Congress will have to steer carefully to avoid a shock to the economy as it strives to balance the budget by allowing tax cuts to expire in the next few years, economists say.
The biggest danger is the alternative minimum tax (AMT), which this year is scheduled to cut deeply into the pocketbooks of as many as 23 million upper-middle-income taxpayers unless Congress extends tax relief.
President Bush’s budget and the House and Senate spending plans rely on the expiration of AMT relief to achieve balance in the next five years. Mr. Bush’s budget provides a one-year fix of the tax, costing $36 billion this year, while providing extensions of his own tax cuts that expire in 2011.
House and Senate leaders put a priority on maintaining AMT relief for the middle class, but their budgets require offsets under pay-as-you-go rules reinstated this year.
Economists warn that ending tax cuts abruptly can damage the economy, which has been weakened by the housing downturn and has slowed with the end of business investment deductions that Congress provided at the end of 2005.
Economists support lawmakers’ goal of balancing the budget as baby boomers prepare to retire.
Federal Reserve Chairman Ben S. Bernanke emphasizes that this will require major trade-offs between taxes and spending. “Addressing the country’s fiscal problems will take persistence and a willingness to make difficult choices,” he has told Congress.
Republicans who favor low tax rates must recognize the need to increase spending cuts, he said, while Democrats who favor higher spending must realize that taxes must be raised and that the “adverse economic incentives associated with higher tax rates” could slow growth.
Economists expect congressional action to do little to set back the economy in the next few years, but some fear that a mishandling of expiring tax cuts combined with a collapsing housing market and imploding mortgage market would be damaging.
The Levy Economics Institute is worried about an economic jolt from expiration of the AMT relief. It estimates that by 2010, half of all taxpayers with incomes between $75,000 and $100,000 will be required to pay the tax unless Congress acts.
Institute President Dimitri B. Papadimitriou said the rising tax burden on the middle class could reverse consumer spending, especially when combined with rising energy prices, slow wage growth, slumping house prices and rapidly rising debt burdens.
“Debt-ridden consumers need tax relief,” he said, noting that tax burdens are scheduled to rise at a much faster pace than incomes or economic growth. In the past, rapid growth taxes as a percentage of the economy has preceded recessions, he said.
The AMT is ensnaring more taxpayers each year, partly because it is not indexed for inflation and because the Bush tax rate cuts have pushed more middle-income families into brackets that make them eligible for the tax.
Mr. Papadimitriou said AMT reform or elimination should be Congress’ first priority but that extending some of the Bush tax cuts scheduled to expire in 2011 would prevent a further drag on the economy.
Democratic leaders support an extension of the Bush tax cuts that help the middle class, including marriage-penalty relief, the 10 percent bracket, and adoption and child tax credits. To offset middle-class tax relief, they favor allowing expiration of rate cuts for upper-income taxpayers.
Studies show that economic growth accumulates over time from across-the-board rate cuts such as Mr. Bush’s. The Bush tax cuts, however, do not appear to have enticed more people into the work force.
Since the tax cuts were enacted in 2001 and 2003, participation in the labor force has declined dramatically. Economists are puzzled, but suspect a slowdown in immigration as a result of heightened restrictions after the September 11 terrorist attacks, the leading edge of baby boomers dropping out of the work force and a leveling-off of the number of women entering the labor force.
Tax cuts used to induce married women to work by enabling them to take home more of their pay. But a study sponsored by the National Bureau of Economic Research found that women’s attitudes toward work have shifted: Most see work as a necessity rather than an option.
“The potential for marginal tax rate cuts to increase the labor supply is much smaller now than 20 years ago,” said economist Francine Blau, one of the study’s authors.
Despite mixed evidence on the effects of the Bush tax, economists say, Congress should not allow them to expire all at once because the effect could be a $200 billion tax increase.
“Such a huge increase in tax revenue would have an enormous contractionary effect on the economy, likely precipitating a recession in 2011 or 2012,” said Roger M. Kubarych, economist with Unicredit Bank.
He also foresees problems with extending the tax cuts and offsetting them with 40 percent cuts in discretionary spending outside the Pentagon, as Mr. Bush proposes. He suggests a middle ground that accommodates the need for both spending and tax revenues.
Mr. Kubarych does not expect to see any permanent resolution of the tax expiration issues until after the 2008 presidential election.
David Wyss, an economist with Standard & Poor’s Corp., warns against deficit financing.
Extending the tax cuts and maintaining spending growth at the same rate as Congress has done since 2000 would result in “deficits of a size that present a threat to long-run economic growth,” he said.
Joseph Quinlan, chief market strategist with Bank of America Corp., agreed.
“In the end, the more the U.S. economy becomes debt-driven and debt-dependent, the greater the risks and subsequent adjustments down the road” for the economy, he said.