Let's say Barack Obama is elected our 44th president. And let's further assume that when he takes office, he faces an economy that is, at best, sluggish. Finally, let's assume he and an overwhelmingly Democratic Congress pass a tax-and-spending package similar to the one Obama is campaigning on. Will that help or hurt the economy? In today's Wall Street Journal, former Bush I economist Michael Boskin thinks it's the latter: "If the proposals espoused by candidate Obama ever became law, the American economy would suffer a serious setback." The key data paragraph is this:
The top 35% marginal income tax rate rises to 39.6%; adding the state income tax, the Medicare tax, the effect of the deduction phase-out and Mr. Obama's new Social Security tax (of up to 12.4%) increases the total combined marginal tax rate on additional labor earnings (or small business income) from 44.6% to a whopping 62.8%. People respond to what they get to keep after tax, which the Obama plan reduces from 55.4 cents on the dollar to 37.2 cents—a reduction of one-third in the after-tax wage!
A few observations:
1) When I have talked to Obama economic advisers—and it should be noted that the campaign has been fuzzy on all this—they have suggested to me an added Social Security tax of 2 to 6 percentage points, not 12.4, is likely. So it might not be as bad as Boskin suggests, though conceivably high-wage workers could face marginal rates on labor at levels not seen since the Jimmy Carter presidency. Plus, there are ideas floating around Congress about an income surtax on wealthier Americans.
2) Can higher taxes cause a recession? I sure think so, and so do others. Goldman Sachs, after running an economic model that assumed the Bush tax cuts disappear after 2010, found that in the first quarter of 2011, gross domestic product dropped a whopping 3 percentage points below what it would have been otherwise. "Absent a tailwind to growth from some other source," the analysis concludes, "this would almost surely mark the onset of a recession."
But wouldn't the Federal Reserve jump in and cut interest rates? The Goldman Sachs experiment assumes it would, to no avail. "In an effort to resuscitate demand, the Fed immediately cuts the federal funds rate, bringing it [2 ½ percentage points] below the status quo level over the next year and one-half.... Despite this, output growth remains well below trend over that period, putting downward pressure on inflation as slack in the economy increases."
3) I also think that Obama doesn't believe higher taxes hurt economic growth unless they rise to extreme levels, like top rates at 70 to 90 percent. That is certainly the belief of his economic confidant Austan Goolsbee and of Warren Buffett, another fellow Obama has consulted. All three might want to check out a recent paper by David and Christina Romer of the University of California-Berkeley that examined U.S. tax cuts since World War II. The study found that "tax increases appear to have a very large, sustained, and highly significant negative impact on output...[and] that tax cuts have very large and persistent positive output effects."
4) Wall Street matters. How the financial markets perceive government policy matters. A recent survey of 29 top economists by Reuters shows an overwhelming 21 of them think a McCain presidency would be better for the markets than an Obama presidency. If we take that as shorthand for investor sentiment, we could see further market selloffs because of fears that Obama will 1) hike taxes through the roof and 2) focus too much on "investment spending" rather than cutting the deficit. Indeed, Obama has stated he will not attempt to balance the budget anytime soon. The Romers' study shows this to be the worst possible economic combination.
5) Obama may be drawing the wrong lesson from the Clinton years. When President Clinton signed his big tax increase bill in August 1993, the economy had been expanding for nine consecutive quarters, more than two years, and was able to power through the negative economic impact of the hikes. In 2009, the United States might be just emerging from a nasty downturn, only to get hit by a tax increase.
6) The core of the Obama growth plan is public spending on energy and infrastructure. Here is what Obama economic adviser Jason Furman told me recently: "Creating jobs is at the center of almost every one of Barack Obama's economic policies. His energy plan would help to create up to 5 million green jobs through investments designed to help make sure that the next set of green industries that we know are coming happen right here in the United States." But the Broken Window Fallacy holds that such "investment" really involves shifting resources around with no net gain.