Should Bush tax cuts be extended?

According to WSJ (link), the majority of surveyed economists in the U.S. suggests that Obama administration should extend personal income tax cuts imposed under Bush administration between 2001 and 2003. Given the dismal effects of $787 billion stimulus, the U.S. economy would greatly benefit from tax cuts on earners in all income brackets. However, is the administration under president Obama willing to reverse the growing trend of government spending?

Critics of Bush tax cuts claim that reduction in personal income tax rates between 2001 and 2003 resulted in a disproportionate windfall gain to the wealthiest U.S. households while the families in the lower tail of income distribution received very low or zero gains from 2001-2003 tax cuts. What would happen if the Obama administration extended tax cuts for all taxpayers? Would the reduction of tax burden lead to stronger and faster U.S. economic recovery? To answer the question, it is essential to understand what actually happened with the U.S. economy when Bush tax cuts were implemented.

Between 2001 and 2003, Bush administration enacted a series of tax cuts aimed at boosting the recovery of the U.S. economy from the 2001 recesion. In this year, tax rate on income in the lowest bracket was reduced to 10 percent while top marginal tax rate was slashed to 35 percent from 39.6 percent. Tax rates were also reduced for middle-income earners. In 2002, the administration reduced tax burden on new business investment while in 2003 tax rates on dividends and capital gains was decreased. These measures were a part of broader $1.35 trillion tax cut program approved by the Congress over a ten year course.

However, tax cuts didn't pay for themselves as President Bush promised. The reason is the growth of federal government spending which increased by 2.5 percentage points of GDP between 2001 and 2008. During his term, President Bush signed the so called Medicare Part D plan which assured seniors additional drug prescription. The act created $8.4 trillion in unfunded obligations in present value terms. The CBO (Congressional Budget Office) estimated that extending Bush tax cuts would cost the U.S. Treasury $1.8 trillion in the following decade and would dramatically increase the federal budget deficit.

The war in Iraq was the major source of a growing public debt. Between 2001 and 2008 the federal public debt increased by 5.4 percentage points of GDP. Due to the growth of government spending, tax cuts led to a widening budget deficit. It should be noted that tax cuts were not the cause of the 2008-2009 budget deficit as critics often argue. An analysis by Center for Budget and Policy Priorities has shown that Bush tax cuts account for about 25 percent of the 2009 federal budget deficit.

If tax cuts are not accompanied by the reduction in government spending, the outcome is likely to result in either budget deficit or growing public debt. This is exactly what happened in the medium term with Bush tax cuts. A reduction in tax burden on personal income can result in higher tax revenue only if government spending is reduced. The U.S. budget outlook suggests a dismal fiscal future for America, marred by high public debt and a wide budget deficit that is unlikely to disappear before 2017. Bush tax cuts should be extended for earners in all income brackets, but only under a permanent reduction of government spending. Otherwise, any further tax cut would only add to the magnitude of federal budget deficit.

The economic nonsense of corporate income tax

The share of corporate income tax in tax revenue has been growing in the last two decades in the majority of countries. Beginning in 1990s, policymakers in developed countries have trimmed corporate income tax rates in the hope of fewer distortions to saving and investment. As a consequence, tax revenues from this particular tax have increased as a share of the GDP. Surprisingly, leaders in corporate income tax reduction were high-tax European countries such as Sweden, Austria and Germany. Today, the lowest corporate income tax rates in developed world are found in European countries such as Cyprus and Ireland.

What is the economic feasibility of corporate income tax? In fiscal theory, the rationale for this particular tax lies in the existence of benefits from legal protection enjoyed by the corporations and private limited companies. Joseph Stiglitz has argued that this particular tax is a tax on entrepreneurship as it discourages new capital formation. Corporation's tax base depends on the amount of revenues minus expenditures for labor, materials and capital goods. The real paradox of corporate income tax is that it is preferable for the corporation to create new debt than to issue equity. In fact, the debt is considered as a deduction from corporation's tax base. Thus, it is difficult for start-ups to get the loan from the banks as the bank is not willing to take on the risk involved with the repayment of the loan since start-ups' success is uncertain. Therefore, the existence of corporate income tax hinders business investments and entrepreneurial activity in general.

The abolition of corporate income tax would be an important boost to capital formation and new business investment. In addition, many economic distortions would disappear. It should not be neglected that tax incidence in corporate income tax is not shifted to the corporation. The ultimate payers of this tax are workers, customers, suppliers and shareholders. The tax is shifted in lower wages, higher prices and lower dividends. At last, the tax also creates perverse incentives that discourage investment and, nevertheless, job creation.

Source: OECD Tax Database (link)

Taxing soda drinks and fast food

In the U.S., average Body Mass Index (BMI) for men is 26, one point above the critical level. Given widespread growth of childhood obesity, policymakers in Washington have pondered the idea of levying a tax on soda drinks and fast food. The consumption of these products has negative impact on bystanders. Moreover, due to obesity, insurance premiums and costs of health care are rising. Each year, childhood obesity raises insurance premiums by $147 billion. In addition, childhood obesity is likely to become the major source of future growth of Medicare costs. Although the obesity pattern is the strongest and most significant in the U.S., Europe is not immune to widespread childhood obesity. The highest percentage of overweight children in Europe was found in Spain, Greece, Germany and in the UK. In general, obesity rates in Europe are catching up the U.S. level.

Academic studies have shown that the major factor of obesity among children and adults is excess availibility and low prices of soda drinks and fast food. In addition, large exposure of vending machines in schools also contributes to obesity through the consumption of candies and other high-calory products. For instance, an interesting study has examined the effect of vending machines on body weight. It showed that people with direct access to vending machines in schools and workplace gained cca. 3 kg more than those without access to vending machines. Therefore, is a tax on soda drinks and fast food a viable way to contain the growth of obesity?

