What Role for Government in Economic Policy?

Congress will be busy at the end of 2012. We expect that Congress will likely delay most of its significant budget and spending decisions until after the November election. Yet if Congress does nothing before December 31, sweeping tax cuts affecting every income group will expire and, in 2013, mandatory spending cuts of more than $100 billion will take effect. Members of Congress will be under a great deal of pressure to act in the short time they will be in session in November and December.

Anticipating this year-end crunch, the two parties are posturing now. Their rhetoric is part of a larger debate about how the government affects the economy through the tax code. Here are some of the elements of that debate:

How have the tax cuts affected the national debt?

The Congressional Budget Office estimates that the tax cuts adopted in 2001 and 2003 directly added about $1.6 trillion to the debt between 2001 and 2011. This number does not account for the additional interest the U.S. is paying because of its increased debt. Continuing the tax cuts would reduce federal revenues by another $3.7 trillion between now and 2020, according to the Tax Policy Center.

If Congress were to raise taxes now for all income levels, how would it affect families?

When Congress enacted the Bush tax cuts, advocates argued that lowering taxes would stimulate the economy and raise everyone‘s incomes. In fact, people in lower-income brackets saw their incomes rise by only 1 percent due to these tax breaks, while the incomes of the wealthiest 1 percent rose by 6.7 percent. During this period, in part because of tax policies but also because of high profits in the information and finance industries, the income gap widened. Incomes for the wealthiest grew phenomenally, while incomes for the majority stagnated.

The expiration of some tax breaks that are closely focused on low- and middle-income families could have significant impacts on family incomes. If the Child Tax Credit, the Dependent Care Tax Credit and improvements to the Earned Income Tax Credit (low income credits) were to end, it could reduce disposable income, and thus spending power, especially for low-income families.

Upper-income households gained more through the tax breaks and so would lose more. If all the tax breaks were extended, more than 80 percent of the value of the upper-income tax breaks (for incomes greater than $250,000) would go to people making more than $1 million a year. Millionaires receive an average tax break of $164,000 a year from these tax cuts. Even so, ending tax breaks on high incomes would have much less effect on the economy than would ending tax breaks on lower and middle incomes. The reason, according to the Center on Budget and Policy Priorities, is that high-income households would spend a smaller fraction of any increase in their after-tax income than would the typical household.

Do lower taxes stimulate job creation?

Low tax rates do not seem to be the driving force behind job creation. As Congressional Budget Office Director Doug Elmendorf testified to the Senate Budget Committee last November, “increasing the after-tax income of businesses typically does not create much incentive for them to hire more workers in order to produce more, because production depends principally on their ability to sell their products.” In other words, businesses need to be able to sell more products before they can hire more people—which requires that their potential customers have more disposable income.

But it‘s not necessary to speculate. As recently as 1993, Congress raised the top tax rate from 31 to 39.6 percent. Both job creation and economic growth were much stronger after that tax increase than they were following the 2001 cuts (see chart at left). While changes to the tax code in 1993 were not solely responsible for rising employment and accelerating economic growth—many factors were at play—the tax increases did not dampen that growth. And the additional revenue generated by the tax increase helped to lower the deficit substantially—to a surplus in 1999 and 2000—setting the stage for long-term economic stability.

Would raising tax rates on investment income make it harder for people to expand their businesses or start new ones?

The Congressional Research Service found that an increase in the capital gains tax rate “may have little or no effect on private saving” (investments). Also, if the additional revenue that results is used to lower the deficit, then on balance a tax increase on investment income would bolster “public saving” (by lowering the debt). So the bottom line is: reducing the deficit has a positive effect on the availability of capital for private investing.

It comes down to this: our country needs a raise. Along with fiscal discipline—cutting the Pentagon budget and parts of the domestic budget—the nation needs more revenue to meet its needs. Additional revenues that are invested directly in lowering deficit spending, or indirectly in strengthening the economy by supporting education, training and infrastructure repair, will support long-term fiscal health. That‘s how we come back from a deep recession to a tax system and economy that operates fairly for everyone, not just for the top 1 percent.

Find out more about the cost of tax cuts.