RETAIN ALL TAX CUTS AND ADD ANOTHER

My last piece, Cut Taxes and Expand the Budget Deficit Now, advocated just that to avoid a significant dent in GDP growth in 2013 and beyond, 1. the United States needs to avoid the so-called fiscal cliff: higher tax rates, reflecting the expiration of the Bush and other tax cuts in 2013;, and reduced spending due to automatic spending cuts, also in 2013 and beyond. Research suggests that the multiplier effect of increased taxes could be as much as 3x1, that is, for every dollar of additional tax collected due to higher rates, 3 dollars of GDP are lost. 2. we need fiscal stimulus (i.e. a higher budget deficit) in the form of a tax cut in order to keep the economy growing. The tax cut should be applied across the broad middle class for maximum impact. To be clear, this cut is in addition to the retention of existing tax rates. In addition to tax cuts, I stated that government spending on productive public goods and services such as infrastructure should be increased, not cut. The multiplier effects of both tax and spending measures could be significant, although there is a wide range of multiplier estimates. I assume that the tax multiplier in the year following enactment could be in the range of 2x, and spending on productive public goods, also about 2x.2 While both actions tax cuts and increased infrastructure spending are called for, this article is limited to discussion of the former. I calculate that the impact of the new tax cut on debt/GDP to be immaterial due to the multiplier effect.

My definition of the middle class is very broad. It excludes earners making over $120,000 a year. Everyone else is in the pool, so to speak. The middle class, so defined (all earners making less than $120,000 a year) is responsible for about three-quarters of total consumer spending in the United States (Figure 1).

Christina D. Romer and David H. Romer, UC Berkeley, The Macroeconomic Effects Of Tax Changes: Estimates Based On A New Measure Of Fiscal Shocks March 2007 2 David J. Wilson, Federal Reserve Bank of San Francisco, Economic Letter: Government Spending: An Economic Boost? February 6, 2012; Alan J Auerbach and Yuriy Gorodnichenko, UC Berkeley, Measuring The Output Responses To Fiscal Policy September 3, 2010; ibid

Figure 1

In addition, the middle class comprise 88% of all consumers (Figure 2).

Source: US Census Bureau

Figure 2

THE CLIFF WOULD BE AN UNMITIGATED DISASTER A 3% tax cut, by my estimation, would save the middle class $145 billion. By my estimates, this would still result in recession in the cliff scenario

Source: US Census Bureau

(see Appendix for more about the cliff) since the cliff is so overwhelmingly large. The Congressional Budget Office estimates that expiry of the Bush tax cuts and the implementation of automatic spending controls would decrease the deficit by $607b ($399b from tax increases; $208b from spending cuts), or 4% of 2012 GDP. The UK reduced its deficit by a bit over 5% of GDP, over three years, and has reentered recession (Figure 3).

Figure 3

There is no precedent since the WWII defense spending winddown for a reduction that large. (Actually, a similar-sized reduction occurred from 1936-1938, which was followed by recession.) At a time when the economy conceivably may already be in recession, I believe heading off the cliff would be an unmitigated disaster for the economy and job Source: UK Office for National Statistics creation, and that my 1% reduction in GDP under this scenario (Figure 4) could prove optimistic. Without the middle class tax cut, I estimate a 2% drop in GDP. If the cliff is avoided, GDP growth in the 3%-4% range seems possible. In 2014, there is a similar growth gap, with the highest estimated growth, 5.4%, reflecting no cliff and the middle class tax cut, and the lowest, 2% - cliff, no tax cut.

Figure 4

IMPACT OF TAX CUT ON DEBT/GDP As Figure 5 shows, I estimate that the impact of a tax cut on debt/GDP is minimal (see detailed point estimates in the Appendix). I rely importantly on my overarching assumption that tax cuts, and infrastructure spending, have multiplier effects that ultimately result in more revenue coming in Source: Congressional Budget Office, our estimates

than was given up via implementation.

Figure 5

JOBS What about the effect on jobs, which is the most critical issue of the 2012 presidential campaign? Figure 6 is a scatter plot showing GDP change year-over-year and change in unemployment y-over-y since 1949.

Source: Congressional Budget Office, our estimates

Figure 6

Based on that chart, Table 1 presents my best guess for the unemployment rate under various scenarios.

Source: US Bureau of Labor Statistics, US Bureau of Economic Statistics

The bottom line is that going over the cliff next year would push the economy into a serious recession, with or without a middle-class tax cut. The unemployment rate would rise to perhaps over 10% in a worst-case scenario, and at best, rise a point to 9.3%. If we avoid the cliff, and initiate the tax cut, a drop in unemployment to the high-7% range is defensible. In 2014, again, assuming no cliff and the tax

Table 1
Change in Unemployment rate, 2013-2014

GDP Growth Current 2013 cliff with tax cut without tax cut no cliff with tax cut without tax cut 2014 cliff with tax cut without tax cut no cliff with tax cut without tax cut

Unemployment Rate 8.3%

-1.0% -2.0% 4.0% 3.0%

9.3% 10.3% 7.5% 7.8%

cut multiplier rippling through the economy (there is about a year lag before the cut and the multipliers effect), its reasonable to expect an unemployment rate in the low-7% range.

CONCLUSION
2.9% 2.0% 9.3% 10.3%

The impact of the fiscal stimulus urged by this article on the countrys debt/GDP is minimal, based on the well-established 5.4% 6.8% multiplier effect. We have ample room to 4.6% 7.3% expand the deficit that is, to stimulate the economy. The United States faces a stark choice, and distressingly, politics will decide the day. The Republicans are dead set against raising taxes, and committed to cutting spending, while Obama wants to raise taxes on those earning above $250,000. I calculate that eliminating the existing Bush tax rate for this income bracket would increase tax receipts (excluding multiplier effects) by $55b, or .4% of 2012 GDP, not a trifling number. It amounts to about one-third of the $145b tax cut I proposed earlier. Both sides of the aisle have their constituencies to answer to. No business or person can plan with this and other uncertainties emanating from Washington. This is no doubt already applying the brakes to economic growth. If both sides are unable to compromise, the country will automatically go into a tailspin the likes of which we havent seen for a very, very long time.

Appendix Point estimates for Debt and GDP, 2013-2014, Over Various Scenarios
Date/Policy 2013 cliff with tax cut without tax cut no cliff with tax cut without tax cut 2014 cliff with tax cut without tax cut no cliff with tax cut without tax cut 83.0% 82.7% 83.0% 82.7% 2.9% 2.0% 5.4% 4.6% $12,846 $12,556 $13,825 $13,536 $15,477 $15,187 $16,655 $16,366 Debt/GDP GDP Growth Debt GDP

81.2% 81.0% 79.9% 79.7%

-1.0% -2.0% 4.0% 3.0%

$12,213 $12,068 $12,624 $12,479

$15,037 $14,892 $15,797 $15,652

Source: Congressional Budget Office, our estimates

No Cliff Defined
Expiring tax provisions (other than the current reduction in the payroll tax rate for Social Security) are extended; The AMT is indexed for inflation after 2011; Medicares payment rates for physicians services are held constant at their current level (rather than dropping by an estimated 27 percent in January 2013 and more thereafter, as scheduled under current law); and The automatic spending reductions required by the Budget Control Act, which are set to take effect in January 2013, do not occur (although the original caps on discretionary appropriations