Time to Raise Taxes?

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Robert Rubin, Treasury secretary under President Clinton, recently told the Washington Economic Club that "you cannot solve this nation's fiscal problems without increased revenue." Oh, and in case you think that Rubin, a noted deficit hawk, might have been talking about imaginative ways to accelerate the economy–thus raking in more tax revenue–that's not quite what he had in mind. "I think if you were to increase taxes right now, you would have probably about zero negative effect on the economy," Rubin said in response to a question from the high-powered audience. Rubin didn't specify which taxes he was talking about, such as income taxes or capital-gains taxes or dividend taxes.

But raising taxes at this moment would be interesting timing. Each day, more and more economists are cutting their growth forecasts for the economy. And today's weaker-than-expected durable-goods reports–new orders plunged 8.3 percent last month–sure gave more ammo to the economic bears out there. Then there's the sharp drop in the U.S. dollar. A continued decline could be inflationary–by raising prices for imported goods–forcing the Fed to raise interest rates. The beleaguered housing industry would surely love that. And then throw a tax hike into the mix. Certainly a fascinating fiscal policy experiment, one that smells a bit like stagflation, right?

Or how about this: The economy continues to slow, and the Fed starts cutting rates next year. At the same time, the new Democrat-dominated Congress raises tax rates to pay for yet another temporary fix to the alternative minimum tax. (Dealing with the AMT is a big goal of incoming House Ways and Means Chairman Charles Rangel.) As economist Michael Darda of MKM Partners explains: "Higher tax rates on labor and capital would reduce after-tax returns to productive effort, which would slow the growth of output. If monetary policy were eased at the same time, the 'demand' for goods and services would be rising just as higher tax rates were reducing their supply." That also gives you stagflation.

To be fair to Rubin, he's not just talking about the current, rather skimpy, budget deficit but about the budget's massive long-term structural problems caused by runaway entitlement spending. Those fiscal challenges, he added, can't be eliminated "solely on expense reductions." But that's a political statement rather than an economic judgment. A plan put forward earlier this year by Sen. Robert Bennett, a Utah Republican, would bring the old-age program into balance–it's been certified by the Social Security's chief actuary–by doing three main things: 1) changing initial retirement benefits for the top two thirds of workers so that they grow in line with price growth rather than wage growth; 2) starting to increase the retirement age to 67 beginning in 2012 rather than 2022; and 3) after 2017, periodically lowering initial monthly benefits for future retirees to account for longer life spans.

Strong medicine? Sure. Even Bennett says that he's "under no illusion" that such a plan would pass. But cuts might be a less serious drag on the economy than higher taxes. As Donald Boudreaux, chairman of the economics department at George Mason University and coauthor of the Cafe Hayek blog, noted in this blog last week, large spending cuts "would signal less government meddling in the future and, also, the probability of further cuts in the future of explicit tax rates. The long-term benefits for the economy would be wonderful."