12/02/2010 01:07 pm ET Updated May 25, 2011

Let the Tax Cuts Expire

Compromise means nobody gets everything they want, and everybody puts up with something they don't want. So here is a potential compromise: just let the Bush era tax cuts expire. Nothing could be easier to implement. All Congress has to do is to do what it does best: bicker and delay. Time will pass, and come midnight, December 31, 2010, the tax cuts will expire as the ball drops in Times Square.

In a prior post, I showed how spending shifts by individuals would mitigate the consequences of slightly higher marginal tax rates, making the case that it would not be the economic Armageddon that seems to be inside-the-beltway received wisdom. Now, let me make the case, if only tongue-in-cheek, that going back to the Clinton era tax rates might actually be a good thing.

Consider some possible effects on the economy. The easiest way to avoid paying higher taxes is business-related spending: advertising, marketing, travel, entertainment, personal electronics, supplies, research, product development, and so on. It is immediately deductible, saving on taxes. Plus, all these things stimulate other parts of the economy, and do so in ways that encourage businesses to hire more people.

It would be the biggest down-payment on deficit reduction of any of the proposals floating around. Every other proposal is much smaller in dollar impact on the deficit, would take much longer to kick in, and has enough partisan baggage to make passage through either in this rump Congress or the next even more deadlocked Congress rather unlikely.

The Clinton era tax rates represented a modest increase from the Reagan rates. They were enacted because at the time people thought they were necessary to tame the then-record deficit. Conservatives predicted that the rate increases would stifle the recovery from a sharp recession, and moderates shared that angst.

History turned out to be very different. The Clinton tax increase proved to be highly stimulative. Yes, that's right: stimulative. The economy grew rapidly, created jobs, and turned the deficit into a surplus in less than six years. So why is it that a tax increase, which everybody knows is supposed to be the opposite of stimulus, can have a beneficial effect?

The immediate effect, I think, is to build confidence in the future of the economy. If people believe that the deficit will be tamed, or even moderated, then they start to believe that more capital will be available for private investment. Investors do the math, at least implicitly, and discover that less of their return on investment will go to higher taxes than would have been robbed by higher inflation had larger federal deficits persisted. It is amazing how these thoughts about the relatively distant future impact the here-and-now willingness of investors to buy, of lenders to lend, of businesses and individuals to spend.

Compounding the long-term stimulative effect of higher confidence, the detailed nature of our tax system induces people, particularly at higher tax brackets, to do the kind of business-related spending that is most immediately stimulative. Spending leading to hiring leading to more spending, more tax collection, less deficit, and more hiring ... this is the kind of positive feedback loop we need to restart the economy.

Politically, it could benefit both parties to get away from the Bush era tax cuts. The benefit for the Democrats is more obvious, in that they could advocate new tax cut programs that target lower and middle incomes more precisely. The Bush era tax cuts had small impact on lower and middle incomes, but predominately benefited the top brackets. And that is why they failed as economic stimulus: they did not put enough money into the hands of people who would, of necessity, spend it, and gave the richest people, through the complexities of the tax system, more incentive to save than to spend. Finally, it would remove, or at least mitigate, a black mark on the records of those Democrats who voted for the Bush tax cuts long ago.

The political benefit for Republicans is less obvious, particularly to those for whom tax cuts are an article of faith, but oddly may be stronger. The Bush record undermines the desire of the GOP to position itself as a party of fiscal responsibility. The Democrats use this point against Republicans more effectively with the Iraq and Afghanistan Wars than with the tax cuts. Nonetheless, the record of the Bush years weighs heavily on fiscal conservatives and moderates -- both groups the GOP needs to carry to regain power.

Both parties would get to say to their constituencies, "See, we stood tough. The other guys refused to compromise." If you can't win, at least don't wimp out. Everybody gets to share the pain, and the blame. Afterwards, both parties could go at the issue again, this time without the overhang of history.

A final footnote: in Spring, 1982, Senate Republicans, concerned about public perception that the 1981 Reagan tax bill would explode the deficit, pushed through a second tax bill. It made a number of rate increases: some explicit and some covert, like the Alternative Minimum Tax. The long stock market rally started in August, 1982. It was not a coincidence, I think, because the public had more confidence. True, the deficit ballooned in the Reagan years, but would certainly have grown even bigger without the 1982 tax increases.

The punch line: modest tax increases at the end of a recession can speed rather than retarded recovery. It's happened before. Let the tax cuts expire, and watch the economy grow, deadlock or no.