The Great Compromise

A few scattered thoughts on the great compromise (numbered for the convenience of commenters, so you can easily say which part you’re responding to):

  1. There were never any such thing as a “Bush tax cut”. There were only tax deferrals. In the absence of spending cuts, lower taxes today mean higher taxes tomorrow. So all this talk about how, in the absence of an extension, the average family will pay so-and-so many more thousands in taxes — it’s sheer balderdash. We will collectively pay exactly the same amount in taxes, present and future combined, whether or not this extension goes through.
  2. Although the average long-run tax burden is unaffected, changes in the tax code can of course shift the burden from one class of taxpayers to another. The Bush “tax cuts”, for example, probably made the tax code somewhat more progressive, shifting the burden from the poor to the rich. (You might have heard the opposite, but I suggest paying more attention to numbers than to rhetoric.)
  3. Therefore the proposed extension of those “tax cuts” is a victory for the forces of tax progressivity, though not as big a victory as an extension with a $250,000 cap would have been.
  4. Some taxes are worse than others. Estate taxes are worse than income taxes and income taxes are worse than payroll taxes — certainly from the point of view of economic efficiency and also, I would argue (though here a reasonable person might disagree) from the point of view of fairness. This compromise resurrects the estate tax while lowering the payroll tax — two steps in the wrong direction, in my opinion.
  5. Of course it would be best if we could lower taxes for real (by cutting spending). But this payroll tax cut is not a tax cut — it is a promise to raise some other tax in the future. That will probably be the income tax. Higher income taxes in exchange for lower payroll taxes is a bad bargain.
  6. Let me elaborate on that one. As I’ve stressed repeatedly on this blog, a payroll tax is more efficient than an income tax, because a payroll tax only discourages work (which is bad), while an income tax discourages both work and saving (which is doubly bad). It’s also true, at least under the current tax structure, that the income tax is progressive whereas the payroll tax is regressive (falling to zero above a certain level of income). That (uncontroversially) makes the payroll tax enormously more efficient in another way, because the disincentive effects disappear completely once you pass the cap. I’d also argue (controversially) that it makes the payroll tax fairer, because there’s a limit to how much anyone should be asked to contribute.
  7. The payroll tax cut could plausibly boost employment, which is a boon for Obama. But boosting employment in the short run — as opposed to, say, fostering growth in the long run — is not a good policy goal.
  8. The resurrection of the estate tax is particularly disastrous as policy, not least because of the new $5 million exemption, which will mollify most of those now lobbying for repeal — and thus render repeal a dead letter for the foreseeable future.
  9. This compromise also comes with an extension of unemployment benefits, which my gut tells me is a bad thing — though I agree with Greg Mankiw that nobody really knows the right level of benefits.
  10. This thing is about to get loaded up with pork, potentially including subsidies for wind power, energy efficient windows and duck hunters according to the Christian Science Monitor.
  11. Overall, this is very good for Obama, I think. It extends the Bush “tax cuts”, which on the one hand makes the tax system more progressive (as he presumably prefers) while on the other hand making everyone think it’s made the tax system less progressive (giving him something to rail against). He gets the payroll tax cut to boost employment and the benefits-extension which (although it will push employment in the wrong direction) will be very popular with his constituents. It takes estate tax repeal pretty much permanently off the table. And it gives the Democrats one final opportunity, before losing the House, to hand out oodles of pork to their friends, which is pretty much the main thing this administration has been about.
  12. If the Republicans were serious, they’d reject this deal and try again in January after they’ve taken over the House. I bet they could get exactly the same deal on income taxes together with permanent estate tax repeal. They could also, if they wanted, kill the unemployment benefits, though I suspect that they’d rather not be in the position of having to choose between the Tea Partiers who really really want those benefits killed and the substantial constituency that really really wants the opposite — better, maybe, to reach this agreement now and be able to blame it on the Democrats. But the real win, I think, would be if the Dems load this thing with pork, the Repubs kill it, and then the Repubs, in January, pass the exact same bill without the pork — making a meaningful statement that times have changed. I’m not holding my breath.
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24 Responses to “The Great Compromise”


  1. 1 1 Harold

    11 and 12). I think you are right to keep breathing. The original tax cuts only got through because of pork in the form of $20 billion in state aid.

    1). These are tax cuts in the usual meaning of the term. The “tax cuts” reduce revenue, increase the deficit and many people use this as a reason to cut expenditure. You may argue that from an economic perspective this is all backwards, but it does happen. The tax cuts put political pressure on spending cuts, which result in lower taxes in the future.

  2. 2 2 Harold

    2) Who is this guy writing in Slate? Can we trust his figures? Your figures only include couples, so I don’t know how this would change if everyone were included. However, it seems that the tax cuts (can we call them this?) are not as regressive as has been portrayed, if taken in completeness. The overall effect could still be to make the worst off, worse off, as these are more likely benefit from programs now being cut.

  3. 3 3 Seth

    It certainly would be nice to see some serious attention given to cutting spending.

