At 10 a.m. yesterday morning, the Senate Finance Committee held a hearing on extending the 2001 and 2003 Bush tax cuts. Former CBO Director Doug Holtz-Eakin and former Deputy Assistant Treasury Secretary Len Burman squared off in a very informative debate. They didn’t agree on much, except that we desperately need income tax reform to lower marginal rates and broaden the tax base. Holtz-Eakin would focus on pro-growth policies led by making all of the Bush tax cuts permanent and cutting federal spending, and Burman would only extend the Bush tax cuts temporarily for low and middle-income Americans until Congress produces income tax reform and a carbon tax or a VAT to bring the public debt back to 60% — a threshold we will cross in a few months time.
Holtz-Eakin argued pro-growth policies are essential, ruling out tax increases on anyone, and that a tax cut limited to those under $250,000 would damage small businesses and would cut employment of lower income small business workers. The person bearing the tax is often not the person filing the tax return and residing in the top quintile in the distribution tables. He also panned a temporary extension of the Bush tax cuts as much less effective than a permanent extension and provided macro model estimates to that effect. To deal with our unsustainable explosion of federal debt, Holtz-Eakin recommended cutting federal consumption spending and reforming the income tax to lower marginal tax rates and broaden its base. He would not add a VAT to our system because it would magnify tax distortions far beyond those if we had a free standing VAT without a large income tax.
Burman countered that we simply can’t afford to extend $3 trillion of tax cuts over the next 10 years and that taking them away from high income taxpayers, who don’t spend them anyway, won’t hurt the economy. He said it would be a mistake to suspend all of the Bush tax cuts because the economy is too weak and that it would be a mistake to make the Bush tax cuts permanent because it would remove the impetus for reforming our income tax, which “is a mess.” Making the Bush tax cuts permanent won’t “starve the beast,” citing co-blogger Bruce Bartlett on past failures to force federal spending cuts, nor with they pay for themselves. He expressed deep concern about the federal debt. “It is possible that interest rates will remain low for years, creating a kind of debt bubble: our ballooning debt appears affordable to us and our lenders as long as interest rates stay low. At some point, investors perceive a risk of default on the debt (or inflation, which would devalue it). This pushes up interest rates, which in turn raises the risk of default, creating a vicious cycle.” Better to curtail the Bush tax cuts for high income taxpayers, reform the tax system, and stabilize the public debt at 60% with a carbon tax or a VAT. He noted that “Deficits are simply deferred tax increases or spending cuts.”
Today’s hearing showed Congress is just as deeply divided on these issues as the American people are. So what is Congress likely to do this year? My conversations with top Hill staff of both parties convince me that Congress is very likely to wait until a lame duck session in December to pass a one-year extension of the Bush tax cuts for those under $250,000 ($200,000 for singles). This will maximize tax rate uncertainty for small businesses and will hit the equity markets with a 39.6% dividends top tax rate, up from the current 15%. Both President Obama and Senate Finance Chair Max Baucus (D-MT) want a 20% top rate on dividends, but I don’t see Congress reaching an overall compromise on the Bush tax cuts that would pay for the 20% rate. Then, if the Republicans take the House on November 2, we’ll experience budget gridlock as the public debt rises toward 87% by 2020. This is a prescription for another economic downturn in a year or so that will hurt those low- and middle-income Americans least able to bear it.
We’d be much better off if, next January, our leaders headed off to Andrews Air Force Base and locked themselves in a room until they agreed on a sensible deficit reduction package balanced between base broadening, marginal rate lowering tax increases and federal consumption spending cuts like we did in 1990. Of course, that cost President George H. W. Bush a second term, but it also set us on the path for record economic growth in the 1990s. That’s the dilemma facing our leaders.