Lately, the media has been dominated by the compromise on US federal tax policy that has been brokered by President Obama that will lead to an extension of current income tax rates, lower estate and payroll tax rates and an extension of unemployment benefits. It is very likely to pass almost intact and free up the logjam that has hampered this lame duck session of Congress.
From the point of view of a resident of Main Street, the economy is still ailing. Consumer demand is still off. A stubbornly high unemployment rate persists. Real estate values continue to drop in most markets and at best have settled in at levels not seen in nearly a decade. In general, it’s not a pretty picture.
On the other hand, business profits, productivity and cash (now sitting at about $2 Trillion) are up. And this has been reflected on Wall Street by a healthy rise in most major indices.
So the prescription for getting out of this funk is a familiar one: Low taxes leads to growth. Sometimes, though, conventional thinking can be dangerous.
From a purely economic theory point of view, there are really only three participants in the economy who can spur demand and ultimately growth: consumers, businesses or government (at all levels).
With consumer spending hampered by unemployment and nervousness about what assets, income and jobs that they may have, you can’t really expect consumers to be leading us to growth.
While businesses have the cash and the profits, they seem to be in wait-and-see mode “keeping their powder dry.”
So that leaves governments at the local, state and federal level. Unfortunately, most local and state governments don’t have the resources or the legal authority to continue deficit spending so that leaves us dependent on the federal purse to help spur the economy.
Tax Package as Stimulus
The tax package compromise as proposed is not perfect. Like any piece of legislation, it is a mash-up (though the versions seen on Glee are usually much more fun to watch). It certainly provides the potential for much-needed economic stimulus.
By putting cash in the pockets of the persistent unemployed, it will help keep households running and bolster their local economies when cash is circulated. By reducing payroll taxes on those who are working, it will also lead to direct spending in much the same way that the under-reported stealth “middle class tax cut” of 2010 did.
By patching the Alternative Minimum Tax (AMT) for another year, more than 21 million households were protected from an unexpected hike in their personal tax burden (estimated at around $3,000 to $5,000 for each family) which might have choked off funds available to circulate in the rest of the economy for goods and services.
The big question will be whether the upper income brackets will use their tax breaks on income and estate taxes to pump up the economy. Certainly, it could help with high-end consumer goods, vacation homes, and furnishings. But as much as these purchases will help jewelers, real estate agents, car salesmen and clothing retailers, there’s only so many shoes, watches, cars and homes that someone can consume.
Good Politics May Make for A Bad Economy Long-Term
But will this create jobs? How quickly can an expected $100,000 cut in income taxes for the richest 1% of Americans translate to business investment that creates jobs? And at the end of the day, does this potential added economic activity keep us on track for growth?
These are the kinds of questions that probably prompted credit analysts at Moody’s Investor Service, a credit rating company, to put out a cautionary note about the possible negative impact on federal finances with its ultimate impact on consumers.
From a purely political point of view, this may be a good deal. From a short-term economic stimulus point of view, it provides some benefits. In the long-term, though, there is a real risk that the nation’s strained finances will take a hit to its credit rating leading to higher borrowing costs for the government directly and for all consumers seeking credit as well.
The Rich (And The Government) Are Different
Why? Well, ask any mortgage borrower. When you have pristine credit, it’s easier to borrow money at the most favorable rates. Over the long-term, borrowing $200,000 at 6% will cost you more than borrowing the same amount at 4.5%.
On the other hand, when a borrower’s credit score is lower – even by a little – then the options available can dry up or cost more.
This is what may happen as we move forward and digest the impact of this tax plan. It ultimately is kicking the can down the road for others to deal with. The estimated price tag on the plan is between $700-billion and $900-billion to be added on top of a trillion-dollar plus federal deficit. And the proposals for cutting the deficit prompted much gnashing of teeth and proclamations of lines in the sand indicating that there is no likely easy compromise on their recommendations especially in a grid-locked Congress next term.
US Credit Score on Watch List
Is there an immediate problem? No. As long as we still have investors who are confident that they will get paid back on the money that they lend us through their purchase of our government’s debt. Unlike the mortgage borrower in my example, the government can vote to increase its credit limit and authorize the printing of cash. Not something that your typical consumer or state government can do.
And investor’s in the marketplace seem to be OK with that as seen by the cost of insuring against default through derivatives. An insurance contract to protect $13.-million worth of U.S. government debt currently costs €41,000 a year, according to data from credit-information firm Markit Group. That is down from €59,000 in February of this year, and far less than in early 2009, when it cost €100,000.
But this can turn on a dime. Ask those folks in Greece. They are painfully aware what can happen when investors and banks lose patience and pull the plug and the credit line.
Yes, Greece is not the US, which has the benefit of being the world’s reserve currency. But that should not lead us to complacency and hubris. We need more than conventional thinking and political party maneuvering. We need the kind of shared sacrifice that the Greatest Generation exhibited which won the peace in a global conflict and pulled us out of the other greatest global economic calamity of the last century.
Either we need to make the tough choices now while we can or we will be forced to pretty much at gunpoint down the road. That’s not a pretty picture nor a way to grow in the long-term.
Maybe we can get the folks from Glee to work on a musical mash-up of sorts that will make this happen.