  4. 4 4 Jeff Semel

    In 7, I think “The payroll tax could plausibly boost employment” should read “The payroll tax cut could plausibly boost employment”.

  5. 5 5 Steve Landsburg

    Jeff Semel: Good catch. I am editing to correct this.

  6. 6 6 Jeff Semel

    In 1, the policy question is: Can lower taxes cause spending cuts? This is the old “starve the beast” argument, and seems more valid now that deficit spending has become such a lightning rod for criticism.

  7. 7 7 The Money Demand Blog

    The benefit of payroll tax cut is that lots of recipients are bound by credit constraints and thus they cannot benefit from the intertemporal optimization of consumption. Payroll tax cut should be offset by permanent reversal of the cut together with a slight increase so the whole scheme is budget neutral on net present value terms. Those recipients who are not credit constrained will save the cut and will repay it out of their savings and accrued interest, recipients who are credit constrained will spend the cut and will repay it from their future wage income.

    Why the private credit sector is unable to help workers constrained by the credit and why Obama has to step in with the payroll tax cut scheme? Because equilibrium fed funds rate where savings and investment balance is below zero these days, so the Fed is driving private sector out of business by offering above-equilibrium interest rates on currency and reserves. First best solution is to temporarily lower fed funds rate below zero until market equilibrium is restored, but this solution is not technically and politically feasible, so a temporary payroll tax cut is a good substitute. The only fear is that the cut is too small to drive the equilibrium fed funds rate into the positive territory, and we will be stuck with the bloated Fed’s balance sheet for the long time.

  8. 8 8 Jeff Semel

    @Harold: Oops, I just realized you already made the same point, that tax cuts may cause spending cuts.

  9. 9 9 Seth

    “There were only tax deferrals. In the absence of spending cuts, lower taxes today mean higher taxes tomorrow.” -SL

    By higher taxes do you mean higher tax rates or higher tax collections?

    Do you agree that lower tax rates could generate more tax collections in the future?

  10. 10 10 Glen

    Steve, holding spending constant, and holding the type of taxation constant, do you consider it a matter of complete indifference whether we tax now or tax later?

  11. 11 11 Mark

    Look at the entire tax system as consisting of two parts: (1) the federal income tax which is progressive, and (2) everything else which is regressive. Note that (2) includes state and local taxes, sales taxes, etc.

    A reduction of taxes collected from (1) shifts the burden to (2), so the Bush tax cuts make the system more regressive.

  12. 12 12 Steve Landsburg

    Glen: No, it is not a matter of complete indifference. To minimize distortions, it’s desirable to spread taxes out as equally as possible over time.

  13. 13 13 Steve Landsburg

    Mark:

    A reduction of taxes collected from (1) shifts the burden to (2), so the Bush tax cuts make the system more regressive.

    But it’s not that simple, because we had not just a reduction in (1) but a change in the structure of (1).

  14. 14 14 The Money Demand Blog

    Steve, you said:
    “To minimize distortions, it’s desirable to spread taxes out as equally as possible over time.”

    In general yes, but it is desirable to temporarily lower taxes when there is a temporary shock to the financial intermediation activities of the private sector. Quantitative easing is another substitute for the financial intermediation activities of private sector, but temporary tax cuts may be a better option because in latter case the private sector retains the the right to make capital allocation decisions (the downside is that tax burden allocation decisions have to be made).

  15. 15 15 J

    Dr. Landsburg,

    You state: “Glen: No, it is not a matter of complete indifference. To minimize distortions, it’s desirable to spread taxes out as equally as possible over time.”

    This seems to be true only if tax payers stay the same. In other words, marginal costs of current expenditures will be larger than the marginal benefits if temporary politicians/taxpayers can shift taxes onto future generations. Is this correct? What does desirable tax policy look like under a set of continuously changing tax payers?

  16. 16 16 Will

    I’ve just started reading your books and this blog. Can you point me to where I can see an argument against the estate tax?

    The way I’m wired, I’m trying to build my estate as big as possible so that I won’t be a burden to my child in retirement, give to charities, and leave money to my daughter.

    Is the argument against an estate tax that without an estate tax I wouldn’t have to save as much for my child? I.e. If I want to give 1 mil to my daughter, I don’t have to save 2 mil to do it.

    Is the argument that people aren’t wired like me and don’t want to leave money for their children and that removing the estate tax will encourage them to start saving for their kids?

    Neither of these make sense to me, hence, my request for the argument against the estate tax.

    If anyone replies to this, please go easy on my obvious stupidity. E.g. please no “Well duh Will 1+2=3 so the estate tax is obviously bad you idiot.”

  17. 17 17 Steve Landsburg

    Will: Suppose you earn a dollar, pay 50 cents tax, and save the remaining 50 cents for your daughter, who pays a 25 cent estate tax.

    That nets 75 cents for the govt. But the govt could accomplish the same thing by just taxing you 75 cents in the first place, at the moment when you earn the dollar.

    The advantage of assessing the tax entirely up front is that it doesn’t distort your incentive to save. By splitting the tax into two parts, we risk encouraging you to spend more freely in order to (partially) avoid the second part of the tax.

