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Permanent Tax Cuts Pack a Bigger Punch

Congress recently renewed several tax breaks for households and businesses, which the president signed as part of the year-end budget deal. Whereas previous renewals generally expired after one year, Congress made many of the tax “extenders” it renewed in December permanent.

This can be helpful. When it comes to tax cuts, how long the cut remains in place, as well as whether they are offset by spending cuts, can be important in how effective the cuts are.

As we note in our January edition of Business Conditions Monthly, “There is something for everyone” in this package of tax cuts. For businesses, permanent extensions include deductions for research and development investment and acquisitions of certain assets.

For individuals, permanent extensions include tax credits for children and college education, and enhancements in the earned income tax credit. As the chart below shows, the majority of the provisions as measured by 10-year revenue impact ($562 billion) are permanent, with the bulk of the remainder ($74 billion) now extended until 2019 and only $49 billion now set to expire in less than five years.

tax cuts

Economists have long suggested that permanent tax cuts have greater impact on business and household behavior even in the short run. Informed by rational expectations theory and the permanent income model, many argue that consumption and investment decisions are made based on lifetime wealth rather than current income.

The R&D credits permanently extended by the current deal provide an instructive example. Under a one-year extension, a business might allocate slightly more spending to R&D in the current year, but under a permanent extension, the business knows its investment will achieve more lucrative returns in perpetuity. R&D is often planned out several years in advance, so the business will now be free to pursue a more ambitious program without concerns that the tax benefits will decrease down the road.

However, rational expectations theory also suggests concerns about the current deal from a policy standpoint. The extended tax breaks, estimated by the Committee for a Responsible Budget to reduce government revenue by $680 billion over ten years, does not offset this revenue loss with any decrease in spending or other tax increase. The theory of Ricardian Equivalence, a logical extension of rational expectations, asserts that households and businesses will not respond as desired to tax cuts and fiscal expansion because they understand that they will eventually need to be offset by tax increases or spending cuts.

Though this conclusion is somewhat extreme in the real world, it does serve as a reminder of the dangers of continued fiscal irresponsibility, whether in the form of increased spending or tax cuts. Households and businesses respond not just to extra money in their pocket today, but how they think government action will impact their wealth down the road.

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2 Comments Post a comment
  1. Katy Delay #

    “The theory of Ricardian Equivalence, a logical extension of rational expectations, asserts that households and businesses will not respond as desired to tax cuts and fiscal expansion because they understand that they will eventually need to be offset by tax increases or spending cuts.”

    On the above, I’m curious to know more about this assertion. When I look at the number of supposedly intelligent and rational people who get themselves in hot water with their credit spending, I wonder if households and businesses are really that forward-thinking. On the contrary, many seem more inclined towards what I’ll call the Las Vegas theory of “Ricardian Nonequivalence,” i.e. when you get it, spend it because tomorrow is another day.

    Like

    January 26, 2016
  2. Great observation, Katy, I agree completely. These neat and clean theories only give us ideas about the direction things may go; we have to leave it up to the data to have the final say (however imperfect that may also be).

    Like

    January 26, 2016

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