Saturday, November 6, 2010

The future of the Bush tax cuts

The future of the Bush tax cuts

  • As projected, sitting Democrats suffered a crushing defeat at the Congressional midterm elections. In the Senate, they only managed to retain a wafer-thin majority, while in the House of Representatives the Republicans even succeeded in winning a comfortable majority.
  • The political gridlock that must now be expected is being “disturbed” in the short term by the fact that the Bush tax cuts are set to expire at the end of the year. If the two parties cannot reach an agreement by then, the tax rates on income, capital gains and dividends will all increase.
  • We have conducted a scenario analysis to investigate the impact of various tax policy options on the personal savings rate and private consumption.
  • If President Obama’s proposals were to be accepted, the growth of consumption and the personal savings rate will likely both decline by one percentage point at the beginning of 2011. Without an agreement, the negative ramifications for the economy would be much more serious.

A very special kind of gridlock
The Congressional midterm elections produced the projected result: The Republicans gained a comfortable majority in the House, while in the Senate, where only one third of the seats were up for re-election, the Democrats were able to defend a wafer-thin majority. This balance of power most likely means political gridlock.

There is, however, one thing that will compel the parties to collaborate in the short term: the expiration of the Bush tax cuts. If Republicans and Democrats cannot reach an agreement by the end of this year, both income taxes and the taxes on capital gains and dividends will increase as of 1 January 2011.

EGTRRA + JGTRRA = Bush tax cuts
The temporary tax cuts commonly referred to as the Bush tax cuts are based on two separate pieces of legislation: the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). The two major provisions of these
programs are:

  • A reduction of the marginal tax rates on personal income by 3 to 5 percentage points (EGTRRA),
  • A reduction of the top tax rates on capital gains and dividend income (JGTRRA).

While the reduction of income tax rates resolved in the EGTRRA were always scheduled to expire at the end of 2010, the reduced top tax rates on dividends and capital gains were originally set to expire after 2008. But in 2006, Congress voted in the Tax Increase Prevention and Reconciliation Act (TIPRA) to extend these programs up to the end of 2010 as well.

There is agreement on some points
The question now is whether these so far temporary tax cuts will expire in a few weeks or whether they will – at least in part – be extended again for a limited period or will even be made permanent. Theoretically, there is agreement between the two parties that the tax cuts for households with an annual income of less than USD 250,000 are to be made permanent. Beyond that, however, there is the parting of the ways.

While the Republicans are against any tax increase, most Democrats want to let the tax cuts for households with an annual income of more than USD 250,000 expire. A recent representative poll conducted by CNN and the Opinion Research Corporation (ORC) reveals that the opinions among voters are split in a similar way: While roughly 80% of respondents favor extending the tax cuts for families with an annual income of less than USD 250,000, views differ when it comes to the tax cuts for higher income families (cf. chart).

The President’s plan
At the beginning of this year, President Obama essentially made the following proposals on how to handle the expiring Bush tax cuts:

  • The tax cuts for households with an annual income of less than USD 250,000 (individuals making less than USD 200,000) will be made permanent. That relates to both income taxes as well as to the taxes on dividends and capital gains.
  • The tax cuts for households with an annual income of more than USD 250,000 are, in contrast, to expire as planned. These households would also have to tax their dividends and capital gains at a top rate of 20%.
  • The Alternative Minimum Tax (AMT) will be indexed to the inflation rate (cf. box next column) in order to prevent a further increase in sly progressive taxation.

Alongside the Bush tax cuts, further tax cuts are set to expire at the end of the year. These include provisions that have been in effect for a number of years (e.g. the Research and Experimentation tax credit), as well as provisions that have only recently been enacted (e.g. Making Work Pay tax credit). The Congressional Budget Office (CBO) estimates that the extension of the Bush tax cuts, the indexing of the AMT to inflation as well as the extension of the other expiring tax provisions combined would increase the deficit (excluding debt service) by more than USD 6 trillion over the next decade (cf. chart). That is no less than 41% of current GDP.

In the following, we use the CBO calculations to assess the impact of various tax policy options on the savings rate and private consumption. In the process, we assume that the change in the federal deficit calculated by the CBO can be translated one for one into a change in disposable income (we look at the change in the deficit excluding debt service).

