The White House has responded to the recent Ernst & Young study showing the negative economic impact of President Obama’s proposal to increase taxes on top small-business income earners. Boiled down, the White House raises six key points of disagreement. Here are those criticisms and our response.
1. The study assumes the revenues from the higher rates would be spent, but the President’s position is that the new revenues would be used for deficit reduction instead.
It is correct that the study assumes the money will be spent. That is the more reasonable assumption. The Administration is free to claim the money will be saved instead, but they have yet to show exactly how that would happen.
To the contrary, the Administration’s most recent budget submission called for more spending, not less. As scored by the Congressional Budget Office (CBO), the Administration’s budget called for an additional $1.1 trillion in spending over ten years compared to the CBO baseline. That’s approximately the same amount as the ten year revenue estimate from raising the top rates. Money is obviously fungible, but with the Administration’s FY 2013 budget calling for more spending, it is difficult for them to make a credible case that the money from these tax increases will be saved.
2. The study does not take into account the other tax policies promoted by the President.
This study is focused on the tax policies at the heart of the debate over extending some or all of the Bush tax cuts – whether or not to raise the top rates on individuals, pass-through businesses, and investors. It is not an analysis of the Administration’s entire budget or current wish list.
Moreover, the vision outlined by the Administration in their budget and in their response to the E&Y study is at odds with the basic concept of tax reform. Rather than lower rates and broaden the base, the Administration’s approach would do the opposite — raise marginal rates and narrow the base through a series of industry-specific tax deductions and credits. This approach is unlikely to generate long-term economic benefits
3. The study results have no bearing on the economic impact of higher rates in the short run.
The Ernst & Young study looks into the long-term harmful effects of raising marginal rates on businesses. What would happen if you raised the effective marginal tax rates on new business investment? Over time, Ernst & Young found that you’d see lower investment, lower wages, and fewer jobs.
The short-term effect of these pending policies has already been fully explored and the evidence is overwhelming that they will be harmful. In the spring, the CBO made clear that not addressing the fiscal cliff would push the economy into recession beginning next year.
The American Action Forum released a study that also explored the short term impact of not addressing the full fiscal cliff:
There are significant economic consequences to going over the fiscal cliff. Using conventional methods, we estimate that a 6 percentage point drop in GDP triggered by a jump off the fiscal cliff would increase unemployment by 2 percentage points, or to over 10 percent, resulting in an additional 2.8 million people unemployed, with large losses in California, Texas, Florida, and New York.
A recent New York Times article suggests the Fiscal Cliff is already having a material impact on hiring and investment:
With the economy having slowed in recent weeks, business leaders and policy makers are growing concerned that the tax increases and government spending cuts set to take effect at year’s end have already begun to cause companies to hold back on hiring and investments.
Economists say the magnitude of the effect remains unclear and the fiscal uncertainty is probably not the economy’s main problem, but is instead one of several factors — along with Europe’s troubles, the spike in oil prices this spring and a continuing hangover from the housing bubble — restraining growth.
“We think it’s an issue now, and it will be increasingly an issue in the second half of the year for people’s decisions,” Douglas W. Elmendorf, director of the nonpartisan Congressional Budget Office, said recently. He warned that the uncertainty could stifle gross domestic product growth by as much as 0.5 percent this year.
4. The President is calling for returning rates to where they were in the 1990s, when we saw robust economic growth, so the conclusions of the study are wrong.
That is not correct. Rates will not return to their levels in the 1990s. The Administration neglects the increase in the HI payroll tax and the creation of the new 3.8 percent tax on investment income used to fund health care reform. Moreover, the Administration ignores other material differences between now and the 1990s, including the end of the Cold War and the resulting Peace Dividend. Few observers would compare where we are now to where we were in 1993.
5. The study uses unrealistic assumptions, including an excessively high labor response rate to the higher taxes.
The White House cites a prior 2006 Treasury estimate on the economic impact of extending all the Bush tax cuts when they were initially set to expire in 2010. The White House says:
The authors’ unrealistic assumptions lead them to find a larger increase in long-run output and about twice as large an effect on employment over the long-run as the Bush Administration Treasury Department found when conducting a similar analysis of extending the high-income tax cuts.
In fact, the E&Y study and the preceding Treasury work found similar results and used similar labor response rates.
Treasury 2006 E&Y 2012
Output +1.1% -1.3%
A key difference, obviously, is that Treasury looked at the effect of extending lower tax rates while E&Y looked at the effect of raising them. Another key difference is the new 3.8 percent tax on investment income, plus the higher 3.8 percent Medicare payroll tax. These higher taxes were not part of the 2006 analysis since they didn’t’ exist then. They were created as part of health care reform and would be expected to increase the output and labor effects.
The White House claims the E&Y study uses a labor response rate that is not reasonable, but the labor supply elasticity of 0.4 used by the E&Y report is well within the range used in other dynamic models, especially for modeling changes for high income households.
For example, see the surveys by Browning, Hansen and Heckman (1999) and Keane (2010), and recent papers by Ziliak and Kniesner (1999, 2005) and Lee (2001). These papers estimate a labor supply elasticity used in these types of models for men that ranges between 0.0 and 0.5. The econometric literature has generally found larger labor supply responses for women compared to men. While there are few studies that measure the response for this group for these types of models, at least one study (Aaronson and French, 2002) suggest this value is believed to be around 1.
6. The study cannot be trusted because it was supported by pro-business groups.
Ernst & Young is a respected and objective accounting firm and conducted its research without the input or influence of NFIB or other groups. The economic modeling and data was produced by respected researchers Dr. Robert Carroll and Gerald Prante. Any suggestion that the data is false, fabricated or tailored to specific outcomes is completely baseless.
Bottom Line: The assumptions made by E&Y were reasonable and well within the mainstream of the economic literature.