Imagine for a moment that you are interested in lowering your nation’s debt-to-GDP ratio. Let’s assume you are determined to ignore the experience of other nations and you are dead-set on lowering your debt-to-GDP ratio by raising revenue rather than by cutting spending.
This leaves you with two choices:
Choice A: increase tax rates.
Choice B: leave rates where they are but close loopholes.
President Obama’s erstwhile deficit commission, Simpson-Bowles, favored Choice B. And I think it is fair to say that most economists do as well. Why? Put simply, a rate increase has deleterious demand and supply-side effects, whereas a loophole closing only has deleterious demand-side effects. If you raise rates, people are incentivized to spend less and work less (or hide more of their income from the IRS). But if you close loopholes, people are incentivized to spend less while their incentive to work is unchanged. What’s more, when you close loopholes, you tend to remove other distortions in the economy (think: mortgage interest deduction) and you diminish the incidence of government-favoritism.
There are at least three strikes against the fiscal cliff deal struck this week:
- It ignored the evidence that tax increases are more economically harmful than spending cuts.
- It opted to raise revenue through rate increases rather than loophole closings.
- It actually expanded corporate tax loopholes!