Will Republicans Really Block Tax Cuts Because They Go Only to Earners Below $250K?

President Obama proposes allowing the Bush tax cuts to expire next year — as they are scheduled to do if nothing is changed — for those earning more than $250,000, but changing the law so as to extend the tax cuts for those earning less than that amount.   Republican politicians are opposing the proposal.    I don’t understand what they are thinking.  Their position doesn’t make sense to me, regardless whether they are thinking about short-term stimulus, long-term fiscal conservatism, good economics, or even pure politics.   

Start with the pure politics.   What is the end-game?   Are congressional Republicans prepared to block the Obama proposal extending the tax cuts for those making less than $250,000 and to let them expire as in the original legislation proposed by President Bush and passed by the Congress in 2001-03?   More than 95 % of Americans make less than $250,000.   Their taxes will go up on January 1 as a direct result if Republicans block the Obama proposal.  How are they going to explain their position to the voters when the current law takes effect?    Will it be: “To address budget deficits we need to let taxes go up on most Americans”?   That doesn’t sound like them.   Or: “Minimizing taxes for the rich is so important that we are willing to let taxes go up on everyone else”?     When it comes down to the wire, surely they would have to back down.  So why aren’t they thinking ahead?  

The same goes for the estate tax, which under the original Bush legislation is scheduled in January 2011 to bounce back from oblivion (beneficiaries of any rich people who die in 2010 don’t have to pay a dime of tax) to the old system of taxing estates worth over a million dollars at 45%.  The White House proposal is to exempt in future years all estates under $ 3 ½ million, $7 million for couples, and to tax only the largest estates.  If the Republicans are going to continue to oppose Obama, how are they going to explain this to the electorate?   That the only benefits that matter are those for the tiny minority of super-rich?

Now let’s move to economics.  If you were going after stimulus because the recovery is still weak, and if you believed that only tax cuts created stimulus, the priority should be in other areas like extending the Making Work Pay provisions for low-income workers, which are also set to expire.   This proposition holds regardless whether
(i) your idea of stimulus is Keynesian demand expansion (the lower-income workers have a higher marginal propensity to consume), OR even if
(ii) your idea of stimulus is purely enhanced incentives to work.  (Lower income workers face overall effective marginal tax rates that are often higher than the rich face, when one factors in payroll taxes, etc.)    Alec Phillips of GS US Global ECS Research points out that the amount of revenue (and stimulus) that is at stake in the expiration of Making Work Pay is greater than in the expiration of tax cuts for those over $250,000, and yet the latter question is getting all the attention and the former question is getting no attention.

Fixing the Alternative Minimum Tax is another sensible policy that qualifies as a tax cut relative to existing legislation, and should be part of any fiscal package.

If we want to achieve short-term fiscal stimulus from the viewpoint of good economics, then we should realize that well-chosen spending programs give far more bang-for-the-buck than most tax cuts.   (”Bang for the buck” means a high ratio of short-term fiscal stimulus to long-term damage to the national debt.  It’s the opposite of how the Bush fiscal program was designed in 2001-03.)    Examples of well-chosen spending programs include aid to the states (which Republican congressmen have been voting down) so that the hard-pressed states don’t have to lay off firemen, policemen, bus drivers, teachers and road workers.     Examples of tax cuts with much less bang for the buck include not just those for the rich (e.g., the abolition of the estate tax), but even garden-variety income tax cuts, because they are partly saved.    Don’t take my word for it.   Martin Feldstein (whose work on taxes and incentives led to the supply side revolution, and who was the Chairman of Reagan’s Council of Economic Advisers) argues that almost all of the income tax cut that was passed n response to the recession in 2008 was saved by households rather than spent, and predictably so, and that government spending would bring more short-term stimulus.

Of course good economics would mean not just short-term fiscal stimulus, but equal emphasis on measures to bring the budget deficit under control in the long run.   The best proposals are the least popular, as so often.   Fixing social security would be a huge step toward long-term fiscal responsibility, without endangering the current recovery.   A good package would combine all these measures. 

Reserves and Other Early Warning Indicators Predict Crises After All

With aftershocks of the recent global financial earthquake still being felt in some parts of the world, it would be useful to have a set of Early Warning Indicators to tell us what countries are most vulnerable.    Nobody should be surprised that it is hard to forecast crises with high reliability;    low-risk opportunities for profits are never easy to find.   Thus it is especially hard to predict the timing of a crisis.  Some economists, however, are skeptical that Early Warning Indicators (EWIs) have any useful predictive ability at all.  A common assessment is that EWIs have failed, in the sense that in each historical round of emerging market crises (1982, 1994-2001, 2008) those particular variables that appeared statistically significant in that round did not perform well in the subsequent round.   This is not the right conclusion.

