Kimberly Burham from the Penn Wharton Budget Model and Alan Auerbach from UC Berkeley discuss the potential impact of extending individual tax breaks in the U.S.

The Tax Cuts and Jobs Act brought much cheer to individuals, but that is limited because those tax cuts are set to expire at the end of 2025. There is much speculation over whether the cuts would be made permanent, and the resulting economic impact of those so-called “extenders.”

The Penn Wharton Budget Model (PWBM) analyzes what would happen if those individual tax cuts are extended to 2040, and projects more than $5 trillion of increased government debt and reductions in GDP during the first 10 years and beyond.

The PWBM lays out what individuals have to be prepared for after 2025, and the major changes will be as follows: The top individual tax rate is set to increase from 37% to 39.6%. The exemption from the alternative minimum tax will be lowered. Households will no longer be able to deduct 20% of the first $315,000 in income from pass-through businesses. The standard deduction will also fall, almost in half, in exchange for the personal exemptions that existed before the tax cuts. For households who itemize deductions, the cap on the mortgage interest deduction will increase to $1 million in mortgage debt, and the deduction for state and local property taxes will no longer be capped at $10,000. The child tax credit will be reduced from $2,000 to $1,000 per qualifying child.

“Even though you’re getting tax cuts that can stimulate growth, they have an income effect that people might work less rather than more,” said Kimberly Burham, managing director of legislation and special projects at the PWBM. “And so you find a situation where the debt just completely outweighs the positive impact of growth from these tax cuts, and the economy shrinks.”

“It’s very easy to give people candy. It’s hard to take that way,” said Alan Auerbach, professor of economics and law at the University of California, Berkeley, and director of the Burch Center for Tax Policy and Public Finance at the university. The only way to stimulate economic growth is by increasing taxes, which appears difficult to achieve under the current circumstances, he added.

Burham and Auerbach discussed the implications of extending the individual tax benefits on the Knowledge at Wharton show on SiriusXM channel 111. (Listen to the full podcast using the player at the top of this page.)

Below are highlights from their discussion:

Longer-term Damage

The PWBM study finds that while over the next 10 years average annual GDP growth falls “only slightly,” it falls more sharply between 0.04 and 0.06 percentage points from 2028 to 2040, owing to larger debt.

In the short run, the increase in debt “won’t be that big, and there will be a big stimulus in demand,” said Auerbach. “[However], eventually the stimulus is going to wear off – probably with the help of the Federal Reserve as interest rates go up – but the debt overhang will get bigger as the deficits accumulate and as the national debt to GDP ratio reaches levels we haven’t seen either ever or certainly since the end of World War II. That’s going to crowd out private economic activity, eventually.”

Businesses, too, will have to deal with much uncertainty, Burham noted. ”It’s hard for businesses to know how to invest and make decisions when you have tax cuts that may or may not expire, that may or may not be extended on a temporary basis,” she said.

Short-term Benefits Projections

Auerbach said the individual tax provisions are not the primary driver of the so-called supply side benefits such as more investment and more work by families – those would apply more to business taxes. He noted that forecasts project economic growth driven by a demand stimulus, as the tax cuts would leave more money in people’s pockets.

As it happens, stronger economic growth ahead is on the cards even without the help of the tax cuts, Auerbach said. He pointed to last week’s report by the Congressional Budget Office that projected the unemployment rate falling to 3.3% in 2019 (although it is set to rise in later years).

“It’s very easy to give people candy. It’s hard to take that way.”–Alan Auerbach

“As a result of the tax bill, there’ll be some positive growth effects in the short run,” Burham said. “It’s more about the possibility of negative effects … in the long run that causes concern.” She also noted that one driver of economic growth in the tax bill is the ability for immediate expensing of business investment. Although it is a temporary feature, it rewards new investment, she added.

Taxes Poised to Rise All Around

“In the long run, we add a lot more debt to the system, and there’s not really any free lunch here – at some point, someone has to pay for that,” said Burham. They could either be U.S. households or foreign households, and “we think it will probably be some combination of the two,” she added. “That means investment will go down, which is not good for economic growth.”

Auerbach said he expected the federal government and state and local governments to increase taxes in future, especially because they are saddled with unfunded pension liabilities, deferred maintenance on infrastructure and other expenses. “The question is: How will we do it in a way that’s best for the economy and equitable?” he said. “[Such] important questions … were not considered at all in the tax reform discussion this past year.”

Social Security funding is at risk beyond 2034, while Medicare is expected to stay solvent until 2030. Finding ways to keep them well funded will “put upward pressure on the debt, and decisions have to be made about spending,” said Burham. “Do you cut [those] benefits, or do you raise taxes to pay for them?”

Wrong Timing for Tax Cuts

“It was very irresponsible to have a tax cut this year,” said Auerbach. “The only conceivable argument one could have made for a tax cut would have been if the economy were weak.” However, in the long recovery period following the 2008 recession, the unemployment rate has recovered to levels of 4%, “which certainly is in the neighborhood of full employment,” he added. “So to have a tax cut when there’s no argument for traditional Keynesian policy, you would have to come up with some argument, and I’m not aware of any argument, particularly given that we were already facing fiscal pressures.”

“In the long run, we add a lot more debt to the system, and there’s not really any free lunch here – at some point, someone has to pay for that.”–Kimberly Burham

What Will Force Corrective Action?

Any attempts to mitigate the loss in GDP growth would need bipartisan consensus, said Auerbach. “It will mean a change in politics or some sort of economic crisis which forces politicians to get serious.” He recalled the 2008 economic crisis which made room for bipartisan consensus to pass the TARP proposals [the Troubled Asset Relief Program to help the financial sector] because nobody wanted to have a depression. “Unless something like that happens, we’re likely to have a lot of stopgap measures, a lot of brinksmanship, possible government shutdowns, temporary extensions and a lot of very unsatisfactory processes.”

Among the possibilities over the next years is another recession, said Auerbach. “It’s been almost nine years since the last recession officially ended. And we know that we’ll have another recession at some point in the future.” He noted that in the last recession, debt as a share of GDP grew by some 35% – “a very big increase.” That was a result of both weak growth and revenue declines, but also the cost of the economic stimulus measures that followed, he explained. In the current situation with already high debt that is set to get bigger, it will be hard to accommodate economic stimulus programs without serious policy changes that have bipartisan support, he said.

Politicians tend to kick the can down the road because the impact of all those factors sink in gradually, said Auerbach. He noted that several commissions including the Bowles-Simpson National Commission on Fiscal Responsibility and Reform introduced by the Obama administration produced “very sensible recommendations” that did not see the light of day.