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Let the Tax Cuts Expire—Yes, All of Them

It’s been clear for a while that President Obama has all the leverage in the tax debate. Now it’s clear the Republicans know it.

On Friday, Obama met with congressional leaders for the first time since his reelection. The subject of discussion was how to handle the tax hikes and automatic spending cuts set to take effect on January 1. House Speaker John Boehner came with a proposal: Instead of racing to craft an alternative package before the new year, Boehner suggested, why not just pass a bill preserving the status quo for six more months, giving everybody a chance to work out a deal? But nobody expects Obama to go for it, unless Republicans agree to a deal on taxes that's largely to Obama’s liking. A senior Democratic aide on Capitol Hill thinks he sees a game of Texas hold 'em underway, with Obama winning: 

My read is that the Republicans are playing poker with the President. The Republicans know they have a 2-7 unsuited, and the President has pocket aces. The Republicans want to see the flop, and are limping in. But they know the odds are against them. As long as the President doesn’t fold, he wins.

That's how most people seem to read the situation. But what exactly will Obama win? And what should he be trying to win?

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Republicans want all the Bush tax cuts to become permanent, while Obama wants the tax cuts on household incomes over $250,000 to lapse. Obama has the right idea. The long-term goal of our fiscal policy should be to reduce deficits, so that public debt is not growing as a proportion of the economy. That’s not possible without raising taxes, and the place to start is on high incomes, effectively returning those rates to what they were during the Clinton era. Restoration of those rates on high incomes would affect only the wealthiest Americans, who are most able to afford it. And it would not harm the economy, according to the best evidence out there.

Unfortunately, raising taxes on the wealthy will probably not be sufficient to solve our fiscal problems. If we are serious about living up to our financial commitments—in particular, the guarantees of financial security in retirement and provision of basic health care to all—then eventually we will need more revenue. There are lots of ways to do this. The ideal would probably be a carbon tax, because it would have the virtue of raising revenue and slowing global warming. There's also a case for some kind of consumption tax, which economists tend to think is more efficient than income taxes. But since neither option seems to be viable right now, the next best thing might be to let all of the Bush tax cuts expire, so that everybody—not just the wealthy—go back to paying what they did during the Clinton era.

But wouldn’t raising taxes on the middle class slow the economy? Yes, if the rates went up right away. In fact, one of the most worrisome elements of the fiscal debate right now is that deficit reduction has so much focus. As the economist Peter Diamond has said, Washington is acting like we have a debt crisis and an unemployment problem, when the opposite is true: We have a debt problem and an unemployment crisis. Diamond’s point—which Paul Krugman made in the New York Times recently—is that we should concentrate on bolstering the job market now, while working to stabilize federal finances for the future. The former ideally would involve putting more money into the pockets of the poor and middle class, who are most likely to spend it. Raising taxes on the middle class immediately would, of course, have the opposite effect.

That's why a better approach might be to preserve tax breaks on incomes up to $250,000, and to renew anti-recessionary programs like extended unemployment insurance and a payroll tax holiday, but only on a temporary basis. And rather than setting these measures to expire on a fixed date, Congress could try an idea economist Peter Orszag has floated: Setting these tax cuts to expire when, and only when, the economy had become stronger. For example, Congress could declare that the tax cuts stay in place until four consecutive months of unemployment below 6 percent, at which point they would slowly phase out. Or Congress could set the tax cuts to expire based on some other indicator, like the employment-to-population ratio, or a combination of several.

Maybe this sort of arrangement is impractical, as policy or politics. (As far as I can tell, nobody has fully worked through the logistics.) And maybe the most important goal, for now, is simply breaking the ironclad Republican opposition to any new taxes. Obama seems well on his way to achieving that. But among mainstream economists there seems to be a lot of enthusiasm, and maybe even a consensus, for the idea of there being stimulus now, and deficit reduction later. In theory, that's exactly what this sort of plan would achieve.