The economy needs investors to get back to investing. They have demurred out of fear of tax rate increases and a general uncertainty about the government's intentions. A short term (e.g., two year) extension, as the Administration, post-election, seems prepared to grant, will not work well. It is urgent to settle the Bush tax cuts as normative until at least after the next election, as our senior fellow, John Wohlstetter, points out in his Letter from Washington:
"The outlines of a compromise tax bill are being suggested by pols & pundits alike. Essentially, the compromise under consideration would permanently extend the Bush tax cuts for those below a certain income ceiling ($250K is Obama's number, $1M is Chuck Schumer's number), while extending the tax cuts for those above the ceiling for two years. GOP leaders may support this idea.
"Here is the trap: Tax cuts only increase incentives to invest if they are sufficiently long-term to induce investors to increase investment. Ideally the reductions would all be permanent, maximizing incentives to invest. Tax rebates (such as those signed by President Bush 43) do not change incentives, and thus to not stimulate economic activity. Permanent tax cuts (e.g., President Reagan's 1982 cut & the 1978 & 1998 capital gains tax cuts) increase government revenue (capital gains historically increase in the first year the new rates take effect).
"The Bush 43 tax cut ran for 7-1.2 years, sufficient to increase investment incentives so that by FY2007, the last pre-financial meltdown year, the deficit had shrunk to 1.2 percent of GDP (it is now ten times that figure)--even with a hugely costly war in Iraq.
"Where exactly between a one-year rebate & a seven-year tax cut the investment horizon becomes too short to alter investor attitudes is unclear. Intuitively, two years seems more like a rebate than a true cut. Three years might work, and would defer expiration of the cut until the first year of the next administration (Obama II or GOP I), rather than leave the choice to extend to a post-Presidential election lame duck session. Intuitively, three years seems a far better choice, both in terms of investor perception & legislative timing. GOP Leaders should push for this option, so that the richest investors see real incentives to invest more and thus create more jobs.
"Bottom Line. If the GOP result in the Senate was a disappointment, the GOP's statehouse & legislature sweep was far more important for the long-term political picture. It will enable the GOP to gain several House seats in time for 2012, via the 2011 reapportionment based on the 2010 Census. The GOP's huge majority in the House enables it to pass bills that embody the party's governing principles; nervous Senate Democrats might sign on in some cases. Obama will veto anything that he sees as threatening his major programs, but that sets up for the GOP issues for the 2012 election."
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