Raising Taxes Won’t Stimulate the Economy

BY KATHRYN NIX – Earlier this week, Maya MacGuineas, a fiscal policy expert at the New America Foundation, ranked Congress’s options in addressing the pending expiration of the 2001 and 2003 tax cuts. A little more than two months remain before an automatic tax hike on all American earners sets in, and Congress has yet to act. Here, we compare MacGuineas’s rankings to our own solutions.

Above all, MacGuineas favors sweeping tax reform, describing the current system as “outdated, overly complex, a drag on economic growth, and as leaky as an old fisherman’s dingy.” She’s right. Tax reform should simplify the tax code and reward investment and growth in the United States economy.  We highlight the way forward in Solutions for America: Tax Reform.

But unfortunately, there isn’t time before 2011 for such an endeavor. In the meantime, MacGuineas proposes allowing the cuts to expire and using the revenue to stimulate the economy in other ways. The Congressional Budget Office (CBO) suggests that extending unemployment benefits or aid to states would stimulate the economy better than would extending current tax rates. But this finding has its basis in the assumption that throwing more government money into the economy is effective stimulus. In other words, CBO assumes what it sets out to prove.

In reality, this kind of stimulus—injecting money into one area of the economy by taking from another—is a zero-sum game.

Extending current tax rates may not stimulate the economy, but allowing them to expire would be certain to cause further damage. Heritage’s Center for Data Analysis (CDA) conducted a dynamic simulation of the President’s plan to allow the cuts to expire for high earners while maintaining current rates for the lower and middle classes, and found that raising taxes on high incomes alone would result in the loss of, on average, 690,000 jobs each year.

The best option, which MacGuineas ranks last, is to extend all of the tax cuts permanently. She writes that this “will make climbing out of the fiscal hole we are in nearly impossible,” but this isn’t so. After recovering from the recent economic downturn, tax revenues are expected to return to their historical average by the end of the decade, even with the tax cuts. It is rising spending that is to blame for growing deficits. To reverse course, policymakers must reduce spending, which is too high, not increases taxes, which are not too low.

Moreover, even if tax hikes on high earners did occur, the revenue generated would be lower than expected as a result of reduced economic growth. CDA’s simulation shows that the President’s plan would generate only 34 percent of the revenue predicted by the CBO’s static model.

At the very least, Congress should extend all of the cuts until the economy recovers. They should then use this time to pursue tax reform that favors economic growth and investment in America.