Tax Law

To Hell With Tax Reform -- For Now

I hate to drag you away from your fascination with Herman Cain's 999 plan and Rick Perry's flat tax, but if we are going to make real progress, we can't fixate on every overhyped, half-baked tax slogan that comes along. Sooner or later we must get back to basics. Here's the main question: Should taxes be cut, raised, or reformed without changing overall revenue? The answer is that taxes should be cut in the short term, raised after we are clearly out of our cyclical downturn, and then reformed only after we have settled on the magnitude of tax increases needed for deficit reduction.

Step 1: Short-Term Tax Cuts

Though it has been three-and-a-half years since the economy began its tailspin, we still need stimulus. Throughout modern history, politicians have been notoriously -- and sometimes disastrously -- slow in implementing fiscal stimulus. But this downturn has been so deep and long that getting the timing right is no more difficult than stepping onto a department store escalator. The unemployment rate is 9.1 percent and is unlikely to get below 8 percent before 2013.

Even more to the point, there is a lot of excess capacity in the economy. The Congressional Budget Office estimates that the "output gap" -- the shortfall in aggregate demand relative to aggregate supply -- is about 5 percent of GDP (CBO, "Confronting the Nation's Fiscal Policy Challenges," Sept. 13, 2011). This estimate implies that government policies could increase demand by approximately $750 billion and still not crowd out aggregate private spending or increase inflation. The amount of stimulus needed depends on the multiplier effect. For example, a well-designed stimulus could have a multiplier of 2. That would mean $375 billion would be needed to close the output gap.

OK, you say, maybe there is need to increase demand. But that doesn't mean government policy can actually do it. After all, hardly a day passes that you don't hear that the Obama stimulus has been a complete flop. And doesn't our recent experience prove that stimulus doesn't work? You have been told wrong.....


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