Macroeconomic Advisers finds that, compared to an indefinite extension, impending expiration of numerous prior tax cuts would trim 2011 growth by 0.9 percentage points, while only allowing an increase in taxes for high-income individuals and families would trim growth 0.2 percentage points.
The European
sovereign debt crisis has led to serious consideration of allowing the Bush and
Obama tax cuts to sunset in their entirety. Our analysis suggests that doing so would come at a cost in
terms of near-term economic growth.
- The European sovereign debt crisis has led to serious
consideration of allowing the Bush and Obama tax cuts to sunset in their
entirety. Our analysis suggests that doing so would come at a cost in
terms of near-term economic growth.
- Full sunset of the Bush and Obama tax cuts, as called
for under current law, would result in a sharp rise in personal taxes on
January 1.
- We considered the macroeconomic effects of this and
two alternative policies: (i) extend the tax breaks indefinitely and (ii)
allow only tax cuts on high-income individuals to sunset.
- Relative to the indefinite-extension case, full
sunsets would shave 0.9 and 0.3 percentage points off real GDP growth in 2011 and
2012, respectively.
- The unemployment rate would be 0.6 percentage point
higher and core inflation 0.1 percentage point lower at the end of 2012.
- This happens despite an assumed delay in Fed rate
hikes and additional unconventional easing, which is assumed to reduce
long-term yields about 100 basis points.
- Allowing only tax cuts on high-income individuals to
sunset would trim only 0.2 percentage points from growth over both 2011 and 2012.
This is essentially what is assumed in the Macroeconomic Advisers’
forecast.
Under current law personal taxes
will rise sharply on January 1. According to CBO estimates, failure to extend
tax law provisions scheduled to expire at year’s end will boost receipts by
$235 billion in fiscal year (FY) 2011 (or $313 billion at an annualized rate)
and $377 billion in FY 2012, or roughly 2.4% of GDP. Given the anemic economic recovery, not long ago it seemed
unthinkable to allow taxes to rise so dramatically in 2011. Now, however, given the specter of the
European sovereign debt crisis, some observers, including Alan Greenspan, are
openly discussing the immediate need for these tax increases.1
In this Macro Focus we assess the
impact on the near-term economic outlook of the expiration of previous tax
cuts. First we review the
provisions slated to lapse at year’s end.
Then we present macroeconomic projections with and without these tax
“sunsets.”
Our analysis suggests that,
relative to the case in which all expiring provisions are extended, allowing
them to expire instead would reduce GDP growth the next two years an average of
0.6 percentage point. In addition,
the yield on 10-year Treasury notes would fall by about 100 basis points as
investors come to expect the Federal Open Market Committee (FOMC) to delay the
first tightening from early 2011 until late 2012, to tighten more gradually
thereafter, and to make additional asset purchases.
Expiring Tax Provisions
The list of tax cuts that may
lapse at the end of the year is both long and consequential. The major provisions slated to expire
were enacted as part of either the Economic Growth and Tax Relief Reconciliation
Act of 2001 (EGTRRA), the Jobs and Growth Tax Relief Reconciliation Act of 2003
(JGTRRA), or the American Recovery and Reinvestment Act of 2009 (ARRA).
Individual Income Tax Rates:
The 10% individual income tax bracket will be eliminated, with the rate
returning to 15% for single filers earning below $8375 and joint filers earning
below $16,750. The remaining
structure of individual income tax rates will shift up: from 25% to 28%, from
28% to 31%, from 33% to 36%, and from 35% to 39.6%.
Personal Exemption Phase-Outs (PEP): The PEP will be reinstated for high-income taxpayers (at
$170,000 for single filers and $256,700 for married joint filers).
Marriage Penalty: The size of the 15% bracket for married joint
filers, which currently is double that of single filers, will shrink to less
than double that of single filers.
The standard deduction for married joint filers, which currently is
double that of single filers, will shrink to less than double that of single
filers.
Capital Gains: The
capital gains tax rate will rise from 0% to 10% for those subject to a top
marginal rate of 15%, and from 15% to 20% for all others.
Dividends: Personal
dividend income, which currently is taxed as capital gains, will be taxed as
ordinary income.
Alternative Minimum Tax (AMT): There would be no “patch” or indexation against inflation,
without which the number of taxpayers paying taxes under the AMT is projected
to rise from 16 million in 2011 to 35 million by 2020.
Making Work Pay (MWP) Tax Credit:
Currently the credit is 6.2% of income up to $800 for married joint filers and
$400 for single filers with phase-outs at higher levels of income.
Child Care Credit: The
credit will fall from $1,000 to $500 and families with less than 3 children
will no longer qualify for the refundable portion.
Earned Income Tax Credit: Both the threshold and the limit for the
phase-outs are reduced for married couples.
Estates, Generation Skipping Trusts (GSTs), and Gift Taxes: The maximum tax rate on estates and GSTs
will rise from 0% to 55%. The
maximum tax rate on gifts will rise from 35% to 55%. Lifetime exemptions for these taxes revert to previous,
lower levels.
CBO’s estimates of the static
revenue impacts of the expiring provisions, prepared in January, are summarized
in Table 1. Easily the single most
important line item is the income tax provisions of EGGTRA, but others —
including the AMT and its interaction with EGGTRA, the MWP credit, and the
estate tax — are important, too.
Simulation Design
We began by constructing a
simulation that assumes the current tax code is extended indefinitely. To do this, we removed from the MA
forecast the assumed high-end tax increase of about $60 billion per year that
is included in the Administration’s proposed budget for FY 2011.2 This simulation is referred to as
“indefinite extension” in the nearby charts. Next we introduced all the tax
sunsets by raising the average personal tax rate to generate the “static”
revenue estimates shown in Table 1 and also restoring marginal tax rates on
wages, dividends, interest income and capital gains to their 2000 levels. This
simulation is labeled “full sunset” in the nearby charts. In our model, an increase in the
average personal tax rate reduces disposable income, consumption and hence
aggregate demand in the short-run, while higher marginal tax rates discourage
saving and investment over the longer haul.
