As the Bush tax cuts are set to expire this year, there has been considerable debate about whether to extend them, and to whom. While President Obama vowed to repeal them for those making more than $250,000 a year, there is now growing dissension about that pledge within the Democratic Party. Budget Director Peter Orzag's latest piece in the New York Times may in fact embolden more centrist Democrats to abandon the President on this issue.
There are only a few possibilities. First, Democrats will allow all tax cuts (including those for the wealthy) to remain in effect for fear of being labeled "tax-and-spend liberals" in a tough election year. Everyone acknowledges the large cost to the tax cuts. Beyond the medium term fiscal impact ($200 billion to $350 billion a year from 2015 to 2020) though, people may come to permanently expect the lower rates. After paying Bush-era tax cuts for 15 years or more, people of all socioeconomic classes could well be up in arms when politicians try to raise taxes. To keep getting reelected, these same politicians will have every incentive to keep the cuts in place.
The only other way to close the deficit while keeping the tax cuts will be to dramatically reduce entitlement spending. But if politicians can't summon the courage to raise taxes, how will they then cut Medicare and Social Security when the recipients of those programs--the elderly--tend to be among the most active voters? Politicians will be left trying to make draconian cuts in programs like Medicaid and food stamps to make up the difference, but those programs won't yield enough savings to meaningfully close the gap.
Second, politicians could maintain the tax cuts for all but those making over $250,000 a year. But even that would have a great cost. And middle class tax payers would become accustomed to the Bush rates that they would balk at any raises. So the deficit will still remain quite large, and drastic savings will have to be found. Again, it is doubtful that politicians who won't raise taxes on the majority of voters will simultaneously decide to withhold entitlement benefits from them. Since there won't be enough savings from entitlement programs aimed at the poor, the only alternative left will be to raise taxes sharply on the wealthy--the same people who invest capital and start businesses.
Last but not least, politicians could show they really mean business about reducing the deficit and repeal all of the tax cuts. This would bring in a great deal of revenue, but at what cost? This is the worst downturn since the Great Depression, and major tax hikes now would take money out of the economy that could be invested, lent, or spent at a time when such action is sorely needed. In fact, raising taxes now might exacerbate the downturn which would only serve to diminish the amount of tax revenue coming in.
The solution to all of this is relatively straightforward, if hard to enact. We should freeze tax rates for the next five years, and then commit to raising them back to Clinton era levels or higher for the next five. This would allow businesses and investors to have certainty about what their tax liabilities will be for the next ten years and it would give the economy any stimulative effect that lower taxes would have. Since uncertainty is one reason that they continue to sit on so much capital without doing anything productive with it, providing certainty can only help. Doing this however would require both Democrats and Republicans to agree on a solution, and stick to it for the next ten years. Given the depth of partisan rancor right now, I don't see how that would happen.
Failing that sort of solution, there lies a paradox: If politicians can't work up the courage to raise at least some taxes, then America's deficit situation will fester until it has real economic consequences. If they do summon the courage, they might abort the economic recovery. Then again, perhaps the prospect of a lose-lose situation will give those same politicians the incentive to really get creative and put aside partisanship for the good of their country.