It was touch and go there for awhile. You could almost hear a collective sigh of relief when federal tax rates were extended for two more years.
In December, President Obama signed into law an extension of the 2010 federal income tax rates. For this year and next, the top federal income tax rate remains 35 percent, instead of 39.6 percent.
At the signing ceremony, the president said the tax bill “will grow our economy and will create jobs for the American people." It is easy to follow the president’s math.
Most small business owners file taxes under individual, rather than corporate, tax regulations and would have paid $46,000 more on every $1 million in income — easily enough to hire an additional worker. The new law also includes a one-year reduction in payroll taxes for workers and a one-year business investment tax credit.
Some have pointed to the passage of this tax bill as the reason holiday sales last month were better than expected. With less concern for higher taxes in 2011, consumers apparently spent more on Christmas 2010.
But what then should we expect for Christmas 2012?
If the permanent income hypothesis holds, the answer is nothing. This theory proposed and developed by Nobel laureate Milton Friedman states that consumers make consumption decisions based not on current income but on income expectations. Any short-term change in disposable income has little or no effect on the economy.
A related theory, known as Barro-Ricardo equivalence, suggests that the timing of tax changes does not affect the economy today. If reduced tax rates are not offset by spending cuts, the government must borrow more by selling bonds. The public buys up the new bonds and in so doing reduces current consumption.
Together, these two theories suggest the tax-rate extension will have no meaningful effect on the economy. The payroll tax reduction and investment tax credit may move some spending into this year from next, but higher taxes down the road remain a possibility.
To support economic growth and lower unemployment, public policy needs more permanence. An effort in that direction is the president’s announcement that tax reform is a priority for 2010. The 10,000 plus page U.S. Tax Code creates its own uncertainty.
Idaho also needs a simpler and more efficient tax code. According to a recent study from Good Jobs First Idaho, tax exemptions like that for production equipment and supplies sales cost millions annually. Suspending such tax breaks can broaden the tax base and keep total tax revenue the same even if tax rates were lowered.
Tax reform at the federal and state level will also improve what economists call the tax incidence, or how the burden of a tax is shared. For example, studies of the labor market show that workers, not businesses, bear most of the burden of payroll taxes.
Pushing off for two years the question of higher tax rates is meaningless. Unless all tax policy becomes clearer, the economic recovery will still be touch and go.
Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. His column, published weekly at IdahoStatesman.com, will appear here every other week. Reach him at prcrabb@NNU.edu.