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The Way to Cut Taxes and Deficits

Thursday, December 16, 2010

Paying down the budget deficit requires a long-term solution, while countering the recession requires a short-term solution. Using time-sensitive tax rates based on the business cycle truly can ‘kill two birds with one stone.’

Hypocrisy is the first, and favorite, pejorative used in political argument. When Nancy Pelosi (D-California) became Speaker of the House in 2007, she promised to "Clean House!" and restore fiscal balance with efforts such as PAYGO, which requires all new spending to be paid for with cuts elsewhere. Republicans cried hypocrisy when the annual deficit on Pelosi’s watch ballooned to nearly $1.5 trillion in 2009 and exemptions to PAYGO included … everything. Hypocrisy charges were hurled back at Republicans during the 2010 elections when they promised to extend the Bush tax cuts and reduce the deficit in the same breath. In mid-August, comedian Jon Stewart lambasted Sarah Palin for promising both in a single sentence.

Is hypocrisy impossible for a politician to avoid? More specifically, in the context of federal budgets, is it possible to favor fighting a recession (either with tax cuts or spending increases) while balancing the budget?

I believe there is a way. Congress can resolve the recession/deficit paradox by implementing a tax rate rule that would automatically adjust with the business cycle. Such a rule takes advantage of the dimension of time. After all, paying down the budget deficit requires a long-term solution, while countering the recession requires a short-term solution. Time-sensitive tax rates based on the business cycle truly can “kill two birds with one stone.”

Is it possible to favor fighting a recession, either with tax cuts or spending increases, while balancing the budget?

The tax rate rule I propose would tax payrolls with a rate that equals the current 12.4 percent (Social Security combined employer and employee wage tax rates of 6.2 percent each) on average, but would float up and down over time, countering the unemployment rate. If, for example, the unemployment rate rose 2 percentage points above its 10-year moving average, then the payroll rate would adjust down proportionally. The rule I model here is a 2.5 percentage point decrease in payroll tax rates for each percentage point increase in the unemployment gap.

If you believe that taxes influence behavior, then their impact on employment depends on how strong you believe this influence is. There is simply no consensus among economists on the elasticity of labor supply, nor demand, nor their intersection. I model a labor-tax elasticity of 0.1, meaning that a change of 1 percentage point in the tax rate will lead to a 0.1-point change in the rate of unemployment. Thus, if payroll automatically adjusts down from the norm of 12.4 percent to 9.4 percent (a 3-point drop, crudely equated to a 3 percentage point increase in wages), then employment levels will rise by 0.3 percent and the unemployment rate will adjust approximately 0.3 down from wherever it would have been.

The two following charts illustrate the relationship between unemployment and payroll tax revenue, as it has been historically and as it would have been if my rule were in effect (using my simplistic assumptions—keep in mind that this is a rough sketch of the idea). In most years, the unemployment effect would be minimal. But in severe recessions, such as the current episode, the rule could potentially keep the unemployment rate a full point below its normal level. In addition, the second chart shows that the auto-rate rule scenario would have cut payroll tax revenues from the current monthly $5.5 billion to approximately $1 billion, leaving an additional $4.5 billion in the private economy every month, or roughly $54 billion per year.

Kane A

Kane B

Just another automatic stabilizer?

Textbooks describe automatic stabilizers (e.g. unemployment insurance) as good for the macro economy because they adjust in a timely way to macro fluctuations, something that “fine tuning” politicians do badly. Most automatic stabilizers operate by increasing government expenditures during downturns, thereby giving spending stimulus to sagging aggregate demand.

Unfortunately, spending stabilizers have the negative side effect of getting the incentives wrong. Unemployment insurance cannot help but pay people for being jobless, which, research shows, raises the overall level of joblessness. A flexible tax rate would operate similarly, but through the private sector rather than a government expenditure channel. Most importantly, a tax rate rule would also get the incentives right: rewarding hiring and working, rather than firing and not working.

Budget buster?

If the unemployment rate rose, for example, 2 percentage points above its 10-year moving average, then the payroll rate would adjust down proportionally.

Because tax revenues would decline even more during downturns with a rate rule, it might seem like a budget buster. Over time, however, the average tax rate would be the same as it is now, making the policy budget-neutral.

A flexible tax rate rule is not a tax increase. In fact, having rule-based policy is more likely to control deficits because it does not require politicians to make unpopular choices during economic recoveries.

In fact, a valid objection to this idea is that balancing the budget annually becomes all but impossible, almost the antithesis of the balanced budget amendment (BBA). Yet the BBA lacks economists’ support precisely because—as designed now—it could act as an auto-destabilizer. Maybe then, a smarter BBA includes a rate-rule flexibility that would reconcile budget hawks and recession fighters.

Do variable taxes mean greater uncertainty?

Some have said uncertainty haunts the U.S. recovery, particularly the uncertainty about whether Congress will extend the temporary income tax cuts from 2001 and 2003. Critics will claim that a flexible tax rate will cause constant uncertainty, making it difficult for employers and employees to plan. Such critics confuse cyclical variation with real uncertainty. Do the four seasons hinder farmers from harvesting wisely? Cyclical variations in tax rates would, in fact, cushion concerns about profitability during downturns. More importantly, employers would know—reliably, if not predictably—that relief from taxes would come immediately during a recession.

Milton Friedman’s life-cycle research does show that permanent tax cuts have a larger behavioral effect than temporary cuts, but that research does not speak to a variable rate rule. Logically, a rule-based policy would carry more certainty than politically driven rate cuts (which usually are temporary, and cannot be linked to the recessionary cycle). If he were still with us, I think Uncle Miltie would endorse this innovation. Permanently.

Tim Kane is a senior fellow at the Ewing Marion Kauffman Foundation.

FURTHER READING: Veronique de Rugy offers a lesson on “Taxes and Presidential Math,” Alex Pollock explains “Why the Fed Cannot Regulate ‘Systemic Risk,’” and Andrew G. Biggs argues that “Spending, Not Tax Cuts, Is the Real Driver of the Fiscal Mess.” Norman J. Ornstein foresees that the “Game of Chicken over Bush Tax Cuts Is Near,” and Michael Barone observes, “While His Base Rages, Obama Faces Tax-Cut Reality.”

Image by Rob Green/Bergman Group.

Data sources
Monthly OASDI revenues.
CBO’s outlook with a spreadsheet on revenues as a percentage of GDP.
• The BLS unemployment rate series.

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