Fixating on Tax Cuts; Ignoring Real Problems

In the Bush years the Democratic leadership made the battle over the Bush tax cuts the holy grail of American politics. People were thrown out of the party if they ever referred to the tax cuts without an adjective like “costly,” “reckless” or “irresponsible.”

To be sure, the tax cuts were a bad use of public money. As we know, they disproportionately went to the wealthy. This money could have been much better used rebuilding infrastructure, promoting renewable energy and conservation, or even as tax cuts oriented more towards middle-class and moderate-income families.

However, the tax cuts were not the economic disaster portrayed in the Democrats’ attacks. The deficits were not especially large in the Bush years. And, the economy needed deficit spending to get out of the recession caused by the collapse of the stock market bubble. Furthermore, the trade deficit caused by the over-valued dollar inherited from the Clinton Administration, necessitated some alternative source of demand, like a budget deficit, to bring the economy anywhere near full employment.

Unfortunately, the political elites’ fixation on the tax cuts and the deficits led them to ignore the economy’s real problems.

The housing bubble grew to ever larger proportions, eventually reaching a point where its collapse would lead to the sort of recession that we are now experiencing.

At this point, the way out of the downturn is fairly simple to explain, even if the path might not be politically possible. In the long-run we have to replace the consumption and construction demand generated by the bubble with increased net exports (i.e. fewer imports and more exports). However, this is a long and difficult process involving the decline in the dollar against other currencies. It will also depend in part on the restoration of growth in our trading partners, a prospect that looks rather bleak as many of them are now overcome with austerity fever.

The short-run alternative is increased demand from the government — yes, large deficits. In spite of the Bowles-Simpson clown show, for the foreseeable future the deficit is our friend. We need to get money into the economy to sustain demand and employment.

For this reason, extending the tax cuts to the richest 2 percent for another two years is not especially harmful. It will hand money to people who will spend at least some it, thereby creating demand and generating jobs.

Of course we would be much better off if the $50 billion going to the rich each year instead went to other purposes, such as preventing cutbacks by state and local governments or rebuilding infrastructure, but if the question is whether the economy will do better with the tax cuts or a smaller deficit in 2011 and 2012, the answer is that we will unambiguously do better with the tax cuts to the rich.

There are huge dangers here but they are political not economic. The deficit hawks will whine about this will add to the national debt and create a huge interest burden.

The answer to this claim is that any resulting debt burden will be a political decision by the government. There is no reason that the Federal Reserve Board cannot simply buy and hold the debt issued to finance these tax cuts as well as the deficit more generally in these years of high unemployment.

There is no reason for concern about inflation, which would actually be good for the economy right now in any case. Japan’s central bank is holding an amount of debt that is roughly equal to Japan’s GDP ($15 trillion in the U.S.) and the country is still experiencing deflation. When the economy recovers and inflation does become a concern the Fed can simply raise reserve requirements to ensure that reserves created by buying debt do not become a problem. If the Fed refuses to go this route then it will be the result of a political decision on its part to put stress on the budget, not an outcome dictated by economic necessity.

The same logic applies to the repeal of the tax cuts on the wealthy at some future date. The government will need this revenue at some point. However, it is ridiculous to think that we can never take back these tax cuts. After all President Clinton raised taxes on the wealthy in 1993 and still managed to coast to re-election 3 years later.

So, progressives should not be happy about giving more money to the richest people in the country, but it is not the end of the world either. The key focus should be on getting the stimulus needed to boost the economy. It is outrageous that 25 million people are unemployed or underemployed because of the incompetence of the people who design economic policy.

DEAN BAKER is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy and False Profits: Recoverying From the Bubble Economy.

This column was originally published by TPM Café.



Dean Baker is the senior economist at the Center for Economic and Policy Research in Washington, DC.