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Let's Think Long and Hard About Extending Those Bush Tax Cuts

by: Menzie Chinn April 28, 2008    

Menzie Chinn

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There was a time one could plausibly argue that importing lots of goods and services and borrowing a lot from abroad (financing the budget deficits that we've incurred since 2001) was a great idea. But at the time, about two and a half years ago, I made the following warning in a Council of Foreign Relations report [pdf]:

The United States faces a wide variety of possible outcomes, with the most dire having a significant likelihood. One real possibility entails the satiation of global investors' appetite for U.S. Treasury securities, combined with an endless vista of government budget deficits. After several years of large losses on dollar assets due to depreciation, they then demand a substantial premium for holding dollar-denominated assets; either the dollar must weaken so as to make Treasury securities cheap, or yields must rise relative to those on other assets.

Here's what the dollar has done over the past ten years.

Figure 1: Log Real Value of the US Dollar, normalized to 0 at peak in 2002M02. NBER-defined recessions shaded gray. Source: Federal Reserve Board, NBER, and author's calculations.

Now, after contemplating that time series, consider this item from Bloomberg.

Of course, this is not the only hazard to the dollar's value. Interest rate differentials, accelerating inflation in the US vis-a-vis other countries, and the possibility of dollar depegging are also important ([1], [2], [3]). Which one will prove the most important is hard to say, which is why Justin Fox quotes me as "confused" about the likely path of the dollar. Downward, sure; but how far, and how long, are the questions that remain.

But my guess is dumping a lot more US Government debt on the market over the next few years by making the Bush structural budget deficit permanent is not the way to stem the dollar's slide.

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This article has 33 comments:

  •  
    Apr 28 08:27 AM
    Good points about the weakening dollar and the potential of bad economy combined with low priced debt, but what's your connection to the tax-cuts continuing or not? Tax-cuts increase tax revenue by increasing economic growth and the velocity of money. Increasing taxes will only exacerbate the problems you reference by harming the economy further.
    Reply
  •  
    Apr 28 08:34 AM
    One of the keys to strengthening the dollar is to cut government spending - especially on entitlement programs. Tax-cuts help the business and the economy grow, allowing the Bush tax-cuts to expire will deliver a knockout blow to the economy.
    Reply
  •  
    Apr 28 08:47 AM
    This article ignores the obvious. A decrease in tax rates at the macro level results in an increase in tax revenues.

    There are many factors at play. The two main problems in our economy are overspending and interest rates that are way too low.

    Credit that is too loose is another factor.

    Look at what the two aforementioned factors did to the housing industry alone. If it were not for leverage (and greed), housing would not have formed a bubble.

    The lack of development of our own natural resources, specifically oil. We are dependent on buying most of our oil supplies abroad.

    Out of control spending at the federal level is the main culprit.

    When Bush took office, the national debt was 7.5 trillion. It is now 9.8 trillion. Unfunded liabilities for Social Security and Medicare are 54.0 trillion.

    Fiscal irresponsibility by almost everyone in Washington.

    Reply
  •  
    Apr 28 08:48 AM
    I'm in agreement with both posts above. These rate cuts increased revenues to the treasury demonstrably. If you let them expire, it will accelerate the downward pressure on treasuries (drive rates up).
    The depreciation of the dollar is an obvious policy decision whether stated or not.

