Tax cuts are the way to nudge capital toward productive uses.

By ALBERTO ALESINA and LUIGI ZINGALES

Wall Street Journal - link

In virtually all economics classes, including those taught by the many excellent economists on the Obama team, the idea of government spending as an engine for growth is not a popular topic. Yet despite their skepticism of Keynesianism in the classroom, when it comes to public policy, these economists happily endorse a large stimulus package that could bring our deficit to 10% of GDP. Why?

One explanation is that these economists think this recession is an extraordinary one. In normal recessions — the argument goes — an increase in discretionary government spending is unnecessary and even counterproductive. But in the event that a recession becomes a depression, a Keynesian stimulus package might work.

There are certainly economic models that show how government spending can shift the economy from a bad equilibrium (where people do not search for jobs because they do not expect to find them, and firms do not invest because they do not expect to sell), to a good equilibrium (where people search for jobs, and firms invest and generate demand for their goods).

But this particular recession is unique not in its dimensions, but in its sources. First, it is the result of a financial crisis that severely affected stock-market valuations. The bad equilibrium did not originate in the labor market, but in the credit market, where investors are reluctant to lend to risky firms. This reluctance is making it difficult for these firms to refinance their debt, forcing them to default on their credit, further validating investors’ fear. Thus, the problem is how to increase investors’ willingness to take risk. It’s unclear how the proposed stimulus package would help inspire investors to do so.

The second reason this recession is unusual is that it was caused in large part by a significant current-account imbalance due to the low savings rate of Americans (families and government). Even assuming that more public spending would increase private consumption — a big if — such a measure would cause even more imbalance.

So how do we stimulate the economy without increasing the already large current-account deficit? It’s not easy, but here is an idea: Create the incentive for people to take more risk and move their savings from government bonds to risky assets. There is no better way to encourage this than a temporary elimination of the capital-gains tax for all the investments begun during 2009 and held for at least two years.

If we fear this is not enough, we can temporarily increase the size of the capital loss that is deductible against ordinary income. This will reduce the downside of new investments and increase the upside.

More savings need to be invested, and firms need an incentive to invest in order to help aggregate demand in the short term and promote long-term growth. The best way to do this is to make all capital expenditures and research and development investments done in 2009 fully tax deductible in the current fiscal year.

A large temporary tax incentive may be just enough to jolt investors from their current paralysis to take action. Such a switch will also be fueled by the temporary capital-gains tax cut mentioned above, which will motivate people to move their savings from money-market funds to stocks, increasing valuations, investments and confidence.

Many are concerned about what we can do to help the poor weather this crisis. Unlike during the Great Depression, we have an unemployment subsidy that protects the poor from the most severe consequences of this recession. If we want to further protect them, it is better to extend this unemployment subsidy than to invest in hasty public projects. Furthermore, tax cuts have a much better effect on job creation than highway rehabilitation.

No doubt, it is much easier to sell the public and Congress a plan for more public works than tax cuts, particularly while Main Street despises Wall Street — with some good reason. But the role of a good economic team is to courageously propose the right economic policy, even when it is unpopular. The role of a president is to sell it politically, as real change we can believe in.

Mr. Alesina is a professor of economics at Harvard. Mr. Zingales is a professor of finance at the Chicago Booth School of Business.

Today, the bottom 50 percent of US taxpayers pays a total of $30.6 billion in federal income taxes on a combined income of about $1 trillion. So about 3 percent of all federal income-tax payments come from the poorest half of the country. (The top 1 percent pays 40 percent; the top 25 percent pay 85 percent of the federal income tax.)

In 1980, the bottom 50 percent of the nation paid 7 percent of the national tax bill, after refund and credits. It now pays 3 percent; under Obama’s plan, it would pay less than nothing (that is, it would net a profit from the IRS). In 1980, the top 1 percent paid 19 percent of the income-tax burden; now it’s 40 percent. Taxes have become the province only of the rich.

From TYRANNY OF THE TAX-EXEMPT

New York Post - Link to original article

By DICK MORRIS & EILEEN MCGANN

January 6, 2009 

IT now looks like half of President-elect Barack Obama’s stimulus package will take the form of “tax cuts” for 95 percent of all Americans. Yet this wouldn’t so much boost the economy as trigger a massive, unhealthy shift in American politics.

Under Obama’s plan, the majority of American voters would pay no federal income taxes, but would get money from the government instead. That is, these “refundable tax credits” are basically welfare checks - and Obama’s plan would leave the most of us collecting, not paying.

A $200 billion giveaway won’t do much to get a $14 trillion economy rolling again. But the plan would leave any future taxpayer revolt no hope of majority support.

Today, the bottom 50 percent of US taxpayers pays a total of $30.6 billion in federal income taxes on a combined income of about $1 trillion. So about 3 percent of all federal income-tax payments come from the poorest half of the country. (The top 1 percent pays 40 percent; the top 25 percent pay 85 percent of the federal income tax.)

Obama’s plan - he’d give all couples a $1,000 refundable tax credit and all single people $500 - would funnel more than $50 billion to the lowest half of the country, thereby completely wiping out their total federal tax liability. In most cases, it would trigger a “refund” welfare check.

In one stroke, this would transform the majority of voters from taxpayers into tax eaters - and leave an increasingly small minority to pay the bill. Whether or not this is good economics, it is very dangerous politics.

Essentially, it would put those who actually pay the taxes that fund our government into much the same situation as landlords in New York City - hopelessly outvoted by their tenants, who use their political clout to limit rents and landlords’ profits.

Since Ronald Reagan, the anti-tax movement has been based on a blue-collar revolt against high taxes; it would lose that constituency under the Obama plan. Taxpayers would be politically helpless and the tax-eating majority would have free reign to impose any levies it wished.

Almost all of the 68 million tax filers in the country’s bottom economic half would get a check from Washington at tax time. Some would be among the 22 million who get money from the Earned Income Tax Credit (EITC). Others would get a $500 check through the (Bush-passed) Child Tax Credit - and all would get funds through the new Obama tax credit.

Welfare would no longer be only for the poor - the majority of the voters would depend on government handouts. This very system is what makes European social democracies so resistant to change.

In 1980, the bottom 50 percent of the nation paid 7 percent of the national tax bill, after refund and credits. It now pays 3 percent; under Obama’s plan, it would pay less than nothing (that is, it would net a profit from the IRS). In 1980, the top 1 percent paid 19 percent of the income-tax burden; now it’s 40 percent. Taxes have become the province only of the rich.

Of course, the shift in tax burden also mirrors the incredible increase in incomes of the wealthy in the last 30 years - the top 1 percent earned only 8 percent of the total national income in 1980; now it earns 22 percent. And the poorest half has seen its share of national income fall from 17 percent in 1980 to only 12.5 percent today.

So it is both fair and sensible to give the poor a tax break and to draw the bulk of federal revenues from the rich. But to exempt the bottom half - a majority of the voters - from paying any taxes and to award them refund checks instead would dangerously alter the fundamental balance of national politics. For the economically well off, it could effectively become taxation without representation - which, as the founders of our nation warned, leads to tyranny.