Responding to Podesta and Greenstein on the Looming Tax Increase

In today’s Financial Times, co-authors John Podesta and Robert Greenstein add their voices to those calling for higher marginal tax rates for the top two brackets. Unsurprisingly, Podesta and Greenstein claim that a tax increase on the wealthiest 2% won’t significantly slow economic growth and that the new tax revenue should be used for deficit reduction instead. We have discussed the importance of not increasing taxes right now in order to support the (feeble) economic recovery (see here and here). In our view, the spending side of the federal ledger deserves more attention. Recent CBO data shows that the new revenue from this sort of a tax increase would not meaningfully shift the long-term deficit outlook for the U.S. Why? Because spending is out of control.

CBO projects that even if no further spending increases are enacted, primary spending (not including the increasing amount we’ll pay in interest) will increase by 27% by 2035. Federal tax receipts as a percentage of GDP have averaged 18.5% since 1945. CBO projects that the receipts-to-GDP ratio will climb to 20% in 2014 and 24% by 2035. If the more likely budget scenario is used instead (which includes spending increases that Congress is likely to make, such as “fixing” the rates for Medicare physician payments) spending explodes to 26% of GDP by 2035.

Those in favor of increasing taxes now are quick to credit the Clinton Administration with having achieved a surplus through a similar tax regime. They assert that the deficits of the last decade are the result of the “irresponsible” tax cuts of 2001 and 2003. But, it’s important to remember that the Clinton-era surpluses occurred for number of reasons and that it is shortsighted (though politically expedient) to pick out tax policy as the only – or even the primary – factor. For example, the Clinton era saw huge booms in the stock market, which directly contributed to much of the nation’s growth over this period. Likewise, the bursting of the tech bubble and the terrorist attack early in the Bush term adversely affected the economy in ways that really had nothing to do with the tax code.

Regardless of these outside influences (as we pointed out previously) tax revenues over the last decade actually grew 18% more than GDP, while spending continued to balloon at an even greater rate. The resulting $1.3 trillion deficit that we now face should not be attributed soley to the current Administration. Yet, as Brian Riedl concluded, the 2001 and 2003 tax cuts were responsible for a mere 14% of the swing from surplus to deficit. Runaway spending and other factors (like the financial crisis) were really to blame.

Podesta and others argue that “Allowing these tax cuts to expire, on the other hand, would shrink deficits and debt by about $830bn over the coming decade.” While true, when compared to 10-year baseline deficit of more than $6.2 trillion, the number hardly seems significant. In fact, it’s hard to believe that the current holders of U.S debt would be materially moved by such an action and gain any real confidence that the U.S. had its long-term budget well in hand.

While experts on both sides will continue to debate the merits of pro-growth policies moving forward, there is significant data that suggests that if marginal tax rates are kept in check, or even lowered, (especially at the top) more economic growth will result. Ironically, a tax increase now – even if it’s done in the name of bringing down the federal deficit – might send the wrong message to the market. The government should be careful not to signal that it is only willing to act to curtail deficits through tax policies that would slow economic growth rather than accepting the burden of having to make (the inevitable) tough choices to reduce federal spending.