Greg Mankiw has presented the economic point of view in NY Times (link). Generally speaking, the demand for soda drinks and fast food is price elastic, which means that a 1 percent decrease in the price of soda drinks would increase soda drink consumption by more than 1 percent. If government policymakers introduced a tax on soda drinks (fast food included), the burden of the tax would shift entirely on consumers who would pay the eventual cost of health care arising from obesity as a consequence of excessive consumption of soda drinks and fast food. That is why such a tax is feasible. There is no reason why the society should bear the burden of obesity through higher tax burden and rising cost of health care delivery. This is the most obvious evidence how society pays for private action that should be tackled by individuals themselves.

Productivity gap between the US and OECD countries

I collected data from the OECD on GDP per hour worked in each country as a percentage of the US level. The highest level of GDP per hour was found in Luxemburg (140.4 percent of the US level), Norway (136 percent of the US level) and the Netherlands (100.4 percent of the US level). In these countries, the level of productivity is higher as the workers there work fewer hours per year than in the US, so it is no surprise that relative productivity is higher. The least-performing countries are Poland (37.9 percent of the US level), Mexico (33.6 percent of the US level), and Chile (28 percent of the US level). These countries are catching-up developed nations, so in spite of relatively high number of working hours per year their level of productivity is significantly lower.

In the long run, productivity is the only engine of economic growth and the wealth of nations. It is the only hope for less-developed and developing nations to catch the income per capita level of advanced countries. There are many obstacles to higher productivity in the labor market. First, many countries impose minimum wage laws, risking higher unemployment among less-skilled workers. Minimum wages increase labor costs and reduce overall employment. Second, the number of working hours is often restricted by trade union determination of labor contracts and entry requirements in many sectors. Third, some countries reduce labor supply incentives through higher hourly wages on extra working hours so that employers do not encourage employees to work longer hours. And fourth, high marginal tax rates discourage workers from longer work. A reduction in marginal tax rates, the abolition of minimum wages, deregulation of entry requirements and tax incentives for extra hours of work could significantly boost productivity growth and higher standards of living.

GDP per hour in OECD countries

Source: OECD (2010)

How farm subsidies kill Europeans

Cardiovascular diseases (CVDs) are the main cause of deaths in the Europe, approximately 49 percent of all deaths, out of which 30 percent of all premature deaths before the age of 65. Cardiovascular diseases are estimated to cost the EU €169 billion every year.

Let take a look at the data. In Germany, 907 men and 237 women on average die prematurely each year before the age of 75 due to coronory heart diseases (CHD). In the UK, 479 men and 1453 women die each year due to premature death alone. The number of premature deaths is high in Mediterranean countries (Italy, Spain) as well. In Italy, 233 men and 826 women die because of the premature death (link).

"The school milk subsidy scheme introduced by the European Commission likewise means that a child drinking full-fat rather than skimmed milk will consume an additional 1.5 kg of saturated fat every year approximately 4 g per day. British children obtain 23% of their daily saturated fat intake from full-fat milk (link)."

To prevent premature deaths in Europe, European policymakers should impose a tax on the products causing significant health problems such as diabetes, obesity, lung cancer, incresing blood pressure, raising cholesterol etc., and by doing so save more lives. The EU Common Agicultural Policy (CAP) annual budget represents approximately €45 billion which represents 45 percent of the overall EU budget. Through subsidies and direct payments, CAP is a source of massive oversupply and overproduction of dairy products. These products are the main source of excessive butter and full-fat milk consumption which further leads to raising cholesterol, coronary heart diseases, incresed blood presure etc. The CAP has a deadly cost - human lives.

Taxing luxury yachts

The lawmakers in Florida have considered cutting the 6 percent boat registration tax. Florida already has one of the highest sales taxes in the US. Buying a $1 million boat will cost you $60.000 in sales tax. In nearby states such as North Carolina, yacht registration costs you $1.500 at most, whereas only $600 in Rhode Island and $500 in South Carolina. Even more attractive are Cayman Islands where you pay close to zero tax on yacht registration. Because of Florida's uncompatitive tax regime, 8 out of 10 boats in the state are registraed somewhere else, either in other costal states or abroad. The message is clear, raising taxes is tempting but in reality it leads either to tax evasion or capital escape. Higher tax rate lead to the opposite results of what the policymakers expected. Their decision costs Florida $120 million in lost revenue.

This is a clear evidence that higher tax rate does not lead to more revenue, as people and businesses easily move to more favorable tax destinations. To keep the citizens and businesses at home, you should build a more attractive business environment with lower tax rates and friendlier regulations (link).

Tax and labor cost

I composed a graph from Eurostat's database on tax wedge in EU, US, Iceland, Norway and Switzerland in 2008. Tax wedge is a measure of overall tax burden of labor cost. It shows the share of taxed labor cost. It is striking to see that EU goverments take in almost half of what you earn. Tax wedge is the highest in Belgium (50.3 percent). Hopefully, it does not set an example to the rest of EU countries, as EU15 tax wedge is over 40 percent. After all, EU15 is known for high tax burden. As you can see from the graph, tax wedge is the highest in Continantal Europe. Germany, one of the biggest EU economies, scored second with 47.3 percent, next is Hungary (46.7 percent) followed by France (45.5 percent), Austria (44.4) and other countries. All countries that scored above 35 percent should implement some radical reforms and so became more competitive and attractive for doing business. One of the countries that achieved to reduce tax wedge the most is Cyprus (0.0 percent), second best is Malta with 17.9 percent, Iceland (23.7 percent), Switzerland (26.5 percent), USA (28 percent), Luxemburg (29.6 percent) and UK (29.7 percent).

Source: Eurostat