Game Theory and the Tax Cuts

If you enjoy game theory -- guessing how two groups with competing interests will resolve a series of choices as if they were playing a game -- the coming debate over the Bush tax cuts should be fun. Most of the attention so far has been on the income tax. But the debate over the future of the estate tax could be even more interesting. First a review of the game presented so far by the scheduled income tax increases. The original Democratic plan was to play a game of "chicken" with the Republicans before the election -- forcing them to vote against tax benefits for the middle class because they didn't also cut taxes for upper income groups. The claim would be that Republicans were holding the middle class hostage. But the Democrats themselves chickened out, and wouldn't schedule the vote before the election. The next round will occur during the lame-duck session. At that time, it will be far easier for the Republicans to risk being painted as pawns of the rich when the next election is two years away, not two weeks away. So the Senate Republicans, and a few Democrats, may decide to postpone the issue until the new Congress arrives in January. When the game then resumes, President Obama may be presented with an across the board tax cut that he might veto because it gives too much to the "rich". The cries of "hostage taker" will thus be reversed. Republicans will be claiming that Obama is holding the economy, and the middle-class, hostage to his alleged anti-business ideology. The estate tax game will present a different set of choices and timelines. First of all, there is much less urgency to resolving the issues, since estate taxes are not due until nine months after death, and it should be possible for the IRS to extend that deadline. Secondly, the estate tax is almost trivial in terms of its effect on the national debt. It only raises about $25 billion each year -- less than 2% of the $2 trillion of annual Federal revenues. So the debate will be mostly about symbolic issues like "fairness". Unfortunately for the Democratic side, their failure to resolve the issue earlier means that the new estate tax will return at the rates in effect a decade ago. That means that every estate over $1 million will be taxable at approximately 55%. The Democrats will thus have lost the benefit of being able to argue that the tax affects only the super rich. The debate will be between two (or more) proposals to address the fact that -- doing nothing -- the tax will affect millions of middle income families that even the Democrats agree should never be subject to tax. There will certainly be proposals to simply raise the exemption to $4 million or so. But Republicans may counter with proposals to lower the rate to 25%. But if a Republican majority favors more radical action, voting against a bill favored by the majority (or vetoing such a bill) can be portrayed as holding the middle class hostage to an ideology. Making matters worse on the Democratic side, there is little that can be said about the importance of that ideology to reducing the deficit. Both proposals -- Democratic proposals to raise the exemption to $4 million or so and Republican proposals to do that and also reduce the rate to 25% or so - will technically be revenue losers, but both will also be relatively unimportant in terms of the deficit. So the key issues will be ideological. Those issues include whether "the rich" should be taxed up to four times on their earnings -- once when they earn a big salary, again if they invest in public corporations paying corporate tax, again when they pay taxes on dividends or capital gains, and yet again when they die. Conversely, Democrats can argue about whether it is "fair" for billionaires to give their children and grandchildren vast stores of wealth, while so many others can't find a job or get a college loan. Next week I'll examine some of those issues and present some additional "moves" in the game that both sides can consider.