Status Quo Bias and the Tax Deal

In an aside in my long post from yesterday, I asked: “Quick: which constitutes the status quo, a world in which the Bush-era tax cuts are extended, or a world in which they are allowed to expire?” The larger point in which this aside was embedded related to the problems with holding a status-quo-bias with respect to fiscal policy. It might seem rational, in the face of high uncertainty about the impact of policy changes, to be strongly biased in favor of the status quo. But all that does is push the debate about policy into a debate about what is the “status quo.” Is the status quo the state of current law? In that case, status-quo-bias should lead to the expiration of all the Bush-era tax cuts. Is the status quo the state of the law at this moment? Well, in that case status-quo-bias should lead to the extension of all of said tax cuts. Is the status quo a policy of counter-cyclical fiscal policy (deficit goes up in bad times, down in good times) with a baseline “neutral times” budget deficit of a percent or two of GDP? In that case, just how radical a departure from the status quo (if any) was the stimulus bill, given the depth of the recession? (The only thing I’m absolutely sure was not the status quo was that the Federal Government should run a balanced budget, either annually or over the course of an economic cycle.)

The most rational way to define the status quo is with respect to expectations – everybody expects the AMT to get patched, so if one time the AMT was not patched that would be perceived as a change, and an increase in taxes. As this National Review editorial supporting the GOP-Obama tax deal notes, expectations clearly solidified – well before this deal, even before the last Presidential election – around the notion that the overwhelming bulk of the Bush-era tax cuts were actually permanent. The baseline that the Democrats and Republicans both accepted as the “status quo” was not current law (expiration of all the tax cuts) but the law as currently applied (the tax cuts get extended).

As such, the Democrats were always negotiating from that baseline, and the right way to score the deal is by measuring how much change they got, and how important that change was to them. On that score, I think they should be reasonably pleased.

Raising taxes on incomes over $250,000 would have been emotionally satisfying; I doubt it would have had any material economic consequences one way or the other; and it would have made a small contribution to reducing the deficit. But that contribution would have been small; the effect on inequality would similarly have been small; and, most important, if it wouldn’t harm the economy, it also wouldn’t help.

By contrast, while one may doubt whether the payroll tax cut and extension of unemployment benefits will have any material long-term economic impact one way or the other, they should have an immediate positive impact on the economic circumstances of many individual people. Similarly for the business investment deduction: it may or may not boost overall economic growth over time, but it should help many individual businesses immediately.

Are those wins “worth it?” Well, relative to what? The answer must be: relative to seeing tax rates go up for everybody, and, in the wake of the inevitable public outcry, trying to wring a better tax-cut package from the new GOP congress. I’m skeptical that such a strategy would be effective, but even if you think the odds are better, I think you’d have to agree that the uncertainty, and the potential political downsides, are high, and what’s the upside?

I’m not belittling the budget problem. The budget problem is real. We’re not going to solve it without raising taxes on anyone. But we’re also not going to solve it without raising taxes on pretty much everyone – we can’t get where we need to be by raising taxes on incomes over $250,000 and estates over $5 million. As all the serious long-term budget-balancing plans make clear, getting to balance will require action on three fronts: raising revenue from some kind of broad-based tax increase (implementing a VAT or carbon tax, eliminating most of the value of big deductions like those for home mortgage interest or state income taxes, etc.), restraining the growth of entitlement spending (which really means restraining the growth in health-care costs), and scaling back the defense budget. The difference between “we can’t raise taxes on anybody but rich people” and “we can’t raise taxes on anybody” is definitely meaningful, but not in budgetary terms.

To make a difference in budgetary terms, we’ve got to put new, broad-based taxes on the table. So here’s a proposal for the new year: make the payroll tax cut permanent in exchange for the establishment of a new consumption-based tax – the latter not to take effect until 2013. The next two years should feel like a sales-tax holiday, pulling consumption forward, which supposedly is what we need, and the payroll tax cut would put money into people’s pockets to spend during that same period. Of course, businesses would plan for an expected slowdown as a consequence of the tax hike to come in 2013 – but any massaging of the business cycle would have that problem (which is why some argue it can’t be done). But the budgetary consequences of delaying implementation of such a tax for two years would be negligible over the long term, while laying down the marker that new, broad-based taxes are possible – and that we need to levy at least some of them on consumption rather than wages or income – would be worth far more than anything President Obama gave up in this deal.