Economic Insights: Taxing Growth

Guest Contributer: Milton Ezrati, Partner, Sr. Economist & Market Strategist at Lord, Abbett & Co.

Any more taxes will likely contribute to a slowing of the economy’s recovery.

As the economy proceeds toward 2011, three forces will keep the recovery’s pace slow: 1) lingering financial and psychological scars from the 2008–09 crisis; 2) remaining debt overhangs, particularly in the household sector; and 3) prospects of higher taxes in 2011 and beyond, both what the government has planned and what it has threatened. This analysis focuses on the third of these influences, showing how much tax hikes alone will retard the pace of growth, though they probably will not stop the recovery altogether.

The government plans a fairly broad tax assault over the next few years. Actually, a broad assault will occur even of the government does nothing. The Bush tax cuts of 2001 and 2003 are all set to expire at the end of this year. If the president and Congress just sit on their hands, income taxes will rise across the board, from the lowest to the highest brackets, as will estate, capital gains, and dividend taxes. If the president gets his way, and that seems likely, Congress will extend the cuts for all but the two top brackets on wealthier Americans, allowing tax brackets to rise from their present levels of 35% and 33%, respectively, to 39.6% and 36%. Administration plans also would raise capital gains taxes, from 15% to 20%, and raise taxes on dividends, from 15% at present to the ordinary income tax rate on the wealthier Americans. The administration also will likely let the estate tax revert from zero this year to a rate of 55% on all inherited wealth of more than $1 million.

Other legislation already passed and signed into law, mostly in healthcare reform legislation, would add these taxes:

  • Starting in 2013, Medicare levies would extend their 3.8% charge from payrolls to unearned income in wealthier households, including income from dividends, interest, capital gains, annuities, and rents, but not tax-exempt interest or retirement accounts.
  • Also starting in 2013, a Medicare surtax of 0.9% would extend to all couples with annual incomes of more than $250,000 and singles with annual incomes above $200,000.
  • After 2012, medical expenses would have to exceed 10% of income to qualify for a tax deduction. Presently, the threshold is 7.5% of income. Seniors would have to wait until 2016 for this new rule to apply to them.
  • Fees also would apply to businesses that provide health plans that are too lavish or not generous enough. New rules would limit how much firms could provide on health care flexible spending accounts.
  • The law also will limit the amount small businesses can expense. Previously, they could write off as much as $250,000 on new equipment purchases. The new limit will drop to $25,000.

Much debate swirls around the economic effects of these imminent and delayed tax increases. It seems fairly clear, for instance, that investors will take what capital gains they can this coming December to avoid the higher taxes starting in 2011. The initial selling pressure will likely drive down stock prices in December, and likely pick them up again in January, as investors reestablish their portfolios. But a wild January effect aside, most agree that the heightened tax burdens will more fundamentally detract from the flow of spending and the general dynamism of the economy. Indeed, there is evidence that the retarding influence has already begun, as businesses, mostly small businesses, are resistant to hiring or any other sort of expansion until they can assess the new costs of doing business. Households, too, especially wealthier households, must already have restrained spending to set funds aside for future, higher tax obligations.

Probably the most straightforward way to assess all these effects would be to rely on the extensive research done on taxes by Christina Romer, who until very recently was President Obama’s own chairman of the Council of Economic Advisors. In a paper written with her economist husband, David Romer, they concluded that a “tax increase of 1% of GDP [gross domestic product] lowers real GDP by roughly 2–3%.” 1 Since the Congressional Budget Office (CBO) estimates next year’s tax hike at $115 billion and the White House projects 2011 GDP at $15.299 trillion, the increase amounts to some 0.8% of GDP, which, according to the Romers’ formula, would shave some 2.0 percentage points off the economy’s real growth rate. Though the longer haul offers more tax hikes, they are less dramatic, and so the drag on growth likely will dissipate slowly in the out years.

If, then, the typical recovery generates between 4.5–5 % real growth at this comparably early stage in the cycle, these tax hikes alone will likely hold growth closer to 2.75 %, quite apart from the other, growth-retarding influences operating in this recovery. Longer term, the additional tax hikes, largely in the healthcare reform legislation, would, according to CBO estimates, amount to $2–3 billion a year, which, again applying the Romers’ calculation, would shave another 0.1 percentage point off the economy’s real growth rate, keeping the long-term growth trend below the historical rate of 3.5% a year.

But the story does not end here, for the administration has also hinted at additional tax increases. And beyond what the president’s debt commission recommends, many states and cities will likely raise taxes and fees to address their budget needs. Of course, here, nothing is definite. On future state and local actions, there is at best only spotty information. On the federal side, there are rumors of a value-added tax (VAT). In such a levy (already heavily used in Europe), the government takes a portion of the value added at each stage of production. Even a small percentage, though, can raise huge amounts. In the U.S. economy, for instance, even a small 1.0% levy could raise more than $120 billion. But even that would, according to the Romers’ formula, slow for a while the economy’s growth rate trend of 3.5% to less than 1.0%, quite apart from any other retarding influences.

The VAT is far from certain, however. Such a tax would certainly face resistance from the 50 states, which, no doubt, will see it as an encroachment on their primary revenue source: sales taxes. The powerful elderly lobby would also resist the VAT. Having paid income taxes throughout their lives to build their retirement nest eggs, they certainly have no desire now to pay federal taxes again on what they consume. If, however, the prospect of a VAT is questionable, probabilities nonetheless suggest some additional taxes on top of those will cause a significant slowdown in the pace of growth. On this basis, it is hard to look for rapid growth any time for a long time, even if these tax burdens are not sufficient in themselves to push growth rates into negative territory.

1 Christina D. Romer and David H. Romer, “Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” working paper 13264, National Bureau of Economic Research, Cambridge, Massachusetts , July 2007.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision

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