    This simple example assume a 0% interest rate (so that it doesnt matter when the govt gets it money). With a positive interest rate, 25 cents today is not exactly the same as 25 cents tomorrow, so the arithmetic gets a little trickier. But the same principle holds: Whatever the govt takes from you, it’s better that they take it all up front, so as not to distort your savings decisions.

  18. 18 18 Other Will

    I agree with pretty much everything here, although I’m really not sure that making everyone pay the same percent of their income is the most “fair” system. What I find interesting is how the public sees this; all my liberal friends are mad at Obama for extending the evil Bush tax cuts, and my conservative friends (when they can manage to advocate any policy other than ‘Hell No’) are actually somewhat appreciative of what he’s doing. How did we wind up in a situation where both sides do exactly the opposite of what their supposed principles would have to do? Are people confused? Or is it just another convenient fiction we tacitly collude to encourage so we can keep the political war going?

  19. 19 19 John

    Yes, but abolishing the estate tax may also provide incentives for those who inherit the wealth not to work. So isn’t the quesiton whether, or how much, the economic losses that result from that estate tax’s disincentive to save exceed the economic losses that result from the disincentive to work in the absence of an estate tax?

  20. 20 20 Steve Landsburg

    John: I should have been more careful in my wording — the issue is not just “disincentives to work”, the issue is *distortionary* disincentives — that is, disincentives that decouple the private reward to work from the social value of that work. The effect you’re describing is not distortionary.

  21. 21 21 Will A

    Other Will:

    Making everyone pay the same percent is a progressive tax on the rich. Someone making 1,000,000/year pays 10 times more in taxes than someone making 100,000/year. E.g. assume 25% tax rate. The person making $ 1,000,000 pays 250,000 in taxes. The person making $100,000 pays 25,000 in taxes.

    If this is fair, then we should probably have tuition to public universities be based on parental income. E.g. a child from a family making $ 100,000 would pay twice as much in tuition as a child from a family making $ 50,000.

  22. 22 22 Harold

    I do not think that a tax system where all pay the same rate is considered progressive in the usual meaning of the term. As for education, is it not the case that the wealthy spend more on their children’s education through higher fees and private tutors etc?

  23. 23 23 Will A

    Harold:

    I’m curious as to what higher fees you are referring to. I know that in California universities out of state residents pay an additional fee, but this isn’t based on wealth.

    Also, on the fees you are referring to, are they based on percentage of income or range of income? E.g. if you make more than $ xxx,000 you pay a certain amount.

    As it relates to the tax being progressive, I guess it depends on what it means for a tax to be progressive means. Is the following a progressive tax:
    If you make less than $ 25,000 you pay nothing.
    If you make $ 25,000 – $ 49,999 you pay $ 5,000.
    If you make $ 50,000 – $ 74,999 you pay $ 7,500.
    If you make $ 75,000 – $ 99,999 you pay $ 10,000.
    . . .
    If you make $ 1,000,000 – $ 1,024,999 you pay $ 102,500.

    If it is a progressive tax it, then it is a progressive tax that is less severe than having everyone pay the same percentage.

    **** Soap Box Alert *****
    As a caveat, I am a christian and a democrat and have a deeply held belief that those who have more should contribute more and that everyone should give 10% of their income to help others.

    However, as it relates to fairness, the question I have to ask on all of my deeply held beliefs is whether or not it is fair to push them on to other people.

  24. 24 24 TF

    Formally speaking, is a progressive tax one where the marginal rates increase as you head up the scale? Or where the tax as a percentage of income increases?

    Under our present system, the effective marginal tax rates are very high at the bottom of the scale (as the Earned Income Credit is withdrawn), dropping a bit in the middle of the scale, rising again as household income reaches six figures, and then falling when the payroll taxes phase out (and as a greater proportion of income derives from capital gains and dividends).

    Our household marginal tax rate on earned income is around 50% (payroll taxes, income tax, withdrawal of child tax credit, state income tax). As you can expect, that is a serious disincentive to work (especially employment that would incur child care expenses).

    As best I can tell, Bill Gates pays 15% federal tax on the majority of his income. (Not sure what his state income tax would be.)

    Re: #4, I’m not convinced that the estate tax significantly influences savings choices. For most people, the primary motivation for saving is to provide for a comfortable retirement. Given the uncertainty surrounding both investment returns and longevity, some will inevitably leave behind a large accumulation when they die. They may choose to pass that to their heirs, rather than give it to charity, but that doesn’t mean it was ever a significant factor in their planning. Moreover, the wealthy tend to make decisions that are influenced more by prestige and power (both strongly tied to the accumulation of wealth) than by consumption. “I can’t give it to my heirs so I’ll just spend it as fast as I can,” is a motivation that simply doesn’t ring true.

    Re: #5, there are severe limits to how much you can effectively raise via the income tax. I would expect the large future tax increases to be structured as a VAT. Not exactly progressive, but it does encourage saving (or rather, it does less to discourage saving than an income tax).

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