In the long-run, a comprehensive overhaul is necessary. But until that time, here’s the simple recipe:

1. Permanently extend the tax reductions for low- and middle-income taxpayers.
2. Repeal the tax cuts for the top.
3. Use the increased revenue from the upper-bracket repeal for the next three years to help fund additional stimulus, including aid to state governments, unemployment insurance payments, and other job-creation policies.

Result: More jobs now, smaller deficits later (relative to a full extension).

Any questions?

(On #3, it appears that some continue to espouse the supply-side notion that higher tax rates for high-income individuals would result in lower revenue. In the past week, Senate Majority Leader Mitch McConnell issued the remarkable claim that “there's no evidence whatsoever that the Bush tax cuts actually diminished revenue. They increased revenue, because of the vibrancy of these tax cuts in the economy.” His comments followed Senate Minority Whip Jon Kyl’s declaration that “you do need to offset the cost of increased spending… But you should never have to offset the cost of a deliberate decision to reduce tax rates on Americans.”

The reality is that Bush tax cuts resulted in a huge decline in revenue, and permanently extending the upper-income provisions would substantially worsen the long-term budget outlook. The supply-side argument rests on the notion that lower taxes would lead to an increase in economic activity so strong that it would lead to greater revenues. The economic evidence clearly shows this not to be true. For example, in a recent paper with Michael Ettlinger we find that investment, productivity, economic growth, income growth, wages, and employment did not fare noticeably better under supply-side tax regimes (following the 1981 and 2001 tax cuts) than under a non-supply-side tax regime (the 1993 tax increases). At equivalent periods in the business cycle expansion, the average annual GDP growth rate for each of these policy eras was 3.8 percent for the non-supply-side post-1993 expansion, 3.5 percent following the 1981 supply-side tax cuts, and 2.5 percent since the 2001 supply-side tax cuts.

Senators Kyl and McConnell’s claims were so egregiously unfounded that former Reagan economic adviser Bruce Bartlett felt compelled to clarify that top Bush administration economists consistently stated that the tax cuts reduced federal revenue, as was expected.

Another paper by Jeff Frankel notes that the two predominant conservative theories justifying supply-side tax cuts are inherently contradictory; the Laffer Curve, which states that tax cuts pay for themselves by generating a higher degree of economic activity, squarely contradicts the “Starve the Beast,” theory, which assumes that tax cuts increase the budget deficit and will thus force reductions in government spending. Examining the literature beyond the 1981 and 2001 tax cuts, Frankel concludes that marginal tax rates are nowhere nearly high enough for the Laffer Hypothesis to hold traction. As such, a further extension of the upper-income income Bush tax cut provisions will undoubtedly be associated with revenue losses.)

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The following is drawn from my Senate Finance Committee testimony on the subject last week. Here's a link to the Committee hearing page, which has all the testimony and video. (Fellow witness, Doug Holtz-Eakin, had a different viewpoint than mine.)

I believe it would be a serious mistake to make any of the tax cuts permanent now. The income tax is a mess and is badly in need of an overhaul. It doesn’t raise close to enough revenue to pay for current governmental expenditures and is needlessly complex, unfair, and inefficient. A system-wide reform along the lines of the Tax Reform Act of 1986, but with the goal of eventually raising enough revenue to get the national debt out of the red zone should be a top priority for the Congress. Permanent extension of the tax cuts would make such a reform far more difficult and would signal to markets that our budget problems are only going to get worse.

However, I also think it would be a mistake to allow all of the tax cuts to expire as scheduled in 2011. The economy is in a very precarious state and a major tax increase would slow the economic recovery. With credit still in very short supply, low- and middle-income households are facing serious cash flow constraints. A tax increase would result in less spending, which would ripple through the economy, costing jobs and threatening the nascent recovery.

This is not true for the tax cuts affecting high-income households. As the CBO noted in a recent report on stimulus options, the “consumption [of higher-income households] is unlikely to be constrained by their income in a given year.” For that reason, I think the temporary extension should be limited to what the president (expansively) calls middle-income tax cuts.

Besides for reducing the revenue loss associated with extension, allowing top rates to return to pre-2001 levels would give conservatives an incentive to participate in developing a bipartisan tax reform plan. Tax reform should aim to broaden the base and lower tax rates while raising enough revenue to pay for government. A major problem with the current system is that it combines low rates with a loophole-ridden tax base. High-income tax avoiders like that system far better than one with a broad base, but it drains the Treasury of revenues and fuels the tax shelter industry.

Combined with a parallel commitment to meaningful entitlement reform to slow the growth of spending, this plan would continue to provide economic stimulus in the short term while reassuring financial markets that the US has a plausible way to pay its bills down the road. This would be the ideal stimulus.

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