The near-term fiscal drag
associated with the tax sunsets is substantial enough to warrant a monetary response. We assumed that the FOMC: (a) delays
raising the federal funds rate from the second quarter of 2011 to the fourth
quarter of 2012; (b) thereafter raises the funds rate more gradually than in
the MA forecast; and (c) takes additional action, such as changing its MBS
reinvestment policy, that lead market participants to, at least, price out any
possibility of near-term asset sales and, perhaps, even start pricing in a
greater likelihood of further purchases. The combined effect of these steps is
to lower the ten-year Treasury yield by roughly 100 basis points over the next
couple of years, which provides a partial offset to the fiscal drag.3,4 Nevertheless, given the initial
extraordinarily low level of interest rates, the FOMC’s ability to offset the
fiscal drag by facilitating further rate declines is limited.
Simulation Results
Charts 1 through 4 show the
results under the three simulations: indefinite extension of the current tax
code, full sunset of the earlier tax cuts as envisioned under current law, and
the intermediate case of the MA forecast where only high-income individuals and
families are assumed to see their taxes rise.
The simulations suggest that if
all the previous tax cuts sunset, the annualized growth of real GDP will be
reduced by an average of 0.6 percentage point from the beginning of 2011
through the end of 2012 (Chart 1), leaving the unemployment rate at the end of
2012 0.6 percentage point higher (Chart 2). More slack means core inflation is lower by 0.1 percentage
point by the end of 2012 (Chart 3).
The monetary offset reduces the yield on the 10-year Treasury note by
roughly 100 basis points in the first quarter of 2011 (Chart 4).5 In contrast, allowing the
expiration of only those provisions affecting high-income individuals (as in
the MA forecast) trims a smaller 0.2 percentage point of growth from GDP over
both 2011 and 2012.
Concluding Observations
Tax increases may be necessary to
address the nation’s long-term fiscal imbalance, and these results suggest that
the fiscal drag from all the approaching tax sunsets could be absorbed by a
robust economy in which the Fed has ample room to pursue an accommodative
policy.6 However, given
the still tentative recovery, with growth risks skewed to the downside, and the
FOMC’s limited ability to maneuver now, we believe that the consideration of
such large tax increases should be delayed until the economy is growing more
strongly, with more certainty, closer to full employment, and with the federal
funds rate well off the zero bound.
An intermediate, and safer, near-term strategy is to let expire in 2011
just those provision affecting high-income individuals while extending the
other provisions until they can be considered in the context of a healthier
economy. This is what is assumed
in the MA forecast.
Our focus here has been on the
implications for near-term growth.
To some extent this is the old story about short-term pain for long-term
gain. While the process of
reducing deficits can be expected to have a near-term cost in terms of slower
growth, longer-term benefits of lower interest rates, more capital formation,
and stronger growth of potential GDP can also be expected. Perhaps as important as reducing the
deficit to sustainable levels (for example defined as levels consistent with a
stable debt-to-GDP ratio) is the composition of revenue increases and spending
reductions required to achieve meaningful deficit reduction. Thus, while we view the growth
implications of allowing these prior tax cuts to expire as manageable (at least
for a healthy growing economy when the Fed has ample room to support growth if
needed), this does not imply that we endorse a full sunset. Rather, a comprehensive approach that
simultaneously addresses both the spending and revenue sides of the budget is
preferred.
Footnotes
1 For example, On July 16 Judy
Woodruff interviewed Alan Greenspan for Bloomberg TV:
WOODRUFF: On those tax cuts,
they are due to expire at the end of this year.
Should they be extended? What
should Congress do? GREENSPAN: I should say they should follow the law and let
them lapse. WOODRUFF: Meaning what happens? GREENSPAN: Taxes go up.
2 This is our BASE006 Forecast
published in MA’s Outlook Commentary dated July 2,
2010. For upper-income taxpayers, the Administration’s
proposal includes: (a) expansion of the 28% bracket at and re-instatement of
the 36% and 39.6% rates; (b) re-instatement of the personal exemption phase out
and limitations on itemized deductions; (c) imposition of a 20% tax rate on
capital gains and dividends. These
provisions would raise about $60 billion annually over 2011 and 2012.
3 The difference between our
the MA baseline forecast and the “Current Code Indefinite Extension” simulation
was modest enough that we did not include a monetary response in the latter.
4 We assume that the changes
in the expected funds rate path account for 70 to 85 basis points of the
roughly 100 basis point lower path for the ten-year Treasury yield.
5 The simulation assumes that
over the course of the fourth quarter of 2010 investors come to assume the full
sunsets, so that long-term yields actually fall by about 45 basis points in the
quarter before the sunsets. Given
the lags in our model, this has no impact on real GDP in 2010.
6 Indeed, in our long-term
forecast we do assume an eventual rise in personal taxes comparable in
cumulative magnitude to those implied by current law.
Disclaimer
The forecasts provided herein
are based upon sources believed by Macroeconomic Advisers, LLC, to be reliable
and are developed from models that are generally accepted as methods for
producing economic forecasts.
Macroeconomic Advisers, LLC, cannot guarantee the accuracy or
completeness of the information upon which this Report and such forecasts are
based. This Report does not
purport to disclose any risks or benefits of entering into particular
transactions and should not be construed as advice with regard to any specific
investment or instance. The
opinions and judgments expressed within this Report made as of this date are
subject to change without notice.
PDF Version of this document
Contact Macroeconomic Advisers
