Tax Analysts Blog

Tax Hikes Are Coming, But When?

Posted on Jun 3, 2009

Shell-shocked by a recession that dealt a near death blow, the world’s economic leaders are puzzled about what to do next. To date, fiscal and monetary policy has been "on steroids." But everybody knows the economy can’t be artificially propped up forever. As Martin Wolf reminded us in today’s Financial Times:

"On one point all serious analysts agree: public debt cannot rise, relative to gross domestic product, without limit. To embark on fiscal stimulus in the short run, one must be credible in the long run."

The big disagreement is about timing. For fiscal and monetary policymakers the question is: when does long-run austerity replace short-run promiscuity?

For German Chancellor Angela Merkel the long run is now. Despite her leadership of the conservative party and an upcoming tight election, she is pulling back on her plans for a tax cut. And despite the long tradition of politicians keeping mum on monetary policy, she is calling for central banks to slam on the brakes.

The United States is another story. On his “fiscal sustainability” tour to China Treasury Secretary Geithner explained to the Chinese that the U.S. would tighten its belt, but not right away: "We are very committed to make sure that when recovery is established, that we go back to living within our means, that we bring our fiscal deficits down to a sustainable level, that we unwind and reverse these exceptional measures that we've taken in the financial sector," Geithner said in an interview with Chinese state television. And the Fed's willingness to continue expansionary monetary policy was voiced by Fed Vice Chairman Donald Kohn in a recent speech:

"In my view, the economy is only now beginning to show signs that it might be stabilizing, and the upturn, when it begins, is likely to be gradual amid the balance sheet repair of financial intermediaries and households. As a consequence, it probably will be some time before the [Federal Open Market Committee] will need to begin to raise its target for the federal funds rate."

Uncertainty is bad for business, but it serves as a protective smokescreen for politicians.The Obama Administration’s unofficial goal for federal deficits is “roughly” 3 percent of GDP. Making a half dozen unrealistic assumptions is only achievable under current projections in the year 2014, with deficits considerably larger both before and after. Because the fiscal and economic situation is so murky, the White House can get away with this--at least for now--despite its stated iron clad commitment to fiscal sustainability.

But dark deficits clouds are looming on the horizon. If you don't understand this, you cannot read the political landscape. For example, if healthcare reform has any chance of making it through Congress, it must be before Obama imposes new (yet to be disclosed) fiscal austerity measures. Otherwise revenue raisers and presidential political capital needed to pay for health will be diverted to deficit reduction. With the fiscal clock ticking and Obama's extending honeymoon someday coming to an end, advocates of healthcare reform are sensing it is now or never. That’s why Obama summoned Senate Democrats to the White House and told them to get moving. (And, by the way, he is now clearly signaling that he may backtrack on a major campaign theme and consider taxing employer-provided healthcare benefits.)

Sorry folks, unless something wonderful and unexpected happens, major tax increases are in America’s future. Here are three scenarios for the timing :

(1) Pre-election version. Interest rates and projected deficits rise faster than expected. Markets get jittery, China gets mad, and economic advisors are embarrassed. After getting too few practical revenue raising ideas from the Volcker Commission (at the end of 2009) for raising taxes on wealthy, corporations, and tax cheats, President Obama—similar to G.H.W. Bush in 1990—reneges on his no-tax-on-middle-class campaign pledge—and institutes a broad-based tax increase.

(2) Post-election version—with Obama. Obama manages to squeak through 2012 with favorable economic projections and Volcker Commission targeted tax hikes. The Chinese, preferring him to a Republican president, buy Treasuries at a rapid clip to keep interest rates low. After election Medicare and Social Security fiscal crises so long delayed are absolutely unavoidable and lame-duck Obama supports broad based tax hikes.

(3) Post -election version—without Obama. Despite promises from Obama that he will not raise taxes, the voters are not biting and refuse him re-election. Republican President—let’s call him Mitt—tries to adhere to his no-tax pledge. But after a couple of years of trying —like G.H.B. Bush in 1990—he cannot find politically acceptable spending cuts and must raise taxes.

Take your pick.

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