Written by

Martin Feldstein

CAMBRIDGE –The tax package agreed to by President Barack Obama and his Republican opponents in the United States Congress represents the right mix of an appropriate short-run fiscal policy and a first step toward longer-term fiscal prudence. The key feature of the agreement is to continue the existing 2010 income-tax rates for another two years with no commitment about what will happen to tax rates after that.

Without that agreement, tax rates would have reverted in 2011 to the higher level that prevailed before the Bush tax cuts of 2001. That would mean higher taxes for all taxpayers, raising tax liabilities in 2011 and 2012 by about $450 billion (1.5% of GDP).

Because America’s GDP has recently been growing at an annual rate of only about 2% – and final sales at only about 1% – such a tax increase would probably have pushed the US economy into a new recession. Although the new tax law is generally described as a fiscal stimulus, it is more accurate to say that it avoids a large immediate fiscal contraction.

The long-term implications of the agreement stand in sharp contrast both to Obama’s February 2010 budget proposal and to the Republicans’ counter-proposal. Obama wanted to continue the 2010 tax rates permanently for all taxpayers except those with annual incomes over $250,000. The Republicans proposed continuing the 2010 tax rates permanently for all taxpayers. By agreeing to limit the current tax rates for just two years, the tax package reduces the projected national debt at the end of the decade (relative to what it would have been with the Obama budget) by some $2 trillion or nearly 10% of GDP in 2020.

That reduction in potential deficits and debt can by itself give a boost to the economy in 2011 by calming fears that an exploding national debt would eventually force the Federal Reserve to raise interest rates – perhaps sharply if foreign buyers of US Treasuries suddenly became frightened by the deficit prospects.

The official budget arithmetic will treat the agreement on personal-income tax rates as a $450 billion increase in the deficit, making it seem like a big fiscal stimulus. But the agreement only maintains the existing tax rates, so taxpayers do not see it as a tax cut. It would be a fiscal stimulus only if taxpayers had previously expected that Congress and the administration would allow the tax rates to rise – an unlikely prospect, given the highly adverse effects that doing so would have had on the currently weak economy.

Even for those taxpayers who had feared a tax increase in 2011 and 2012, it is not clear how much the lower tax payments will actually boost consumer spending. The previous temporary tax cuts in 2008 and 2009 appear to have gone largely into saving and debt reduction rather than increased spending.

It is surprising, therefore, that forecasters raised their GDP growth forecasts for 2011 significantly on the basis of the tax agreement. A typical reaction was to raise the forecast for 2011 from 2.5% to 3.5%. While an increase of this magnitude would be plausible if a forecaster had previously expected tax rates to increase in 2011, it would not have been reasonable to forecast 2.5% growth in the first place with that assumption in mind. So, either the initial 2.5% forecast was too high or the increase of one percentage point is too large.

What is true of the agreement is also true of the decision, as part of that agreement, to maintain unemployment insurance benefits for the long-term unemployed. This, too, is essentially just a continuation of the status quo. No new benefit has been created.

The most substantial potential boost to spending comes from a temporary reduction of the payroll tax, lowering the rate paid by employees on income up to about $100,000 from 6.2% to 4.2%. But, while the decline in tax payments will be about 0.8% of GDP, it is not clear how much of this will translate into additional consumer spending and how much into additional saving. Because this tax cut will take the form of lower withholding from weekly or monthly wages, it may seem more permanent than it really is, and therefore have a greater impact on spending than households’ very feeble response to the previous temporary tax changes.

The final component of the agreement is temporary acceleration of tax depreciation, allowing firms in 2011 to write off 100% of capital investment immediately, in contrast to the current rule, which stipulates a 50% immediate write-off, followed by depreciation of the remaining 50% over the statutory life of the equipment. But, at a time when interest rates are very low and large businesses have enormous amounts of cash on their balance sheets, this change in the timing of tax payments is not likely to do much to stimulate investment.

A greater stimulus to business investment may come from the perception that Obama’s agreement to extend the personal-income tax cuts for high-income individuals signals his administration’s reduced antagonism to business and the wealthy. Obama’s recent statement that he favors reforming personal and corporate taxes by lowering rates and broadening the tax base reinforces that impression. Let’s hope that’s true.

Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan’s Council of Economic Advisers, and is former President of the National Bureau for Economic Research.

Copyright: Project Syndicate, 2010.
http://www.project-syndicate.org

JEANNINE AVERSA | 12/22/10 11:23 AM | AP

WASHINGTON — Expectations for economic growth next year are turning more optimistic now that Americans will have a little more cash in their pockets.

A cut in workers’ Social Security taxes and rising consumer spending have led economists to predict a strong start for 2011.

Still, most people won’t feel much better until employers ramp up hiring and people buy more homes.

Analysts are predicting economic growth next year will come in next year close to 4 percent. It would mark an improvement from the 2.8 percent growth expected for this year and would be the strongest showing since 2000.

“Looking ahead, circumstances are ripe for the economy to develop additional traction,” said Joshua Shapiro, chief U.S. economist at MFR Inc. in New York. He is estimating growth for 2011 to be above 3.5 percent.

The economy grew at a moderate pace last summer, reflecting stronger spending by businesses to replenish stockpiles, the Commerce Department reported Wednesday. Gross domestic product increased at a 2.6 percent annual rate in the July-September quarter. That’s up from the 2.5 percent pace estimated a month ago. While businesses spent more to build inventories, consumers spent a bit less.

Many analysts predict the economy strengthened in the October-December quarter. They think the economy is growing at a 3.5 percent pace or better mainly because consumers are spending more freely again.

Still, the housing market remains a drag on the slowly improving economy.

The National Association of Realtors reported Wednesday that more people bought previously owned homes rose in November. The sales pace rose 5.6 percent to a seasonally adjusted annual rate of 4.68 million units. Even with the gain, sales are still well below what analysts consider a healthy pace.

Even if analysts are right about 2011 being a better year for the economy, growth still wouldn’t be strong enough to dramatically lower the 9.8 percent unemployment rate.

By some estimates, the economy would need to grow by 5 percent for a full year to push down the unemployment rate by a full percentage point. Even with growth at around 4 percent, as many analysts predict, the unemployment rate is still expected to hover around 9 percent.

The third-quarter’s performance marks an improvement from the feeble 1.7 percent growth logged in the April-June quarter. The economy’s growth slowed sharply then. Fears about the European debt crisis roiled Wall Street and prompted businesses to limit their spending.

“It sure looks like the `soft patch’ is over,” said Nariman Behravesh, chief economist at IHS Global Insight.

In the third quarter, greater spending by businesses on replenishing their stocks was the main factor behind the slight upward revision to GDP.

Consumers boosted their spending at a 2.4 percent pace. That was down from a 2.8 percent growth rate previously estimated. Even so, consumers increased their spending at the fastest pace in four years. The slight downward revision reflected less spending on health care and financial services than previously estimated.

More recent reports from retailers, however, show that shoppers are spending at a greater rate in the final months of the year.

Companies are discounting merchandise to lure shoppers. A price gauge tied to the GDP report showed that prices – excluding food and energy – rose at a 0.5 percent pace in the third quarter, the slowest quarterly pace on records going back to 1959.

Americans have more reasons to be confident. Stock prices are rising, helping Americans regain vast losses in wealth suffered during the recession. Job insecurity remains a problem, but the hiring market is slowly improving. And loans aren’t as difficult to obtain for those with solid credit histories.

Even with the improvements, though, consumers are showing some restraint. In the past, lavish spending by consumers propelled the economy to grow at a rapid pace. After the 1981-1982 recession, the economy expanded at a 9.3 percent clip. Consumers increased their spending at an 8.2 percent pace.

Consumers have yet to display that level of confidence in the economy. While hiring is improving, employers still aren’t adding enough jobs to lower the unemployment rate.

Even with stronger economic growth anticipated for next year, analysts predict it will still take until near the end of this decade to drop unemployment back down to a more normal 5.5 percent to 6 percent level.

The government’s estimate of GDP in the July-September quarter was its third and final one. The government makes a total of three estimates for any given quarter. Each new reading is based on more complete information. GDP measures the value of all goods and services – from machinery to manicures – produced within the United States.