The Senate restarted debate on the small business bill last night. Majority Leader Reid called the bill back up and filed cloture on a new version. Among other changes, the bill now includes an agricultural disaster relief funding provision, and the small business lending provision which received 60 votes last week.

The good news for the business community is that the core of business-friendly tax provisions remains intact, including the bonus depreciation and the shorter, five-year holding period for built-in gains.

The holdup in recent weeks has been a demand by Minority Leader McConnell that Senator Reid allow several Republican amendments to be offered, including efforts to possibly extend the R&D tax credit and repeal the IRS Form 1099 reporting requirement for business purchases above $600. The latter is yet another stealth provision from the health care bill that doesn’t take effect until 2012, but already has the business community in an uproar.

The cloture vote on the Reid bill is set for Thursday, but if they reach a deal on the process for amendments, we could see votes earlier. With the House leaving for August at the end of the week, options there appear limited. If the Senate acts before Friday, the House may take up the Senate’s version, pass it intact and send it to the President. Otherwise, we expect the issue to be resolved in September.


An Old Argument Revisited

A Washington Post editorial today reiterates the old argument that any fiscal stimulus, including tax relief, should be targeted at low- and middle-income Americans because they have a higher propensity to consume. According to the Post:

Analyzing the best bang for the buck policies to stimulate the economy, the Congressional Budget Office found that the least effective was extending tax cuts for the top brackets. The reason is obvious. “The higher-income households’ would probably save a larger fraction of their increase in after-tax income,” the CBO said.

The “poor people are more likely to consume” argument has been a staple of progressive fiscal policy since Keynes, and our understanding of it goes like this: $1 of tax relief for a low-income American (in the form of a refundable credit since low-income Americans donb�t pay income taxes) would result in around $1 of consumption and add directly to the GDP; whereas $1 of tax relief for a high-income American would only result in 50 cents of consumption, and thus result in less fiscal stimulus.

A couple of challenges exist to this argument. First, overall consumption doesn’t make up as much of the economy as commonly thought. As recently appointed the head of the Tax Policy Center Donald Marron points out, correctly calculated, it’s more like 60 percent, which means that 40 percent of our economy stems from savings and investment.

Second, the savings and investment necessary to pay for the stimulus appears to be extremely sensitive to tax rates and after-tax returns. The President’s chief economist Christina Romer penned an article with her economist husband for the American Economic Review last month. Here’s the summary:

This paper investigates the impact of tax changes on economic activity. We use the narrative record, such as presidential speeches and Congressional reports, to identify the size, timing, and principal motivation for all major postwar tax policy actions. This analysis allows us to separate legislated changes into those taken for reasons related to prospective economic conditions and those taken for more exogenous reasons. The behavior of output following these more exogenous changes indicates that tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes.

And the meat of their conclusion:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent. Our many robustness checks for the most part point to a slightly smaller decline, but one that is still typically over 2.5 percent. In addition, we find that the output effects of tax changes are much more closely tied to the actual changes in taxes than to news about future.

So the bang-for-the-buck argument that fiscal stimulus encourages consumption is overstated, while we’ve been underestimating the cost of eventually paying for the stimulus by raising tax rates. These are conclusions most small business owners already know from personal experience, but it’s nice to know the economics world is catching up. Unfortunately, with massive tax hikes on the horizon, we may all experience the theory in short order.

More on the Expiring Tax Relief

Our friends at the Tax Policy Center have an entire webpage devoted to the pending expiration of the 2001 and 2003 tax relief provisions, which strikes us as appropriate. It’s looming over the fiscal policy landscape at the moment. There are only 23 legislative days remaining until Congress recesses for the election and still no plan. Here’s their synopsis of the issue:

Which income tax provisions will change?

  • The 10 percent tax bracket will disappear and the 25 percent, 28, percent, 33 percent, and 35 percent rates will revert to 28 percent, 31 percent, 36 percent, and 39.6 percent respectively.
  • The phaseout of personal exemptions and limit on itemized deductions will return for high-income taxpayers.
  • The standard deduction and the width of the 15 percent tax bracket for married couples filing jointly will both shrink from twice that for single filers to 1.67 times as large.
  • Dividends will be taxed at regular tax rates rather than at the lower long-term capital gains rates.
  • Long-term capital gains tax rates will increase from 0 percent to 10 percent for taxpayers in the 15 percent bracket and below and from 15 percent to 20 percent for filers in higher tax brackets.
  • The child credit will be halved to $500 and become largely non-refundable.
  • The child and dependent care credit and the earned income credit will be pared back.

How will the income tax changes affect revenues?

  • Compared with 2010 law, income tax revenues will increase $240 billion in 2011 and by $3.4 trillion over the 2011-2020 decade.

So, if Congress does nothing, taxes are set to go up by $240 billion next year. That might impact people’s behavior, don’t you think? So might the added threat of the 3.8 percent tax on investment income pending for 2013. Something for policymakers to ponder over the August break.