international analysis and commentary

The tax cut deal: a compromise that leaves many questions unanswered

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There is little doubt that the new tax deal hammered out by US President Barack Obama and the leadership of the Republican Party is the first big bipartisan legislation since TARP, or the so-called “bank bailout”, was passed in 2008. The deal consists of a two-year extension of the Bush-era tax cuts, set to expire at the end of the year, which will keep rates steady for all Americans, and add another $858 billion to the national debt.

As such it is naturally controversial. What is most striking is that, after a year-long campaign during which both Democrats and Republicans fought hard to be portrayed as the ones with the key to a full economic recovery and serious fiscal discipline, they have, in the end, come together on a measure that will probably do relatively little in terms of job creation, while digging an even bigger hole in what is already a ballooning budget deficit.

In the negotiations, both sides had to concede some. Democrats, including the President, campaigned on the promise that, because of America’s unsustainable debt, only the tax cuts for the middle class – defined as an individual making less than $200,000 or a family making less than $250,000 – would be made permanent. For all other income levels, they would be allowed to expire on schedule. Republicans, on the other hand, pushed for tax cuts for all incomes to be made permanent, arguing that, given an enduring economic crisis, no American should have to face a tax increase. “I recognize that folks on both sides of the political spectrum are unhappy with certain parts of the package, and I understand those concerns. I share some of them,” President Obama said last Monday. “But that’s the nature of compromise – sacrificing something that each of us cares about to move forward on what matters to all of us.”

Initially, it was the Democrats who railed more angrily against the deal. For the liberal wing of the party, this was nothing short of a capitulation to the fiscal irresponsibility of the Republican opposition, which put the interest of a few wealthy Americans ahead of that of the country as a whole. On top of extending all tax cuts, the President also agreed to keep in place a reduced capital gains tax rate of 15%, and to allow the estate tax to return (it was suspended for the year 2010) but under terms favored by the GOP. The new version of the “death tax” – as Republicans like to call it since it is, basically, an inheritance tax – would grant exemptions of up to $5 million for an individual, and apply a maximum tax rate of 35% (if no action is taken, it would return instead with exemptions of $1 million and apply a highest rate of 55%).

Voicing the concerns of many Democrats in the House, Rep. Peter Welch from Vermont, originally said, “Borrowing nearly a trillion dollars to finance tax cuts that disproportionately favor millionaires and billionaires, threatens our ability to create jobs, grow the middle class, and protect seniors.”

But gradually, more Democrats have come on board, particularly in the Senate, where the legislation was approved in a largely bipartisan vote this past Wednesday. On the one hand, they have been enticed by a series of stimulus-like provisions that the President was able to squeeze out of the Republicans. The full package now includes a 13-month extension of unemployment benefits, a year-long reduction of the employee’s half of the payroll tax, from 6.2% to 4.2%, and other tax credits for low- and middle-class citizens that were included in the original stimulus package of 2009 but are set to expire. Additionally, Democrats are aware that, with a new Republican-controlled House starting in January, any future deal on the tax cuts would be even more favorable to the GOP, therefore making this the lesser of two evils. “The vote in the Senate indicates an urgency that is felt by a broad spectrum that middle-income taxes not be increased come January 1,” said House Majority Leader Steny Hoyer, from Maryland, early last week, indicating that even House Democrats were coming around. “In order to effect that, you’ve got to pass a bill.” The tax deal cleared the House on Thursday.

In the meantime, with the GOP leadership strongly behind the deal (Mitch McConnell, the Senate Minority Leader, said that by cutting taxes this package will force Democrats to reduce spending), more and more conservatives have started criticizing it, as both irresponsible in this day of ballooning deficits (the GOP leadership has, by making the deal, departed from the electoral promise made to the Tea Party, of fiscal discipline and a balanced budget), and also insufficient. “Because the extension is only temporary, a large portion of the investment and job growth that characteristically accompanies low taxes will be lost,” wrote Mitt Romney, the former governor of Massachusetts and unofficial front-runner in the race for the 2012 GOP presidential nomination, in an op-ed in USA Today. “It will also add to the deficit […] The total package will cost nearly $1 trillion, resulting in substantial new borrowing at a time when we are already drowning in red ink.” The Tea Party Patriots, one of the most influential groups comprising the Tea Party movement, has also come out against the deal as has Tea Party darling Sarah Palin, influential radio host Rush Limbaugh, Senator Jim DeMint and Representatives Darrell Issa and Mike Pence.

Nobel Prize winning economist Paul Krugman estimates that the tax deal would raise the GDP by 0.7%. Michael Linden and Michael Ettlinger, of the Center for American Progress, calculate that the package as it stands could “save or create” just short of 2.2 million jobs.

But in exchange for what is a stimulus of uncertain proportion, the deal would cause the federal deficit for this budget year to balloon to a record $1.5 trillion. Moody’s Investors Service argues that, by adding almost $900 billion to the national debt over ten years, the package would also threaten the AAA credit rating enjoyed by US Treasury bonds. Finally, the deal misleadingly focuses on reducing taxes as a cure to a failing economy, although federal taxes today are already at the lowest levels in sixty years. Personal and corporate income taxes, which represent the most progressive bit of the tax code, are falling, while payroll taxes, the most regressive part, are bearing an increasing share of the cost of running the federal government. According to Janet Novack of Forbes, “if the Obama-Republican tax deal passes, 2011 could turn into the best year yet to be rich, tax wise.”

Precisely because of these concerns, the agreement between the White House and the Republican leadership has triggered all sorts of talks of tax reform to be tackled next year in order to address the problem of America’s growing indebtedness. Tax reform is also among the suggestions offered by the bipartisan Simpson-Bowles Deficit Reduction Panel, set up by the President earlier this year to come up with ways in which the government can reduce its deficit. The idea behind tax reform is that by closing the myriad of loopholes, deductions and exemptions hidden in the American tax code, which, effectively, allow too large a number of people to avoid paying taxes, the government would broaden the tax-payer base and therefore could afford to lower tax rates, a much more popular approach to deficit reduction than a straight-forward tax increase.

While this plan sounds wonderful in theory, the idea that a hyper-partisan Congress, which showed this month that it can only come together to approve more government spending and new tax giveaways, could, next year, find an agreement on balancing the budget (closing loopholes effectively means raising taxes on one taxpayer or the other, and for every loophole, there is an entrenched interest ready to defend it) is far-fetched.

Democrats and Republicans profoundly disagree on the size and scope of the federal government, which are key determinants in establishing the kind of tax system that provides the revenue needed for the government to run. Democrats see the tax code as a means to fund a large federal government, Republicans as a way to shrink it. It’s hard then to see how tax reform could suddenly become a bipartisan cause.

For the time being, American politicians, as well as American voters, who would like to see the deficit decrease but seem unwilling to pay for it, have chosen to put off making hard choices and instead have given themselves a pat on the back and a nicely wrapped Christmas present in the form of a tax cut. But sooner or later, as European countries have just begun to do, the United States too will have to start reigning in its soaring debt, if it wants to preserve its ability to borrow safely on international markets. Already the budget crunch is pushing some of America’s largest states – New Jersey, New York, Illinois and California – on to the brink of a Greece-style collapse. The federal government could be next. The US will also have to tackle its massive, and growing, income disparity, if it wants to continue to foster a vibrant democratic society, cutting-edge innovation and an efficient free-market system. In short, America needs to take action, and quickly, if it wants to retain its predominant position on the world stage. Otherwise, China and India, and other emerging economies, are only too eager to take the lead.