Sunday, June 27, 2010

The Impact of a Tax Hike

In John Mauldin's latest missive The Risk of Recession, he claims a double dip is likely... especially if taxes are increased via an expiring Bush tax cut. While my expectation is that higher taxes are inevitable (and needed), I don't expect a double dip (if we end up going the austerity route... all bets off).

One of the reasons for our difference of opinion is due to a misinterpretation of research I believe he made regarding the impact of a tax hike on economic growth. To John:

I am on record as saying I think there is a 50-50 chance we slip back into recession in 2011, as I think the economy will soften in the latter half of the year and a large tax increase in 2011 (from the expiring Bush tax cuts) will tip us into recession.

This was not based on data, but rather on research which shows that tax cuts or tax increases have as much as a 3-times multiplier effect on the economy. If you cut taxes by 1% of GDP then you get as much as a 3% boost in the economy. The reverse is true for tax increases. Christina Romer, Obama's head of the Council of Economic Advisors, did the research along with her husband, so this is not a Republican conclusion.

If the economy is growing at less than 2% by the end of the year, then a tax increase of more than 1% of GDP could and probably would be the tipping point. Add in an almost equal amount of state and local tax increases (and spending cuts) and you have the recipe for a full-blown recession - at least the way I see it.
Christina Romer's research does hypothesize that a 1% increase in the tax rate causes a 3% decline in economic output, but not in the way he implies. Her conclusion (the report can be found here) showed that:
  • The 3% impact occurred over 3 years (see the chart below), not 1 year; the impact in year 1 was estimated at 1%
  • The decrease ignored the other side of a tax hike... the impact of the additional revenue
Estimated Impact of a 1% Tax Hike (figure 4 - page 57)

Using John's example... if the economy is growing by a bit less than 2% at year end, then the US economy will likely not have a recession based on Christina Romer's research (2% growth > the 1% impact in year 1) all else equal. If the additional revenue from the 1% tax hike is used to pay for something with a high multiplier (i.e. extension of unemployment benefits or state aid to eliminate the need to cut jobs), in theory the hike could actually cause a net increase in GDP (unlikely, but throwing it out there).

More important (and why I think we need higher taxes), is that we are approaching a point where an increase in taxes won't necessarily pay for anything new, but will be needed to simply pay for what was already spent. Outside of an unexpected economic rebound, to balance our budget we will need to:
  • Cut services and public jobs
  • Increase taxes
  • Do both
In an ideal world, the United States will be able to hold off from any of the above options until the economy is back on track. We may even have a small window where we can 'spend vs. cut' or 'cut taxes vs. hike' in an attempt to boost the economy, but in my opinion these just delay the inevitable and make the outlook even worse.