Does Government Tax Policy Affect Markets?

As the expiration of the Bush tax cuts nears, Washington must decide how to respond. Does it: 1) allow them to expire, 2) extend them all permanently, 3) extend them for everyone but the rich, or 4) extend them for everyone but only temporarily for the rich? An argument for the last option can be found here. Strikingly few people are calling for the first or second options, given the nation's debt problems and recession. The Obama administration has argued for the third, as does Allan Sloan in a Washington Post column today. He says that government policy usually has precious little to do with whether the market rises or falls. He's correct, but right now might be different.

First, here's a little of what Sloan says:

Bush 43, during whose administration the market lost 34 percent, took office just before the Internet stock bubble burst and left in the middle of a market-destroying financial panic. Thus, stocks were artificially high when he assumed office and artificially low when he left. It makes no sense to attribute the market's losses to his tax policy.

Similarly, it's silly to attribute the gains of more than 40 percent since Obama's election to Obama. It also made no sense to attribute the losses between his election and the market bottom in March 2009 to him, although many people did.

You also can't attribute the strong market during the Bill Clinton years -- up 189 percent, compared with 107 percent for the Gipper's tenure -- to the tax increases he pushed through. The market rose because the economy was booming, jobs were plentiful and stocks entered bubble territory. Was that because tax rates rose? I tend to doubt it.

I couldn't agree more. In all of these excellent examples, market-driven changes -- not government tax policy -- affected stocks. But in those economies, Washington's whim wasn't a game-changer. Tax policy likely had only marginal effects, because other aspects of the market were more significant. That might not be the case right now.

Many economists see the U.S. in a sort of limbo somewhere between a full-fledged recovery and second recession. If that's true, then the economy might be more sensitive to government tax policy than usual. Even a small political shock could push over a domino causing a chain reaction that leads to one outcome or the other. To see a situation where government policy has definitely made things worse, you can look to the Great Depression. Then, when the economy was very fragile, policymakers repeatedly made poor decisions -- like raising taxes -- which prolonged the depression.

Sloan and others could be right that raising taxes on the rich taxes now may very well not push the U.S. economy back into recession, but there's certainly a chance that they could be wrong. Because the effects of macroeconomic shocks are so difficult to predict, policymakers need to ask themselves whether raising taxes on the rich is really worth the potential risk of double dip. A one-year extension certainly seems like a reasonable solution if Washington wishes to act prudently.