    To the author's thesis: Increasing marginal tax rates will result in fewer taxable transactions and correspondingly lower revenue. If I know it will cost me more next year, I might accelerate the transactions this fiscal year, but I will be loathe to do so when marginal rates increase, and perhaps borrow against that asset instead. That will necessitate a rise in rates and a strengthening of the dollar whether intended or not.
    Reply
  •  
    Apr 28 08:53 AM
    We should get out of deficits with more responsible spending (and growing our way out), not by taxing the people. The people are already taxed enough. Taxes are NEVER the answer.
    Reply
  •  
    Apr 28 09:28 AM
    How about cutting spending first? Or, is that politically impossible? I am skeptical. But! Medicare Part D is a quick way to de-leverage the spending, we could try killing the Farm Bill and end the US Department of Education. and We might privatize SS and make Medicare discretionary and let the old folks keep their SS without taxes. We could do so much but the agenda is not open to cutting?? .
    Reply
  •  
    Apr 28 09:36 AM
    Jeez. Apparently all 10 people who still believe the canard that "cutting taxes increases tax revenue" have shown up right here to post all over the place while citing NO sources, NO proof.
    Reply
  •  
    Apr 28 09:38 AM
    Oh also, if we are going to talk about cutting spending, how can we not talk about the bottomless pit of spending callled Iraq?
    Reply
  •  
    Apr 28 09:39 AM
    When any article mentions US$ exchange rates without even talking about productivity, you can bet your depreciating dollar the author is half-ignorant.
    The best way to combat inflation, dollar depreciation and all the other armagaddon scenarios is to increase productivity.

    Mass Internet is only 10 years old. We havn't even begun to explore its full potential on the business economy. Communications cost are falling like crazy and most business havn't even harnessed 1% of its full potential. Smart Ideas which improve productivity are disseminated more quickly than ever before. All this means is there is higher chance that productivity growth has a better chance of crushing inflation.
    The Silicon Valley is still the forefront of many Business Innovations and US productivity growth relative to Advanced countries will be higher. India/China are coming of a really low base and they will continue to grow at double digits. But, that only means that US can export more stuff to these countries and correct the trade deficit

    I have yet to see one article even scratching this issue. The problem with all these authors is they have a view that
    i) George Bush is an idiot
    ii) Americans are idiots

    and will always look around to pull data to support that ignoring everything else

    Last checked the Googles, the iPhones, the Facebooks, are still coming out of USA and not these super smart countries who are so perfect and whose currencies the market has blindly appreciated
    Reply
  •  
    Apr 28 09:40 AM
    Reducing tax rates increases tax revenue only in Fantasy Land. Which seems where the financial markets seem to have gone on holiday.
    Reply
  •  
    Apr 28 09:53 AM
    Why doesn't somebody (who knows) write an article explaining who gets how much of a tax cut now, why those cuts haven't solved all of our economic woes to date (as everyone in favor of the cuts imply), and when the liberals refuse to extend such a no-brainer-cure-all for economic nirvana will the economy then instantaneously self destruct???
    Reply
  •  
    Apr 28 10:57 AM
    Arthur Laffer curve is just a drawing on a piece of napkin. There is only believers (supply side economists, Reagan, Donald Rumsfeld, Dick Cheney....) and non-believer and absolutely no prove.
    Reply
  •  
    Apr 28 11:18 AM
    Why do we have to still argue about the proven: Increasing tax rates doesn't necessarily increase revenues. The real problem is NOT, not high enough tax rates, it is too much government spending. The government is the true insatiable consumer. No matter what you give the "beast", it'll want more. It's the masses saying "me too" with their hungry mouths.... although, in fact we are overweight, but our politicians are listening and fanning the flames. It's a type of corruption... buying votes.
    Reply
  •  
    Apr 28 11:55 AM
    We've had the tax cuts for 7 years, if they are the golden ticket, why does everything suck. Let em expire for 7 years and see which works better. Expire gets my vote. I don't mind paying taxes as long as they are not being wasted in IRAQ/IRAN and military expenses protecting countries(Germany/Japa... that have descent economies.
    Reply
  •  
    Apr 28 11:59 AM
    "Jeez. Apparently all 10 people who still believe the canard that "cutting taxes increases tax revenue" have shown up right here to post all over the place while citing NO sources, NO proof."

