The Tax Cliff Is a Growth Killer


No matter what happens from now on, 2013 will be a very tough year.

The United States faces an economic collapse thanks to massive tax increases on Jan. 1, and continued deficit spending for years on end.

Keynesians worry about spending cuts and to some extent the expiration of the temporary 2% payroll tax cut. But the looming expiration of the Bush tax rate cuts along with new levies enacted as part of ObamaCare pose the greatest threat.

The breadth of what will hit the country is extraordinary. The top federal rate on personal income will increase to 39.6% from 35%, with an additional 0.9% increase in the payroll tax for Medicare. The highest federal rate on dividends will increase to 43.4% from 15%, and the tax rate on capital gains will increase to 23.8% from 15%.

The rates on capital income are rising because of the expiration of the Bush tax cuts, and a 3.8% tax on investment income for the highest earners enacted as part of ObamaCare. As happens almost every year, there is a large scheduled expansion of the Alternative Minimum Tax (AMT) to ever-lower levels of income. The highest estate tax rate is scheduled to rise to 55% from 35%, with the lifetime individual exemption dropping to $1 million from $5 million. Meanwhile, tax rates will rise in many states.

In all, federal tax increases total almost $500 billion (over 3% of GDP) per year on a static-revenue basis. And that’s not counting the $1 trillion, 10-year increase in excess spending over tax receipts in the ObamaCare legislation. Given that many of the new taxes are rate increases at the margin, they will affect incentives to earn additional income. Thus it is a certainty that we face a lower level of output in 2013.

The blunt reality is that we cannot have a prosperous economy when government is overspending, raising tax rates, printing too much money, overregulating and restricting the free flow of goods and services across national boundaries.

In the 1980s and ’90s, Ronald Reagan’s tax cuts and Bill Clinton’s spending cuts (as a percentage of GDP) and his 1997 cut in the capital gains tax rate propelled the economy to grow rapidly. We’re looking at the mirror image of that in years ahead—a situation in which the economy deteriorates more than it might otherwise.

There are a number of reasons for dwelling on the tax cut experience during the Reagan years. First, tax cuts were ostensibly less important to the economy of the early 1980s than the Obama tax increases are to today’s economy.

Before he became President Obama’s budget director, Peter Orszag once estimated the static revenue losses to the federal government of Reagan’s tax cuts at 2.1% of the nation’s GDP. The tax increases scheduled for Jan. 1 amount to more than 3% of current GDP on a static-revenue basis as scored by the Congressional Budget Office, the Heritage Foundation and others. Mr. Obama’s tax increases will do more harm to the economy than Reagan’s tax cuts helped the economy.

Second is how the contrast between the Reagan tax cuts and the looming increases of next year affect overall economic performance. In anticipation of the legislated tax increases, individuals and businesses have already and will continue to shift income and output from 2013, the higher tax year, into 2012, the lower tax year. This income shift has and will continue to make 2012 look a lot better than it should. But next year will be much worse.

Reagan’s 1981 tax bill phased in the income tax cuts, thus providing people incentives to postpone taxable income from 1981 and 1982 into 1983 and beyond.

For example, 1¼ percentage points of Reagan’s tax cut took effect on Jan. 1, 1981, with the full tax cut increasing to 10% on Jan. 1, 1982, and 20% on Jan. 1, 1983. It was not until that late date that the bulk of his tax cuts went into effect. Under Reagan, people had enormous incentives to defer income. In today’s situation, they have enormous incentives to accelerate income.

For 1981 and 1982, real GDP growth was pretty close to zero, 3% below its long-term average. Then, in the first quarter of 1983, annual quarter-on-quarter real GDP growth was 5.1%, second quarter growth was 9.3%, third quarter 8.1%, and fourth quarter over 8% again.

And the growth continued. In the first quarter of 1984, growth was 8%, second quarter 7.1%, third quarter 3.9%, and by the fourth quarter of 1984 it had fallen to a still respectable 3.3%. Under the current administration, scheduled tax increases have been delayed, thereby providing people with enormous incentives to accelerate income into 2012 from 2013 and beyond. As a result, growth from 2013 on will be below trend.

Even if the 2013 tax increases do not take effect as legislated under current law, a good portion of the income-shifting is already set in stone. Consider what happened in 2010.

We wrote extensively at the time about the impending negative impact of the scheduled expiration of the Bush tax cuts on Jan. 1, 2011. In the lame duck session, President Obama and Republicans reached a compromise solution to extend the Bush tax cuts through the end of 2012. While that compromise prevented a decline in the long-term growth of economic output, the damage from the scheduled tax-boundary effect was already locked in place.

The first half of 2010 saw real GDP growth at slightly less than 4% per year, and the second half stood at 2.3%. And then in the first half of 2011, real GDP growth dropped to less than 1%, and the second half of 2011 was still anemic at 2.2%.

Third, and finally, ObamaCare will (according to the Congressional Budget Office estimate in March) add more than $1 trillion to government spending over a 10-year period over and above revenue raised by the higher taxes and penalties embedded in that legislation. As Milton Friedman taught, government spending is taxation—and therefore increases in government spending are increases in taxes.

America is going to get socked by a triple whammy on output, employment and income. No matter what happens from now on, 2013 will be a very tough year.

Mr. Laffer, an economist, is president of Laffer Associates, where Mr. Scudder, a Chartered Financial Analyst, is chief operating officer.

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