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Taxes and the Debt-Growth Tradeoff

Author: Roya Wolverson
December 15, 2010

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The tax deal negotiated by Senate Republicans and the Obama administration -- which passed with 81 to 19 votes on December 15 (NYT) -- highlights ongoing debate about the potential tradeoffs between tackling U.S. debt and bolstering the U.S economic recovery.

The deal--which includes an unemployment-benefits extension, a two percentage-point cut in payroll taxes, and middle-class tax credits for college tuition--could add $858 billion to the deficit over ten years (Reuters), according to congressional budget estimates. The Obama administration is hoping to use the deal to enact another round of fiscal stimulus--a move rejected by fiscal conservatives--by conceding to Republican lawmakers a temporary tax rate extension for the wealthiest 2 percent of Americans.

The bill faces a tougher audience in the House, where some conservative lawmakers oppose (Politico) financing progressive measures such as unemployment benefits with debt. House Democrats concerned about disproportionate concessions for the wealthy may also demand a vote to modify the deal's estate tax provisions, which, if passed, would send the legislation back to the Senate.

The country's rising debt, which stands at $9.3 trillion, could spur higher U.S. borrowing costs and greater dependence on surplus countries like China. Growing frustration about China's role in the U.S. economy led two senators to seek an amendment to the tax bill (AFP), targeting China's alleged currency manipulation. Rates on ten-year U.S. Treasury bonds also jumped (TIME) on news of the tax deal, signaling investors' reticence about continued U.S. deficit spending. In recent testimony to the Senate Budget Committee, CBO Director Doug Elmendorf †warned that in the long term, tax cuts would "increase budget deficits and thereby government borrowing, [which] crowds out investment, while lower tax rates increase people's saving and work effort; the net effect on economic activity depends on the balance of those forces."

In the near term, pressure on U.S. borrowing costs may be offset by more immediate concerns about troubled eurozone countries. "If the European debt crisis worsens, U.S. Treasuries will once again provide a safe haven," says the Financial Times' John Plender. The Federal Reserve's quantitative (WSJ) easing program--which involves buying $600 billion in long-term U.S. bonds--could also mask bond investors' concerns about U.S. fiscal irresponsibility indefinitely.

Mounting debt concerns are countered by fears that, without more government intervention, the sluggish U.S. economy could stagnate. Some experts point to the case of Japan, which enjoyed a period of robust growth, followed by a "Lost Decade" of lackluster demand and deflation. Outgoing director of the White House Economic Council Larry Summers argues Japan's biggest mistake was its failure (Reuters) to act early enough in its economic recovery to boost demand. At a recent CFR economic event, Nomura Securities' Richard Koo agreed that Japan's lesson to the United States should be to maintain fiscal stimulus "until private-sector balance sheets are repaired," though he warned that a tax cut extension "doesn't mean we'll come out of the recession. It just won't make it any worse."

The Center for American Progress estimates the combination of tax cuts would create or save 2.2 million jobs. But the deal's $133 billion in bonus tax cuts would be better used for additional payroll tax cuts--which could save or create 2.7 million jobs--or to reduce the deficit, say CAP's Michael Ettlinger and Michael Linden. Such corporate concessions illustrate the need for U.S. policymakers to reassess the country's values and priorities, says Nobel economist Joseph Stiglitz (ProjectSyndicate). "It is relatively easy to formulate a deficit-reduction package that boosts efficiency, bolsters growth, and reduces inequality," he says. But such a reasonable proposal is unlikely to ever be adopted, because the required cuts "wouldn't benefit those at the top, or the corporate and other special interests that have come to dominate America's policymaking."

Additional Analysis:

On the Daily Beast, CFR's Leslie Gelb questions U.S. spending priorities amid concerns about U.S. economic competitiveness. "How on earth can the administration justify spending billions to build roads, schools, and hospitals in Afghanistan when America's physical and intellectual infrastructure is simply collapsing?" he says.

On Bloomberg, CFR's Amity Shlaes says Democrats are right to attack Obama's tax cut deal because it would compromise public trust in deals and contracts including Social Security.

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