On Friday, Representative Pete Sessions (R–TX) and House Speaker John Boehner (R–OH) ran afoul of Glenn Kessler’s “Fact Checker” blog regarding a study of President Obama’s proposed tax increase. Before deciding on a tax change, policymakers are wise to look at the economic impacts of the change.
In fact, two studies released this year predict that raising tax rates on high-income families and small businesses would hurt the economy. The tax rate increase was proposed by President Obama and involves raising the top two marginal tax rates to 39.6 percent and 36 percent, respectively.
The first of the two studies was performed by Ernst and Young, a large consultancy, for a group of clients representing small businesses. They used Ernst and Young’s proprietary macroeconomic model to evaluate the long-run economic cost of the proposed tax increase, along with tax increases on dividends and capital gains.
The second study was performed by the Congressional Budget Office (CBO) and focuses on the short-term impact of the tax increase on high-income taxpayers. The CBO report must be read carefully, since the baseline is current law, in which tax rates will rise across the board.
The Ernst and Young study predicts that the tax increases will slow investment, resulting in slower growth in employment and wages. Compared to their model’s baseline predictions, the higher-tax economy would have 0.33 percentage point lower employment after 10 years and would asymptotically approach 0.5 percentage point lower employment. In terms of today’s population, that would be 710,000 fewer people holding jobs. In addition, real wages for those with jobs would decrease by 1.8 percent on average.
Because the effects take place over time, they may seem small in any given year, but they build. Long-run models don’t focus on the timing with which effects come into play. However, based on their 10-year figure, a back-of-the-envelope calculation shows that the model probably predicts more than 2.6 million job-years lost in the first decade. If strong effects of the tax increase are felt immediately, as the second study suggests, then the lost job-years in the first decade might be around 3.4 million.
The CBO report estimates that a year from now, the economy will have 200,000 fewer jobs with President Obama’s tax increase than under an extension of current tax rates.
How does the 200,000 job loss predicted by CBO compare to the 710,000 job loss in the Ernst and Young study? Like apples to oranges. Not only are the time frames different, but the key economic mechanisms in each study are different. Nonetheless, despite asking different questions, the two studies get the same answer: Higher taxes slow job growth.
What Happens to All That Money?
One of Kessler’s criticisms is that the Ernst and Young study assumes that the additional revenue from the tax increase would be used to fund more government spending, not to reduce the deficit. This is a reasonable assumption—after all, Harvard economist Alberto Alesina and his co-authors have shown that increasing taxes to decrease the deficit rarely works, and the President has promised lots of new federal spending in his second term. And if the Ernst and Young model is similar to others in the industry, the assumption that new taxes are used to fund government spending mitigates the predicted job losses. Thus, the “710,000 jobs lost” is smaller than it would be if the new taxes went entirely to deficit reduction.
Are These Numbers Big or Small?
Kessler seems to imply that the economic costs predicted by the Ernst and Young study are small. So let’s compare the economic costs to the revenue that the new taxes might yield. According to the left-leaning Tax Policy Center, such a tax increase would bring in $440 billion over 10 years, even if the economy were unaffected. If the tax increases result in a loss of 3 million jobs over the same 10 years, that would be one job lost for every $150,000 in revenue. In addition, wages, investment, and gross domestic product (GDP) would also be lower. That’s a pretty pricey tax increase.
Will the Tax Increases Make a Dent in the Debt?
Kessler correctly points out that high debt can slow economic growth, as recent scholarship has shown. Will the revenue gains from higher tax rates outweigh the revenue losses from lower wages and lower employment? And is this an efficient way to slow the growth of the national debt?
The Ernst and Young study predicts that long-run GDP with the higher tax rates would be 1.3 percent smaller. If that 1.3 percent of lost GDP had been taxed at 20 percent (a conservative guess), then the loss of tax revenues from smaller GDP would be about the same size as the static revenue gains estimated by the Tax Policy Center.
Without modeling all these components together in the same framework, one cannot be certain how to relate them, but the best evidence is that the costs of the tax increase are large compared to its benefits.
Source material can be found at this site.