Would Raising Taxes on Rich Hurt the Economy?

President Obama might have thought when he nominated William Donaldson and Martin Feldstein to his economic advisory board that he was setting himself up for bipartisan agreement with his policies. Former high-ranking economic officials in the Bush II and Reagan administrations, respectively, Donaldson and Feldstein hail from the moderate-establishment wing of the GOP. But when Obama convened a meeting of his economic advisers on Monday, Feldstein and Donaldson publicly pushed the president to reverse his campaign pledge to extend the income tax cuts enacted by George W. Bush, scheduled to expire this year, only for those individuals earning below $200,000 and married couples earning less than $250,000. Donaldson and Feldstein maintained, as did virtually all Republicans in Congress and a few moderate Democrats, that allowing taxes on dollars earned over $200,000 per year to tick upward by a few percentage points during a slow recovery would be damaging to the economy. The two urged that the cuts be temporarily extended; congressional Republicans want to extend them permanently.

The argument has been framed as protecting economic growth on the one side and reducing the deficit over the long term on the other, with Republicans in favor of the former and President Obama and most congressional Democrats in favor of the latter. Some prominent conservatives, such as former Federal Reserve Chairman Alan Greenspan and David Stockman, who was Ronald Reagan's first OMB director, have gone further than the Democrats, calling for all the tax cuts to expire.

But is this really the choice we currently face—between dour, flinty responsibility or profligate favors for the fortunate? Not necessarily. Nonpartisan economic analyses show that while any tax increase will lower overall demand and thus reduce economic growth, the Bush tax cuts for the wealthy create far less economic growth than other potential tax cuts or spending increases of equal size. So if we were to let the Bush tax cuts on top earners expire and use the money for something else—whether it's infrastructure spending or more effectively targeted tax cuts—we could be much better off.

"The concern about raising taxes now is completely valid," says Chuck Marr, director of federal tax policy at the Center for Budget and Policy Priorities, "but you have to think about which taxes, and net taxes. It's not that you can't raise some taxes: maybe you should raise some to cut others."

If we were to raise the total tax rate on society as a whole, we'd run the risk that the government would suck money out of the economy. But that doesn't mean you can't raise a specific tax on a specific group. Tax cuts for the rich put relatively little back in the economy compared to tax cuts for middle-class or poor people, even though, as advocates of tax cuts for the rich are usually quick to point out, the top 2 percent of earners account for a disproportionately large proportion of total consumer spending. "High income people don't live paycheck to paycheck," explains Marr. "Their spending is less sensitive to taxes. It's inefficient to rely on tax policy to increase or decrease their spending. Yes, they are high spending, but if their spending is not responding to taxes, so what?"

The other argument that advocates of tax cuts for the rich make is that many small-business owners would be see their taxes go up and thus would be discouraged from hiring workers. The facts do not support this. "Only 3 percent of small-business owners are in the top bracket," notes Roberton Williams, a senior fellow with the Tax Policy Center, which is sponsored by the Brookings Institution and the Urban Institute. And, he adds, "They are not all what we think of as job-creating small businesses. A lot of them are hedge-fund managers and law-firm partners." So other than perhaps a few restaurateurs on Manhattan's Upper East Side, the workforce is unlikely to be affected.

Anyway, even the iconic tech startup won't be cutting jobs because its founder faces a slightly higher top marginal tax rate on his profits. "It's a misreading of how business works," says Marr. "The owner isn't hiring or firing based on his personal income tax rate. He hires or fires someone based on whether they are profitable."

So does that mean we should just let the Bush tax cuts on the wealthy expire? That is what deficit hawks would like to see happen, because expanding the deficit will ultimately create a drag on the economy. In congressional testimony last week, Congressional Budget Office (CBO) director Doug Elmendorf warned that extending the Bush tax cuts would ultimately take more money out of the economy than it would inject into it, because increased deficits will eventually slow growth. Elmendorf writes on the CBO blog:

"Even a temporary extension [of the Bush tax cuts] would add to federal debt and reduce future income if it was not accompanied by other changes in policy. A permanent extension of all of those tax cuts without future increases in taxes or reductions in federal spending would roughly double the projected budget deficit in 2020; a permanent extension of those cuts except for certain provisions that would apply only to high-income taxpayers would increase the budget deficit by roughly three-quarters to four-fifths as much. As a result, if policymakers then wanted to balance the budget in 2020, the required increases in taxes or reductions in spending would amount to a substantial share of the budget—and without significant changes of that sort, federal debt would be on an unsustainable path that would ultimately reduce national income."

Earlier this year the CBO analyzed the cost effectiveness of 11 possible approaches to spurring economic growth. Cutting income taxes came in last. It was estimated to increase GDP by 10 to 40 cents for each dollar it adds to the deficit in 2011. Increasing aid to the unemployed, in contrast, which ranked first, was projected to generate 70 cents to $1.90 for every dollar spent. Democrats may be reluctant to push for more generous unemployment insurance, what with its vaguely European, socialist connotations, but a payroll tax break, which the CBO ranked as the second most effective approach, could be a politically palatable alternative. "A temporary reduction in payroll taxes paid by employers would also have a large bang for the buck," writes Elmendorf, "as it would both increase demand for goods and services and provide a direct incentive for additional hiring."

Some economists endorse a more targeted payroll tax cut, focused entirely on new hires so that it would give the maximum possible increase in employment. Others, such as Dean Baker of the Center for Economic and Policy Research, while opposing extension of the tax cuts for the top 2 percent of earners, are skeptical of the efficacy of a payroll tax holiday on the employer side. (Presidential adviser Feldstein, for his part, responded to the CBO estimates in an e-mail to NEWSWEEK, saying, "The CBO assumption about the effect of extending the current tax rates does not take into account the impact on investor/consumer psychology about the attitude of the administration.")

But whichever approach we choose, there are clearly more cost-efficient ways to spur growth than keeping income tax cuts for the rich. Even supporters of keeping the cuts, such as Feldstein, acknowledge, though, that political practicality may be driving the decision more than pure policy. "The only issue on the table with a very short amount of time is what to do with the expiring tax cuts," Feldsein says, "not what more general policy might be adopted." While full tax-cut extension would exacerbate income inequality, many alternative proposals, such as payroll-tax cuts for workers or unemployment benefit increases, would reduce inequality but might be less politically palatable. Other approaches, such as investing in infrastructure, would give society something tangible for its investment, with potential economic or environmental benefits in decades to come. Polls suggest the public appreciates these facts, which raises the question: why not simply expand the realm of what is politically feasible? Why not put one of these more effective proposals into a bill that extends the tax cuts for those making less than $200,000? In theory, Democrats should do just this when they reconvene after the midterm elections. In practice, will they have the good sense to? If their past behavior is any guide, don't count on it.