    No Proof? Didn't the amount of taxes the government receives on Capital Gains surge after the rates have been lowered by the President in 2003?
    Reply
  •  
    Apr 28 12:02 PM
    There is plenty of evidence that cutting taxes increases government's revenue - the Kennedy tax cut - the Reagan tax cut to name two. The problem is that when politicians see all that extra revenue, instead of using it to reduce government debt they become wide-eyed spend-happy zombies. So rather than use the new revenue responsibly, they use the monies to increase government.
    Reply
  •  
    Apr 28 12:48 PM
    Several people have commented that reduced tax rates lead to higher tax revenues. Unfortunately, the well documented record of both the Reagan and Bush tax cuts demonstrates that the revenue growth from increased economic activity that such cuts stimulate does not make up for the initial revenue loss from the cuts themselves. Note that this effect has nothing to do with government expenditures. It is purely a revenue phenomena. The result is that unless there is a large reduction in government expenditures to match the overall loss in tax revenues, there will be a long period of increasing government deficits. This is exactly what the US saw under both Reagan and Bush. The Clinton tax increase had exactly the opposite effect: a large revenue enhancement which was almost, but not quite, large enough to reduce the total deficit (current tax revenue + current SS revenue - current expenditure - current SS payments) to zero.

    Read this NYTimes piece on Douglas Holtz-Eakin for details: www.nytimes.com/2008/0...

    Dr. Holtz-Eakin served as the Director of the Congressional Budget Office and also served for 18 months as Chief Economist for the President’s Council of Economic Advisors under President George W. Bush and for two years as Senior Staff Economist for President George H. W. Bush’s Council of Economic Advisors. He is now an advisor for Republican Presidential Candidate John McCain.
    Reply
  •  
    Apr 28 01:11 PM
    I totally agree with the previous comment. is not how much we tax, is how much the government spends (waste). If the people in charge fail to control government spending, pack it up boys this sip is going down.
    Reply
  •  
    Apr 28 01:22 PM
    You make the same mistaken assumption that politicians and bureaucrats make and that is that by raising taxes, you will raise revenues $1 dollar for every $1 increase in taxes. All the credible studies I have read show that after an initial jump there is a commensurate drop in government revenues when taxes rise above 30%.

    Given that the US has the second highest corporate tax rate in the world, taxes are already past the optimal tax rate/revenue threshold. The Laffer Curve explains this quite well (see www.investopedia.com/a... )

    You clearly show that you are among the misguided group that mistakenly believe that governments can spend your money better than you can. Given the high degree of mismanagement,waste and porkbarrel spending programs, I find this premise completely at odds with reality.
    Reply
  •  
    Apr 28 02:05 PM
    it is intuitive that there is a theoritical optimal income tax rate at which revenues are maximized. anything above or below the optimal rate reduces tax revenue.

    i suspect that there is probably a fairly wide range of tax rates over which tax revenue would not differ materially. this is heretical to most republicans, of course, who would like everyone to think that any tax rate in excess of 0 is confiscatory and that whatever the current rate is, it's too high.

    the argument is strictly political. nobody knows the optimal income tax rate. if one of you fellow brain surgeons can figure it out you'll win the nobel prize for economics....

    Reply
  •  
    Apr 28 02:18 PM
    I agree with Trader T. Removing the Great Bush Tax Cuts will send us all into a financial black hole! When the Germans and the Japanese are driving Chevrolets and Fords because they are cheaper and better than the domestic brands, the dollar will strengthen and joy will return to Mudville.
    Reply
  •  
    Apr 28 02:26 PM
    There is nothing more radical than the ideas of a born again liberal! The problem with the U.S. economy is NOT tax cuts, it's unfettered and irresponsible spending. What government must do is drastically curtail spending, particularly, earmarks and financial support for corporations such as Big Oil and unfriendly foreign countries.

    However, don't hold your breath until congress acts on these much needed and practical matters. In order to inspire them, the voters must throw out the bastards, starting in November 2008. Replacements should come from a new third party dedicated to the desires and will of the electorate and the hell with the special interest lobby!

    I won't hold my breath. As H.L. Mencken wrote: "Nobody ever went broke underestimating the intelligence of the American public." Watch them in November as the march in route step to re-elect the same idiots who have manufactured the current and past crisis and who will be responsible for future ones.

    If anything needs to be done to save our economy and high standard of living, it is to further cut taxes, balance the budget, curtail spending, eliminate the "nanny" state, develop hydrogen for automobiles and home generation of electric power, return the use of farm products to feeding the people not fueling automobiles, stop illegal immigration, expose the fraud of manmade global, curb the abuses of environmental wackos, shut down Berkeley, eliminate funding for "sanctuary cities", and begin to act like adults instead of clueless spoiled brats.