In a recent NBER working paper (featured in a ReutersTV interview today), George Saravelos and I began by examining more than eighty contributions to the pre-2008 literature on EWIs.   The table below reports which variables were most often found to have performed consistently well in predicting crises in the past.   Among 17 categories of indicators, the level of international reserves and  exchange rate overvaluation stand out by far as the two most useful leading indicators.  These results hold across different crisis episodes stretching from the 1950s to the early 2000s, even though different authors have defined “crisis” and “useful” in different ways.

The 2008-09 financial crisis

The recent global financial crisis was in a sense a perfect experiment for testing the performance of EWIs, because it originated in a shock that was exogenous to the smaller countries of the world.    It hit everyone at the same time, so we don’t have to worry about the issue of timing.  We can focus on what economic variables indicate vulnerability to such a shock.

To summarize the findings in our paper, the EWIs from the pre-2008 literature do relatively well in predicting which countries got hit in 2008-09, and the indicator that was found to be the top performer in past crises was also the top performer this time:   foreign exchange reserve holdings, especially expressed relative to a denominator such as debt.

Other economists have not gotten such strong results.   The first wave of analysis of the global crisis — by top scholars including Blanchard, Obstfeld, and Rose — found that few, if any, indicators were useful in explaining which countries got hit the most.(See references below.)   Why do we get stronger results?   These papers necessarily defined the crisis period as the year 2008; they lacked data on 2009 at the time when they were written.   We define the global crisis as beginning in earnest in the latter part of 2008.  (Recall that the failure of Lehman Brothers came in September.)  We extend the period under consideration through early 2009, because many aspects of global financial markets and the real economy did not begin to recover until the 2nd quarter of that year.   We believe that the difference in the period that is defined to be the crisis is the reason for the difference in results.

The table below summarizes our results.  Each column represents another criterion for gauging the severity of the 2008-09 crisis in a particular country.  We consider a country to have suffered more from the crisis if it experienced larger output drops, bigger stock market falls, loss in demand for its currency, or a need for access to IMF funds.   We regressed each of these dependent variables against the list of useful EWIs indentified in our literature review.  A darker color in the figure indicates greater statistical significance for that indicator.

We controlled for GDP per capita, allowing us to mix high-income and low-income countries in the same data set.   The last three years have featured a historic role reversal in which some “advanced countries” were badly hit (Iceland, Greece, and others on the periphery of Europe) while some big emerging markets” did much better (China, Brazil, Indonesia and others).

What works?

At the top of the list is central bank reserves.   We find that the level of reserves in 2007 was a statistically significant predictor of crisis incidence in 2008-09.   The best-performing of the reserve measures expresses them relative to short-term debt.   This is consistent with earlier findings, including the Guidotti Rule that tells emerging market central banks to hold reserves equal to at least the amount of debt maturing within one year.

Next on our list is overvaluation measured by past movements in the real effective exchange rate (REER). It is statistically significant in predicting devaluation, exchange market pressure and access to IMF stand-by arrangement programs.    A few of the other leading indicators stand out as well.  A higher current account balance or level of national savings is associated with lower crisis intensity. Other variables with some explanatory power but less consistently useful across different measures include the level of external debt, its composition (e.g. short-term vs. long-term), and the extent of Foreign Direct Investment (FDI).  Broadly speaking, many Eastern European countries suffered in the crisis for these reasons, while most Asian countries did much better.

We conclude that early warning exercises can indeed be a useful tool for assessing future vulnerabilities.   The same variable that topped the list of indicators in the earlier literature, central bank reserves, also worked the best in predicting who got hit in the 2008-09 crisis.

Click here for .pdf enlargement of the table below

[A slightly longer version of this summary appears on Vox.]

Berkmen, Pelin, et. al., 2009, “The Global Financial Crisis: Explaining Cross-Country Differences in the Output Impact,” IMF Working Papers 09/280.

Blanchard, Olivier, Hamid Faruqee, and Vladimir Klyuev, 2009, “Did Foreign Reserves Help Weather the Crisis.”

Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor, 2009, “Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008,” American Economic Review, 99, no.2, May, 480-86;   and 2010, “Financial Stability, the Trilemma, and International Reserves.” Amer. Ec. Journal: Macroeconomics.

Rose, Andrew, and Mark Spiegel, 2009a, “The Causes and Consequences of the 2008 Crisis: Early Warning,” Global Journal of Economics, forthcoming;   and 2009b, “The Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure,” Pacific Economic Review, forthcoming.

Guidotti, Pablo, 2003, in Gonzalez, Corbo, Krueger, and Tornell, eds., Latin American Macroeconomic Reforms: The Second Stage.