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October 20, 2011
News Analysis: The Dangerous Demise of Temporary Tax Policy
Joseph J. Thorndike

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When did we lose the notion of temporary tax policy? Rhetorically, of course, the idea is alive and well. We've been talking about temporary tax cuts for a decade now. But increasingly, temporary policies look pretty darn permanent.

And that's a bad thing.

Once upon a time, politicians took it for granted that taxes would go up and down, usually in response to the business cycle. Sometimes these changes were automatic, as the tax base grew and shrunk along with output. But other times they were deliberate, as policymakers manipulated taxes to regulate the business cycle.

Over the decades, politicians have frequently cut taxes to boost demand during a slump. But they've been less willing to raise taxes during a boom to keep the economy from overheating. (Except during wartime, when arguments about sacrifice and patriotism have greased the skids for the unpleasant side of demand management.)

For decades, most economists endorsed countercyclical fiscal policy, although they focused more on spending than taxation. But by the early 1970s, the Keynesians were losing their grasp and the monetarists were on the rise. As Ronald Reagan kicked off the long Republican ascendancy, he repudiated countercyclical demand management and replaced it with supply-side nostrums.

Crypto-Keynesians

Or so the theory went. In practice, elements of Keynesian fiscal policy -- the popular ones -- remained central to the policy process. As James K. Galbraith observed in the Washington Monthly in 2009:


    After 1982 Keynesianism in academia was done for, but in the policy world it was not. Policymakers are practical. They recognize that voters dislike unemployment and that recessions are unpopular. The political instinct remains to react to recessions with a "stimulus package."

Today, of course, stimulus is in poor repute, even with voters who dislike unemployment. And Republicans have returned to their anti-Keynesian talking points. But that's a function of power, or more precisely, the lack of it. Stimulus is the burden and the privilege of majority status.

When the Democrats ran Washington during the quarter-century after World War II, countercyclical fiscal policy was their domain; Republicans were complicit, but rarely explicit, in supporting the idea.

When Reagan led the GOP resurgence (for the purposes of fiscal policy, Richard Nixon is best viewed as a mislabeled Democrat), he inherited the fiscal reins. And he used them to good effect. The 1981 tax cuts were billed, accurately, as a supply-side reform, but their effects on aggregate demand were profound.

As the economists Wallace C. Peterson and Paul S. Estenson wrote in 1985 for the Journal of Post Keynesian Economics, the economic recovery of the mid-1980s was a function of fiscal stimulus. Reagan "took advantage of a simple but empirically valid principle, namely, that government deficits stimulate economic activity," they argued.

Republicans, in other words, were Keynesians, too. Just secret ones. And they could afford to keep their Keynesianism under wraps, because the economy did reasonably well for decades after the deep recession of the early 1980s.

John Maynard Bush

It took another economic shock to force some candid stimulus talk from reluctant Republicans. After the dot-com crash, a newly inaugurated George W. Bush vigorously championed expansionary fiscal policy. "Our economy, while there's some good news, needs more stimulus," the president said in February 2002. "I still think we need to pass a bill that will help workers and help stimulate the economy."

Later, at the beginning of the current economic meltdown, Bush again made the case for stimulus. The White House worked with congressional Democrats to develop what Bush called "a booster shot for our economy." The resulting legislation -- the Economic Stimulus Act of 2008 -- was "a package that is robust, temporary, and puts money back into the hands of American workers and businesses," Bush declared.

Note the word "temporary" in Bush's statement. It's a familiar term for students of Bush fiscal policy, since the president's signature tax cuts of 2001 and 2003 were also temporary, at least notionally. But those tax cuts were always billed as functionally permanent, their temporary nature merely a byproduct of arcane budget rules. No one expected them to expire -- not their champions and not their detractors.

By contrast, the 2008 stimulus bill was supposed to be temporary. Because that's what countercyclical fiscal policy requires.

Permanently Temporary

But here's the problem: The fake temporary status of the 2001 and 2003 tax cuts has begun to infect the real temporary status of the stimulus legislation. And not just the Bush stimulus, but Democratic versions, too.

The payroll tax cut is a case in point. The cut was always billed as a temporary measure to prop up the ailing economy. But increasingly, its defenders are sounding like Grover Norquist, president of Americans for Tax Reform and the Svengali of modern Republican tax policy. Norquist defines tax increases broadly. Generally speaking, he claims that any revenue increase constitutes a tax increase.

Today a lot of Democrats seem to be channeling Norquist when talking about the payroll tax cut. "We can't allow that tax cut to expire," President Obama said last month. "It would hit middle-class families with a tax increase at the worst possible time."

Obama went even further, insisting that Republicans should agree with him: "You guys have made pledges never to raise taxes on everybody ever again. You can't make an exception when the tax break's going to middle-class people."

Obama has essentially dared the Republicans to make the payroll tax cut permanent. Parsed carefully, his statement leaves wiggle room for letting the cut expire at some point that isn't the "worst possible time." But by harnessing GOP talking points to his own proposal, he comes very close to adopting their position, at least when it comes to his tax cuts. (And of course, his repeated promise never to raise taxes on middle-income taxpayers constitutes its own sort of tax pledge. And its own sort of fiscal straitjacket.)

Downward Ratchet Effect

Obama's temporary tax cuts have nearly achieved the kind of quasi-permanency that Bush's cuts already have. Can anyone seriously foresee a good time to raise taxes on the middle class? A time when restoring the payroll tax to its former glory seems politically plausible?

Which brings us back to countercyclical fiscal policy. It basically doesn't exist anymore, at least on the tax side of the fiscal equation. Every cut is now permanent, whether directed at the narrow top or the broad bottom of the economic pyramid. Both parties have committed themselves (with varying degrees of vehemence) to never rolling back their tax cuts.

And in all likelihood, both parties will get their way. The Republicans lack the desire to raise taxes (or to let tax cuts lapse -- not the same thing, but that's the point). And Democrats don't have the stomach for it either.

Political scientists have long studied the ratchet effect in fiscal policy, by which both spending and taxes rise steadily over time (often in response to wartime mobilization that is hard to unwind after the shooting stops). Today we're entering a new phase of fiscal history, marked by a reverse ratchet effect.

Every tax cut -- whether enacted to boost short-term demand or encourage long-term growth -- will be permanent, eroding the revenue structure over time. Meanwhile, the old, upward ratchet effect continues on the spending side of the budget. Their rhetoric notwithstanding, the history of Republican governance gives us no reason to expect a decline in long-term spending trends.

So the various tax cuts will continue to limit revenue, and the spending will continue to climb. We all know how that process ends. But only the bond markets know when.