    Let me know when you have accomplished this and I'll give you some more guidance.
    Reply
  •  
    Apr 28 02:48 PM
    Matt Blackman clearly shows that he is one of those who does not consider a study to be credible unless it reaches conclusions that he has previously decided should be the correct conclusions.

    Why is it that proponents of the Laffer Curve always assume we are at a point in our tax system where decreased tax rates must necessarily lead to increases in revenues (the right half of the Laffer Curve)? Remember, the Laffer Curev has two sides. Maybe we are closer to the left half where decreases in tax rates actually decrease revenues because the additional work incentive is simply not enough to make up for the initial lost revenue?
    Reply
  •  
    Apr 28 03:21 PM
    Skjellifetti--right on. I agree completely. There is too much ideology posted here, and not enough critical thinking.

    It reminds me of debates on abortion, gun rights, and the Iraq war. Both sides know they are right, and neither side listens to the other.

    From a previous post--"More taxes are never the answer"? --is a curious comment. Then does it follow that "lower taxes are always the answer"? To an effective rate of Zero?

    How bout this thought: Taxes are a patriotic duty.

    What a concept.

    The tax debate is the wrong one to focus on anyway--the real debate should be--how can we stop our currency from falling?

    This is at least as important as it erodes everyones purchasing power, and "taxes" silently. With the dollar falling and off some 40% in 8 years--the "tax" to your income is every bit as real, but more severe.

    Isn't this the point th author was making?
    Reply
  •  
    Apr 28 03:49 PM
    eliminate tax altogether...bennie and the jets can give fiat currency to all the govt agencies.

    then the zimbabwe dollar will be on par with the us...and we can heat our homes by burning paper dollars.

    better yet, go fully electronic...computers can generate zeros faster then the printing presses can mow down forests

    this way, perhaps the cost of lumber will drop.
    Reply
  •  
    Apr 28 05:12 PM
    It would be unwise to add middle and upper middle class tax hikes as Obama proposes. I have many senior citizen clients who earn barely above the $50,000 threshold he deliniates that would be devistated by his cancelling the preferred dividend and capital gains tax programs in place.
    We do have a conundrum as to how low can rates go? Since over 60 % of our oil is imported, an inverse relationship with the dollar and oil exists. The lower the dollar goes, the higher oil costs us. If we were at parity with the euro we would be grousing about $2.50/gallon vs what we have. Further rate cuts will lower the dollar more and a tax hike would also be untimely. It is uninformed to compare our current situation with the 90s. Since the credit has been too easy for a much longer period, some nasty chicanery has been going with respect to these new fangled structured financial products. Most people that own these products have no clue as to what they are.
    What needs to happen is happening, but slowly. Americans need to look at their debt portflio and consider cutting out debt on depreciating assets like cars and use them a little longer and quit abusing them. I am no green guy by any means, but when I see a motorist alone tearing off from the green light in his 6,000 lb. SUV, I think... No Wonder. So when more Americans become less finacially dependent on the economy, economic swings will be less violent. Our politicians, including Obama, will continue to lie and we can't stop that. We can talk loudly with our purse strings to the world and say the party is over for you, but not for us. The best part about the internet is that real communication can happen.
    Reply
  •  
    Apr 28 06:10 PM
    I think Selene let her "hate Bush" clud her analytical thinking and knowledge of the history of economics. Capital in the hands of those who invest it creates jobs, additional GDP AND tax revenue. Punish those who take risk, confiscate their earnings (includes investment return) and see where it takes you.

    Want proof and examples? Look at what happened in Venezuela, Look at Mexico's oil industry, how about the exodus from France of wealthy people who got tired of having an onerous tangiles tax?

