The Tax and Spending Compromise-Becker

 

 

Both supporters and opponents of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 usually confuse its short term-stimulus effects on the economy, and its long-term effects on economic growth. I would give it a grade of C+ as a short-term stimulus to the economy, and a grade of B+ for its effects on longer-term growth.

The Act provides for a one-year two-percentage point reduction in employee contributions to social security taxes at an estimated cost in tax revenue of over $100 billion. This will add a significant amount to the budgetary deficit for the year going forward, while providing very little short-term stimulus. Even the most simplistic Keynesian analysis recognizes that a one-year tax reduction will be mainly saved in order to spread out the added consumption from this additional “wealth” of households over more than a single year. In economics terminology, a one-year tax relief would be considered a transitory increase in income rather than a permanent increase.

Evaluating the desirability of the extension of unemployment compensation to the long term unemployed (up to 99 weeks of unemployment) is more complicated. Although, like the social security rebate, this also is just a temporary windfall to these unemployed, they are likely to have exhausted their liquid assets during their long period of being unemployed. They would tend to become liquidity constrained, and hence would consume a large part of their unemployment benefits.

This extension of benefits to the long-term unemployed could have been made more or less revenue-neutral by reducing, or preferably eliminating, unemployment compensation to the men and women who have been unemployed for less than 3 months (they constitute about 40% of all unemployed). The great majority of the short-term unemployed are not liquidity constrained since they can finance their unemployment from savings, earnings of spouses, and borrowing from relatives and friends.

Unemployment benefits as insurance against the risks of becoming unemployed are best concentrated on the longer-term unemployed because they are more likely to have run out of assets. Just as with other insurance, the optimal unemployment insurance would have a sizable deductible-that is, little payment during the first several months of unemployment- and then significant insurance coverage for longer-term unemployment. Also, as with other insurance, a good program tries to protect against moral hazard; that is, against the unemployed not looking for jobs because they prefer to continue to collect unemployment checks. Such moral hazard considerations imply that payments should begin to fall, and eventually be eliminated, after say six months or so of unemployment. One exception would be during and shortly after severe recessions, as at present.

The largest component of this Tax Relief Act is the extension of the Bush-era tax cuts on incomes, dividends, capital gains, and estates. This extension will have some relatively short-term benefits to the economy by stimulating investments and the formation and expansion of small businesses, but the main case for extending these tax cuts is their effects on longer-term economic growth. The growth rate in per capita incomes is determined mainly by the rates of investments in human and physical capital, and by technological progress. Both these drivers of economic growth are in good part in turn determined by tax rates on personal and business incomes.

I view the maintenance of the Bush tax cuts as only the first important move of the American tax code toward a more effective income tax structure. That structure would have a broad-based low rate flat tax on personal incomes, with little, if any, taxation of corporate incomes, and with dividends and capital gains taxed as ordinary income. As the majority report of the recent National Commission on Fiscal Responsibility and Reform proposed, the income base should be greatly broadened by eliminating the deductibility of interest on mortgages, and a variety of other special deductions that result from the political influence of various special interests.

I showed in a post last month (see 11/07/10) that even a one-half percent increase in the American long-term rate of economic growth would have a large effect in 20 years on both per capita incomes, and on the size of the US debt relative to its GDP, as long as the rate of growth in government spending was not allowed to increase along with the growth in incomes. Control over the rate of growth of spending is essential even with faster economic growth in order to try to prevent the debt to GDP ratio from becoming a major problem.

A broad-based flat income tax could have a relatively modest tax rate- perhaps about 25%- and still raise as much revenue as the tax structure that would exist if the Bush tax cuts were allow to lapse. A flat consumption tax would be even better than a flat income tax since such a consumption tax would not distort the incentive to save. However, this type of consumption tax is unlikely to be introduced as a substitute for the income tax. It could play a role as a supplement to the income tax if that combination were necessary to prevent a narrow-based progressive income tax system from being imposed.

 

 

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