resident Obama and lots of other people argue that allowing the Bush tax rates to expire will do no harm. After all, they argue, the 1990s economy performed pretty well with those tax rates so what’s the problem? Well, as Joel Harris points out, it wasn’t tax rates that determined economic growth in the 90s:
There is another major difference between the late 90s and now that I think has an even large effect. From 1995 to 2002 the dollar rose almost continuously and capital flowed to investments in the US. In fact, one reason we got excessive investment in the IT sector (i.e. the internet bubble) was that foreigners starting shipping capital here merely because the dollar was rising. The excess capital had to go somewhere and at the end it was going into anything that could remotely be defined as technology. Since then, the opposite has been the norm and the results are pretty plain. Tax rates are only one factor in the growth equation and not even close to the most important. If we let the Bush tax rates stay in place and continue to pursue policies that weaken the dollar, the results will be disappointing. If we let tax rates revert to Clinton levels and pursue policies that strengthen and then stabilize the dollar the results will be much better. Tax rates are not irrelevant but the dollar is much more important to capital formation and investment. Unfortunately, neither political party seems all that interested in the role of the dollar.
The story of the 1990s economy holds an important lesson for today’s tax debate, but it’s not the one the Administration intends by invoking it. While the Clinton-era expansion did indeed take place under higher tax taxes, it was largely due to crucial changes in IT production and investment that led to growth and once-in-a generation productivity gains. The lesson here is a basic but important one: the past doesn’t predict the future. If the Administration believes there are similar productivity gains on the horizon that will lift the U.S. economy out of its financial crisis-induced hangover, it should explicitly identify the source of these gains. Otherwise, the 1990s experience provides no guidance for what to do about the tax policy set to expire on January 1.