The Obama Tax Cuts

Niels Bohr, who won the Nobel Prize in physics, reportedly nailed a horseshoe over his laboratory door. When a visitor asked whether he really believed it would bring him good luck he reportedly replied -- "Of course not. But I am told it works even if you don't believe in it."

On that basis, he might have also qualified for the Nobel prize in economics. Unfortunately, no one in that profession can tell us with certainty that raising taxes in a recession either will, or will not, be harmful to economic growth. Even so, almost everyone seems to feel that it's a bad idea -- even if they can't prove it as a matter of economic theory.

Many conservative economists reject the notion of Keynesian fiscal stimulus - whether done through government spending or tax cuts. But they still argue against tax increases during a recession. Perhaps that's because many of them would be opposing tax increases even if we were in recovery.

The Obama administration is also committed to extending the lion's share of the Bush tax cuts, those enjoyed by families making less than $250,000. But the reason for their proposed tax cut is almost certainly not a devotion to Keynesian economics. The compelling reason for extending the Bush tax cuts -- at least for the middle class -- is Obama's pledge not to raise their taxes. Even though these scheduled tax increases were "baked in" to the tax law under the Bush Administration, it is unlikely that Obama could successfully blame Bush if the tax cuts were allowed to expire as scheduled.

Treasury Secretary Geithner is one person in the Administration who appears to be concerned with the purely economic impact of tax increases during a recession. Appearing on Meet the Press last July, he defended the President's decision not to extend the tax cuts for upper income individuals. But he did so using a curious expression. "The country can withstand that. The economy can withstand that." Hardly a ringing endorsement.

Geithner did volunteer that he thought a tax increase on the top earners was "good policy". He explained that failing to renew this small portion of the Bush tax cuts -- roughly 20% of the total package -- would show the world financial markets that we are willing to make "painful choices" to deal with our growing deficits.

Of course, it is hardly a "painful choice" for the Obama Administration to oppose a tax cut for a group they constantly refer to as "the rich". If the Administration wanted to send a more convincing message to global financial markets, it might consider supporting a two-year extension for all taxpayers followed by a gradual phase-out of the Bush tax cuts for all taxpayers.

What would this mean? For those making more than $250,000 the top rate would stay at 35% until the end of 2012. It would then increase by approximately 1% each year until it reached 39.6% in 2017. Those in lower brackets would experience a similar phase-in of higher rates. Capital gains and dividend rates might be capped at 20% -- as Geithner has said should be done in all events.

The two-year extension would satisfy those policy-makers who really believe it could be harmful to raise taxes on anyone right now (or who simply don't want to be blamed, fairly or not, if the economic recovery is not as strong as they hope it will be by 2012). At the same time, the gradual phase-out, although ostensibly kinder to taxpayers than an immediate jump in rates at the end of 2012, would likely be viewed as stronger evidence of our return to fiscal sanity.

Why is that? Congress can always act to prevent scheduled tax increases from taking effect, just as they are set to do this year. But if -- in 2013 -- there is no sudden, severe tax increase for any group, but only a series of gradual tax increases phased-in over several years, the sense of urgency for Congress to act will be substantially reduced. As a result it will more difficult for them to agree on any action. Inertia will tend to favor doing nothing, allowing these tax cuts to gradually fade away. (At that point, perhaps they will be called the Obama tax cuts.) Such gradual, scheduled tax increases are more likely to be viewed by the financial markets as likely actually to take effect.

In the last few days, the Obama Administration has begun to unveil a new strategy to address the perception that raising taxes on anyone is a bad idea during a recession. While still opposing tax cuts for "the rich," they are apparently set to propose spending an equivalent amount of money on cuts in other taxes. They will then argue that these "targeted" tax cuts are more likely to lead to new job creation.

Obviously such an action would undercut Secretary Geithner's view that enacting some kind of a tax increase this year will show the world our fiscal resolve. In addition, such targeted cuts are unlikely to be effective at increasing employment. Next week, I'll address the Administration's proposals in more detail, and explain what they should really do if they are serious about using the tax code to create more jobs.

Donald B. Susswein is a Washington lawyer who practices and writes in the areas of taxation, tax and fiscal policy, and financial institutions and products. He served as an advisor on these issues to the U.S. Senate Committee on Finance. He writes a weekly column for Benzinga every Tuesday.