Mankiw on the Bush Tax Cuts

12/31/2012 12:00:00 PM
Mankiw calls for congress to let all the Bush tax cuts expire:
"both sides have, from the very beginning, agreed on one point: Taxes on the middle class must not rise. But maybe it’s time to reconsider this premise. An unwavering commitment to keep middle-class taxes low could be one reason the political process has become so deeply dysfunctional....the current and future fiscal imbalances are too large to exempt 98 percent or more of the public from being part of the solution"
What's interesting is that this guy was the head of President Bush's council of economic advisors when many of the now-expiring tax cuts were enacted. Mankiw has a point--slightly higher taxes on the middle class won't destroy the economy. Just remember that most of our economy's highest growth years occurred back when tax rates were much higher on both the middle and upper classes. And frankly, the 1990s weren't so bad.

Id add that I'm very skeptical of the whole notion that recessions are bad times to raise marginal tax rates. I certainly won't claim that net increases in total taxes are expansionary in recessions, but it is quite plausible that in a liquidity trap a revenue-neutral increase in the marginal tax rates would be expansionary. If you take sticky-price New Keynesian models literally, that is actually one of the implications (intuitively, raising the marginal tax rate causes wages to rise, which produces inflation that lowers the real interest rate, increasing aggregate demand).

Perhaps what we need is not a plan that makes the middle-class tax cuts permanent, but one that phases out all the tax cuts slowly over the next decade. One way to do this would to let all the marginal tax rates return to the Clinton levels in 2013, but offset the revenues by increasing the standard deduction, that would be scheduled to decrease by increments--over the next decade. This has two distinct advantages: first, it should be expansionary if we really are in a liquidity trap (if we are not in a liquidity trap, then there is no particular reason to oppose raising taxes now instead of later) because it generates a bit of wage inflation. Second, the policy is progressive since everyone would get the same-sized increase in the deduction, representing a larger share of low incomes than high incomes.

I would go further to advocate eliminating all other forms of tax deductions, such as those for retirement plans, mortgage interest, and health insurance, and instead invest those revenues into a larger standard deduction. We should set the marginal income tax rates so that average revenues equals average expenditures, and manage cyclical fluctuations by adjusting the size of the standard deduction.