that wealth, the government could not sustain that infrastructure, and without the economic expansion and employment provided by risk-taking entrepreneurs, we wouldn’t need them at all. Obamanomics is completely backwards, which is why it’s not terribly surprising to see the economy heading in that direction, too.