How much will Obama's tax compromise actually help the economy? 

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Dec. 6 2010 7:32 PM

Here's the Deal

How much will Obama's tax compromise actually help the economy? 

President Obama announced Monday a sweeping compromise that would extend the Bush tax cuts for all Americans, continue unemployment insurance, and cut the payroll tax for employees by 2 percent. A final deal has yet to be struck, but Obama said the new measures "will spur our private sector and create millions of new jobs." Maybe so. But if the past decade of experience with the Bush tax cuts is any indicator, this new round of cuts and credits won't do much.

On Meet the Press this week, David Gregory asked Sen. Mitch McConnell to defend the Bush tax cuts. "You've had these tax rates in place since 2001," he said. "What's been the impact on jobs?" "Imagine," McConnell responded, "how much worse it would have been if we'd had the higher tax rate." Never mind that McConnell has rejected that same argumentit could have been so much worse!—when Obama used it to defend the stimulus package. There's little evidence that the Bush tax cuts have had any significant effect on job growth over the last decade. Indeed, there's not a lot of evidence that tax cuts alone boost the economy much at all.

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You'd never know this from listening to Congress fight. Republicans say the Bush tax cuts of 2001 and 2003 boosted job growth, reduced unemployment, and inspired porpoises to save Dick Van Dyke from drowning. Democrats would have you believe those same cuts precipitated the slowest GDP growth since World War II, not to mention the worst recession since the Great Depression.

Both sides overstate their case. The theory behind tax cuts and job growth is solid: Individuals are more likely to look for work when they can keep more of their wages, and businesses are more likely to hire people when they can keep more of their revenue. Lower taxes, more workers, more jobs—everybody wins.

But in practice, tax cuts don't significantly boost jobs. "I don't know of any convincing evidence that says these things were a huge contributor to growth over the past decade," says Joseph Rosenberg, a research associate at the Tax Policy Center. Bush created fewer jobs than any president since World War II except his father and Gerald Ford. GDP growth between 2001 and 2007 was also the slowest over the same period, at 2.39 percent. McConnell is right that without a counterfactual history, it's hard to pinpoint the exact effect of the Bush tax cuts. (For that reason, a 2008 report by the Congressional Research Service concluded that "it is hard to be certain what effects the tax cuts have had on the economy.") But his premise is flawed: Economists who study the elasticity of taxable income—that is, the extent to which raising taxes makes workers work less—have found that the effect is pretty small. Same when it comes to corporate tax rates: There's just not much evidence that businesses behave differently when they're taxed at 30 percent instead of 35 percent. In other words, we're still on the near side of the Laffer Curve.

Extending the Bush tax cuts will help the economy—but just barely. The Congressional Budget Office recently estimated that extending the cuts through 2012 would reduce unemployment next year by between 0.1 percent and 0.3 percent and by about twice that the following year. It would also boost GNP by anywhere between 0.3 percent and about 1 percent. But that's just the first two years. If Congress continued to extend the tax cuts beyond 2012, it would soon start hurting growth, since more government borrowing would crowd out investment, and interest rates would go up.

That said, the Obama tax cuts may have a better chance of stimulating the economy than Bush's did. For one thing, unemployment is a lot higher now than it was in 2001, which allows more room for improvement. Plus, Democrats have tried to cut taxes in the most stimulative way possible—that is, in a way that benefits the lower and middle classes. Hence the provisions in Monday's compromise to bump the child tax credit and earned income tax credit, plus a reduction of payroll taxes for employees from 6.2 percent to 4.2 percent. The new plan will also extend unemployment insurance. An analysis by Mark Zandi of Moody's Analytics finds that extending unemployment insurance (which Congress let expire last week) would generate more economic activity than cutting taxes for people with incomes above $250,000. The logic is simple: Poor people are more likely to spend their extra money than rich people, giving more bang for each federal buck. If Republicans were serious about helping the economy—and not just their constituents—they would have been pushing to extend unemployment insurance, not just granting it as a concession.

If taxes don't affect the overall economy much, why do politicians talk about cuts and hikes like they determine the fate of the earth? Because it's one of the few things they control. "This is one of the tools that politicians have," says Rosenberg. "They'd like to think it's effective, even if it maybe isn't." That way, they can take credit if the economy improves and cast blame if it doesn't—rather than simply chalking it up to larger forces. At the very least, they can show voters that they're doing something.

In which case, Obama's compromise was a smart move. "I have no doubt everyone will find something in this compromise they don't like," he said on Monday. But he couldn't let the tax cuts on the middle class lapse in the new year—even if it meant extending cuts for the rich. Now, if the economy improves in the next two years, Obama can take some credit. If it doesn't, well, it probably wasn't going to anyway.

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