Impact on personal savings rate and
consumption: a scenario analysis

Our baseline scenario assumes that all tax cuts will be extended. From the tax side, there is therefore no change in the macroeconomic environment between 2010 and 2011. This scenario merely serves as a yardstick for comparison; it is not necessarily the most probable economic scenario. For the sake of simplicity, we assume that disposable income and private consumption increase by 4% per year in nominal terms and that the personal savings ratio settles at 5¼%.6 In scenario 1, we analyze the ramifications of President Obama’s tax proposals on the savings rate and private consumption, while scenario 2 assumes that all tax cuts expire as scheduled.

In our analysis, we initially calculate two extreme scenarios for the personal savings rate and private consumption: In the first, we investigate how strongly the personal savings rate would drop if the entire decline in disposable income (due to the expiring tax cuts) is absorbed by personal savings. If the President’s proposals (scenario 1) were to be approved by Congress, the savings rate could fall by up to 1½ percentage points (to 3¾%) at the beginning of 2011. If all tax cuts were to expire (scenario 2), the maximum decline in the savings rate would even be 4 percentage points.

In the second extreme scenario, we assume that the personal savings rate remains unchanged and that instead
the entire decline in disposable income is reflected in weaker consumption expenditures. In that case, private consumption would even fall in nominal terms at the beginning of 2011 if all tax cuts were to expire (scenario 2). The annual growth rate would decline from currently +3½% to -1% yoy (cf. chart). Quarter over quarter, the annualized decline would even be in the double digits. Under the tax program proposed by President Obama (scenario 1), the decline in consumption growth would be more muted. Here, the yoy rate would slow to 1¾%. Quarter over quarter, nominal consumption would decline at an annualized 3%.

Ricardian equivalence?
From a political and economic standpoint, the best outcome would undoubtedly be that the entire decline in disposable income is absorbed by a lower personal savings rate: Because in that case, the expiration of the tax cuts would not impact consumption and therefore GDP growth. If one lends credence to the Ricardian equivalence theorem named after David Ricardo (1772-1823), this advantageous outcome is even likely to materialize. According to Ricardo, forward-looking households know after all that higher government debt in the present inevitably triggers a tax increase at that point in the future when the government debt is to be repaid. Accordingly, households already prepare in the present for this impending tax hike by raising their savings rate. Vice versa, a tax increase should result in a lower personal savings rate, since this ceteris paribus reduces the government debt. That at least is the theory. Empirical studies show, in contrast, that in reality a complete Ricardian equivalence does not exist. These studies do, however, suggest that at least a part of the income loss is absorbed by personal savings.

According to a recent OECD study, this share for the US and other industrialized nations is roughly 40% – both short and long term.7 In this case, the savings rate would in scenario 1 (President’s proposal) fall to 4½%-4¾%, while nominal consumption growth would slow to close to 2½% yoy (cf. charts). Quarter over quarter, nominal consumption would be roughly unchanged in the first quarter of 2011 (-¼% annualized).

Political struggle
Prior to the midterm elections, the Democrats had stressed that the treatment of the expiring Bush tax cuts would have top priority after the elections. As soon as the dust has settled, the discussion of tax policy will, therefore, gain in intensity again. Since the newly-elected Congress will not commence its work until the beginning of January, the Democrats still have a majority there for close to two months.

In the Senate, however, they already now lack one seat for the filibuster-proof majority of 60 votes. That means the Republicans can delay a vote in the Senate indefinitely and, therefore, de facto kill any bill. And with the regained power, the Republicans will probably be less willing to compromise on such an important issue like taxes. It should not be forgotten, however, that in this particular situation taxes will increase as of January, if the parties cannot reach agreement by then. Against this backdrop, the House Republican Leader, John Boehner, stated at mid-September that "If the only option I have is to vote for some of those tax reductions, I'll vote for it." At the same time, however, he stressed that from this standpoint the extension of all Bush tax cuts is a key prerequisite for stronger growth and more jobs. We believe that since the tax rates will rise without a political compromise, the Democrats have the better cards in the current game of political poker. They are after all offering to extend the tax cuts for 95%-97% of the population. If the parties cannot agree, it would be easy for the Democrats to blame higher taxes on the Republicans in future election campaigns. Furthermore, the expiration of all tax cuts in the current environment poses the threat of a massive economic slowdown.
Full report: The future of the Bush tax cuts

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