Extending High-Income Tax Cuts is the Wrong Answer for the Recovery

President Obama has made it clear that he favors extending the 2001 and 2003 tax cuts for middle-income families, but letting those for high-income earners expire as called for in current law.  Recently, some have argued that extending the high-income cuts is necessary for the economy.  This is simply wrong.

First, extending the high-income tax cuts would provide very little job creation in 2011. There is widespread agreement that the short-run economic benefits of high-income tax cuts are small.  The Congressional Budget Office lists a tax cut for high-income earners as a particularly ineffective job creation measure.  Private sector forecasters have reached the same judgment.¹ The vast majority of economic research shows that higher-income earners spend less of a tax cut and so tax cuts to those earners create fewer jobs throughout the economy.²

That doesn’t mean that all tax cuts are ineffective in creating growth.  In fact, tax cuts designed in the right way can be highly effective.  That is why the President supported numerous tax cuts in the Recovery Act and why continuing the middle-class tax cuts from 2001 and 2003 is so important.  The view that tax cuts focused on the middle class can be important to the recovery is consistent with a wide range of research, including a paper that I wrote with David Romer before coming to government and that was recently published.  This paper showed that tax changes in the postwar United States had larger short-run impacts on output growth than previously believed.  Since most postwar tax changes have been broad-based, our evidence indicates that broad-based tax cuts have large effects.  But it’s important to note that our study did not distinguish among tax cuts for different groups and did not focus on high-income earners.  Thus, it provides no basis for doubting the compelling evidence that tax cuts for high-income earners are less effective than broad-based tax cuts focused on the middle class.

If lawmakers are truly concerned about job creation, as they should be given the painfully high rate of unemployment, many approaches would be more cost effective than extending the Bush tax cuts for high-income earners.  For example, a private sector study recently concluded that a third year of the Making Work Pay tax credit would be far more stimulative.¹  Likewise, estimates by the Council of Economic Advisers suggest that spending $10 billion to prevent the layoffs of teachers, firefighters, and police would lead to nearly twice as many jobs as the estimated $30 billion of high-income tax cuts—that’s twice as many jobs for one-third the cost.  The small business jobs bill currently before the Senate, which contains both targeted tax cuts for small businesses and measures to improve their access to credit, would also be a far more powerful and cost-effective way to stimulate economic growth and job creation.
 
It is ironic that many who are now arguing that the high-income tax cuts must be extended on stimulus grounds opposed the Making Work Pay tax credit in the Recovery Act.  That tax cut, which totaled $110 billion (spread over tax years 2009 and 2010), went to 95% of working families and by all accounts has made an important difference to the trajectory of the economy.  In its third quarterly report to Congress on the American Recovery and Reinvestment Act, the Council of Economic Advisers estimated that the tax cuts and other income support provisions in the Recovery Act saved or created more than a million jobs just through the first quarter of 2010.  The evidence from my work with David Romer implies that the Making Work Pay tax credit may have been even more effective than conventional estimates indicate. 

Finally, near-term stimulus measures must be taken in the context of developing a credible plan to address our Nation’s long-run fiscal challenges.  A benefit of all three of the alternatives mentioned above is that they are clearly temporary measures aimed at jumpstarting job creation.  In contrast, extending the high-income tax cuts would increase pressure to make them permanent.  While the Office of Management and Budget estimates the high-income tax cuts would cost about $30 billion in 2011, the yearly cost is expected to grow as the economy recovers.  Extending them permanently would add about $700 billion to the ten-year deficit.  That is a cost that we simply cannot afford, particularly for something that does so little to aid our recovery.

Christina Romer is the Chair of the Council of Economic Advisers

¹ See Goldman Sachs Global ECS US Research, “US Daily:  Extending the Expiring Tax Cuts:  What, How, When and Why (Phillips),” July 26, 2010.

² Economic studies in the 1940s and 1950s provided the first statistical evidence for the widely-believed proposition that lower-income households tend to spend more out of an additional dollar of income than do richer households, and subsequent research has repeatedly confirmed the proposition.  For an excellent summary of this literature, see Thomas Mayer, Permanent Income, Wealth, and Consumption (University of California Press, 1972).  These differences across groups emerge in a host of ways in more recent studies.  For example, Parker, Souleles, Johnson, and McClelland studied households’ spending responses to the 2008 Economic Stimulus Payments and found substantially larger spending responses among low-income than among high-income households. See Jonathan A. Parker, Nicholas S. Souleles, David S. Johnson, and Robert McClelland, “Consumer Spending and the Economic Stimulus Payments of 2008,” Manuscript, Kellogg School of Business, Northwestern University, February 2010.