    Even JFK knew and introduced a TAX CUT to rekindle the economy! Then LBJ and Carter screwed it up again with tax cuts. By the way, I'm a pragmatist with no political ties and I think Bush is far from the best we've had. But, he does get some things right.
    Reply
  •  
    Apr 28 06:16 PM
    P.S. Eric has it right. The focus should be on the strength of the dollar and the self-serving actions of that Monster From Jekyll Island, the Fed. (tha's the name a a book everyone interested in financial survival should read) Who really believes the inflation rate is 4%? They way the fed has handed out credit (the same as turning on the printing press) to the banking centers lately has driven inflation closer to 12-14%. It is not the price of oil... it's the value of the dollar!
    Reply
  •  
    Apr 28 10:45 PM
    Raising taxes is not the answer. Neither is cutting taxes.

    Raising taxes in an economic decline is like cutting off your leg to cure a leg cramp. Not only will it not go through (especially in an election year), the revenues will be completely wasted anyway as congress has demonstrated again and again.

    Lowering taxes might give a short term shot in the arm, but it's unlikely that it would in this market. The problem is banks aren't lending and credit has been overextended. People aren't going to be spending money on discretionaries, they're going to be paying mortgages, HELOCS, credit card bills etc. . People have already spent that money that's coming in a couple of weeks. It's already gone.

    Plus, you can't cut taxes without cutting spending. Raising taxes won't even make a dent without cutting spending either.

    An earlier poster brought up earmarks. Those account for less than 1% of the budget. Subsidies? Another couple of percentage points. You aren't going to get anywhere cutting at that rate.

    The three largest expenditures of the federal budget are (in order): Social programs (social security, medicare, welfare, etc.), defense (Iraq war, foreign military bases, etc.), and the interest on the national debt (12% of the current budget).

    The social programs plus defense alone exceed the tax revenue the federal government takes in. And we very well can't just stop paying interest on our debt, so you've got two big places to cut from.

    So what are you going to cut? Cutting social programs is political suicide and there are few congress people who have the brass ones to do so. Cutting defense will get you crucified by the fear-mongers who stand to make too much money of all our "enemies".

    So we will continue on our path of self-destruction. Without a change in course, we will be bankrupt. Actually, we're bankrupt right now. We just don't know it yet.

    If you haven't read up on what David Walker has to say (the comptroller of the GAO), he's worth a read.

    ~X~
    Reply
  •  
    Apr 28 10:49 PM
    The left side of the Laffer curve is very steep so that the peak is reached when rates are still relatively low. I don't think we have to worry about being on the left side. And consider this: one of the best stories you'll ever hear is about the geese that laid the golden eggs--don't strangle the golden geese by taxing them too much; in fact, it may be a good idea to lower taxes on the rich--as long as they can be identified as valuable egg layers!
    Reply
  •  
    Apr 28 11:21 PM
    xyrus....

    where are your solutions? ;)

    Reply
  •  
    Apr 29 10:08 AM
    Where did I say anything about Bush?
    Reply
  •  
    May 01 12:43 AM
    Skjellifetti clearly shows that he, she or it is not capable of critical thought. Think about it for a minute. There are many studies that show the impact of raising tax rates on government revenues. Perhaps you are not aware of history but in Britain in the late 1960 the Labour Government raised the top marginal tax rate to 98%. What happened? The Beatles wrote a song called tax man, the rich people left and Britain accelerated its economic decline as entrepreneurs and their money left the country. Have you ever heard the term capital is mobile? Why would anyone is his or her right mind work to give the government 98% of what they earn? Only a government bureaucrat could come up with such a concept. That wouldn't describe you by any chance would it Skjellifetti and explain why you post anonymously?

    It wasn't until Maggie Thatcher came to power in Britain and reduced taxes that the economy really recovered. A similar situation occurred in the US with Ronald Reagan in the early 1980s, that began the 20 year bull market but that is another story.

    Not only have I studies lots of research on the subject, I have done a little myself some of which may be found at www.investopedia.com/a...

    Here is another question for you. Why is it that the US is one of only three countries in the world that taxes based on citizenship, not residency? The other two are the Philippines and Eritrea (in Africa). The reason? It takes a system that taxes citizens no matter where in the world they live to be able to maintain the second highest corporate tax rate and one of the more expensive income tax rates in the world. Without it, more with money (and know how) would simply leave.
    Reply
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