The next big battle in Washington will be whether to extend the Bush tax cuts, and if so, how. The Obama administration has made it crystal clear that, while it wants to extend the cuts for the middle class, it intends to let them expire for the wealthy. Some, including even former Federal Reserve Chairman Alan Greenspan, think that this is the right approach. But a moderate track might be better. The tax cuts for the rich should be temporarily extended -- for one year -- until the recovery has more clearly taken hold. There's no tangible downside to this alternative, but significant potential upside.
Raising the Deficit a Little Won't Scare the Market
Let's start with the cost, because the loss of additional government revenue is what many people complain about. If you extend the tax cuts to the rich for just one more year -- when we all hope and pray the U.S. economy will be in the midst of a more robust recovery -- then it would cost around $70 billion (the 10-year estimate is $700 billion, so take one-tenth of that). Consequently, the deficit will be $70 billion higher if the cuts are extended for just one more year.
But so what? Most on the left argue passionately that the current U.S. debt levels are not a problem. And indeed, the bond market agrees. A one-year extension would raise the deficit by less than 5%, and would increase the national debt by one-half of 1%. That's not going to spook the bond market, particularly if it's perceived as a temporary extension.
The Rich Are the Only Ones Spending
The next major criticism to extending the cuts to the rich is that they won't spend it to stimulate the economy. That may be true. But higher tax obligations will lead to the wealthy having less money to dedicate towards savings and investing. That could cause them to spend even less, so to dedicate more to their nest eggs. This is a problem, because the rich have been the only ones really ramping up their spending much over the past several months. So some portion of the weak recovery is due to that spending. Do we really want to risk that disappearing?
Credit and Investment Will Benefit
So let's say the rich temporarily retain their Bush-era tax levels, but don't spend the extra income they get to keep. What will they do with this money? Although some may visualize the wealthy like Scrooge McDuck swimming through their giant vaults of money, they generally do something productive with the money they don't need to spend. They either save or invest it.
Either one of those options is good for the economy. Credit has tightened for small businesses and consumers. If banks have additional deposits in the form the savings of the rich, then they may lend more of it. But if they have fewer, it's pretty likely they won't. As the rich invest, this will also benefit the market. Better stock performance means healthier corporations and a more optimistic middle class that could also feel more comfortable with additional spending, as the value of their 401ks creep up.
Last Chance for Stimulus
With little time for Congress to pass more legislation before midterms, it's fairly unlikely that any additional stimulus measure will pass. Then, pretty much everyone expects Republicans to add to their seats in the House and Senate. Since they're born again deficit hawks, it's not likely that they'll allow more stimulus in 2011. So even though extending the tax cuts to the rich might not be the best form of stimulus, it might be Washington's only option.
No Better Alternative for the $70 Billion
If the tax cuts are not extended, what will Congress do with that $70 billion? Nothing. You could argue that this $70 billion would be better spent if the other 95% of the workforce got a $310 tax credit each or if a public works program was initiated. But as just mentioned, passing such measure is unlikely. Since this $70 billion will just shrink the deficit by an insignificant amount, a stimulus measure -- even if imperfect -- would be better.
Not Worth the Risk of Double Dip
Finally, if you compare the two potential downsides of extending the cuts temporarily or not at all, then it's obvious which is worse. If you temporarily extend the tax cuts for the rich and the deficit moves a little higher, then there's some chance the bond market won't be thrilled and rates increase slightly. If you repeal the tax cuts, then there's some chance spending, credit, and investment all decline, which would heighten the chances of a double-dip. One lesson from the Great Depression is that fiscal tightening made things worse. The economy will remain in a very fragile state through year's end, where even a small shock could push it back into recession. Is sticking it to the rich really worth the risk?
Although most Americans (including me, sadly!) won't see any direct benefit if the tax cuts are temporarily extended to the wealthy, there's a very real chance that not extending the cuts could cause them harm. All the anti-rich political rhetoric in the world won't chance the rules of economics. And they dictate significant risk if the government clamps down while the economy is still vulnerable to a double dip.