Who Benefits if the Tax Cuts Are Extended?

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by: Zacks Investment Research

By Dirk van Dijk

One of the biggest topics on the agenda when Congress gets back from its summer vacation is going to be: What to do about the Bush Tax cuts that are going to expire. The GOP has argued that we need to keep all of them in place. The Obama administration has called for repealing them just for those that are making over $200,000 a year as individuals or $250,000 per year for couples.

The chart below (from Ezra Klein at The Washington Post) shows the relative size of the tax cuts that will happen under the two plans as opposed to simply following the existing law and letting all the tax cuts go to the great beyond. Relative to the existing law, everyone benefits (other than the U.S. Treasury) under both plans. Under both plans, the more money you make, the greater your tax cut. The difference is one of magnitudes, or in the case of the very rich, orders of magnitude. The rich benefit because the tax system works under a staircase principal. Even if you earn $1 million a year, your first $30,000 of income gets taxed at the same rate as the person who only earns $30,000 a year. The next layer of income is taxed at a higher rate, but not at the top marginal rate. It is not until you get to almost $400,000 a year in income that the next dollar in income is taxed at the highest rate.

If the GOP prevails, income over that level will be taxed at 35% per year. If current law stands, or what Obama has suggested of letting only the top two tax brackets move back to the Clinton era levels, that incremental income, will be taxed at 39.6%. As the chart below shows, that means that people making between $200,000 and $500,000 will on average be paying a total of $413 more in taxes in 2011.

Letting the top tax brackets return to the Clinton levels will cut the 2011 budget deficit by about $40 billion next year, and by almost $90 billion over the next two years. Would raising taxes on the wealthy be a form of anti stimulus? Yes, but so would any method of bringing down the deficit. However:

“CBO examined 11 options to stimulate growth and job creation and found that extending the 2001 and 2003 tax cuts in general came in last in effectiveness. CBO concluded that a job-creation tax credit, funds to help states balance their budgets with fewer cuts in services and tax increases, and extended unemployment insurance benefits would all generate more jobs and growth on a dollar-for-dollar basis." Read more here.

Furthermore, CBO indicated that extending the tax cuts for high-income households in particular would rate even lower in effectiveness than extending all of the tax cuts. This is because, as CBO explained, “higher-income households … would probably save [rather than spend] a larger fraction of their increase in after-tax income.” An economy in a recession or the early stages of a recovery needs more spending, not more saving.

In short, CBO found extending the tax cuts for high-income households to be the worst of all options under discussion for preserving or creating jobs and boosting economic growth while the economy is weak.”

Letting the Bush tax cuts expire, the way they were intended to when they were proposed by a GOP president, and passed by GOP controlled majorities in both houses of Congress, would do far more to address the long term structural budget deficits than almost any other step we could take. However, the middle class is already hurting badly, and the lower and working classes are outright suffering, so keeping the tax cuts for that 97% of the population makes sense, at least until the economy is back on its feet. Ideally we could have an overhaul of the tax system that simplified it by reducing the number of credits and deductions, and lower rates across the board. That however is a very tall order, and any overhaul of the tax system will attract lobbyists like flies too, ummm, sugar.

The main losers if we could accomplish that would be firms like H&R Block (NYSE:HRB), Jackson Hewitt (JTX) and Intuit (NASDAQ:INTU), while most of the economy would benefit. However, I would not hold my breath waiting for it to happen. The last time we made any progress in that direction was back in 1986, and that was on balance a tax raising bill.

Oh, and by the way, somehow the economy managed to survive the Clinton era tax rates under Clinton. Growth was much higher under those rates than it was under the lower Bush tax rates. The theory that cutting the top marginal tax rates is an effective way to spur economic growth is, at best, unproven.

Disclosure: None