WASHINGTON – On this, economists agree: Extending tax cuts passed under President George W. Bush for low- and middle-income people would strengthen the weak economy.
The question is what to do about the highest-paid 3 percent of taxpayers. Should Congress let their tax cuts expire at year's end as scheduled? Extend them for only a while? Or make them permanent?
It isn't just a debate over how much money high-income Americans should get to keep. It's about how much their tax cuts might aid the economy. And how much they'll affect the budget deficit years from now.
But first, consider what would happen next year if Congress let the tax cuts for everyone expire as scheduled. According to Moody's Analytics, the deficit would drop to $732 billion. That's well below the $1.3 trillion deficit for the budget year that ended Sept. 30.
At the same time, the economy would suffer, Moody's says: Growth would tail off to just 0.9 percent next year. That's scarcely more than a recessionary pace. And unemployment would average 10.7 percent next year.
That's because higher taxes would leave people with less money to spend. Businesses would be less inclined to hire. Economic growth would slide. Yet if Democrats and Republicans can't reach a deal during the post-election lame-duck session that began this month, taxes will rise across the board in January.
Republicans triumphant in the midterm elections insist that everyone, regardless of income, should continue to enjoy the tax cuts approved during George W. Bush's presidency.
President Barack Obama wants to extend the tax cuts for individuals with taxable incomes below $200,000 a year and couples with incomes below $250,000. Taxable income is a taxpayer's total income minus allowable deductions and exemptions.
Obama has long argued that income above those levels should be taxed at the higher rates that existed before 2001. Yet since his party suffered major losses in the elections, Obama has signaled a willingness to compromise. The White House has indicated he is open to a one- or two-year extension of the tax cuts but opposes a permanent extension for the highest earners.
Here's how analysts think each of the three leading options would affect the economy next year:
OPTION ONE: Let the tax rates for the highest earners rise back to what they were before 2001, when the first round of Bush tax cuts was passed. But extend them permanently for everyone else. This is what Obama favors.
Moody's Analytics says that under this scenario, the economy would grow 2.6 percent in 2011. That's better than the scant 0.9 percent growth envisioned if everyone's tax cuts expired.
Economists note that low- and middle-income people tend to spend more of their take-home pay than the highest-earners do. That's especially true in a tough economy.
Still, unemployment would average 10 percent next year, up from the 9.7 percent estimated for this year. The jobless rate would tick up as growth weakened slightly next year.
This reflects the Republican argument that a tax increase for high-income taxpayers would hurt some small-business owners, making them less inclined to hire.
The budget deficit would fall to $904 billion in 2011, from $1.3 trillion in the just-ended budget year. That would be due to the additional taxes paid by higher-income Americans.
OPTION TWO: Extend the tax cuts for one or two years for the highest earners and permanently for everyone else.
Moody's Analytics estimates this scenario would help the economy more than the first approach. The economy would grow 2.95 percent next year — a 0.4 percentage point improvement over Option One.
Unemployment would average 9.9 percent next year. That would be slightly worse than the 9.7 percent average rate estimated for this year. Stronger growth wouldn't be enough to prevent the unemployment rate from rising as more jobseekers, perhaps feeling better about their prospects, resume their search for work.
Even though no one's taxes would rise in 2011, the budget deficit would drop to $943 billion from $1.3 trillion this year. That's because tax revenue would rise as people spent more and stimulated more economic activity.
The reasoning is that Option Two would deliver a psychological boost: Americans, regardless of income, would know their income taxes wouldn't rise anytime soon. High earners would have more money to spend than under Option One.
Obama and Republicans have signaled their openness to extending the tax cuts for everyone temporarily, perhaps for one or two years. That would force Obama to face the issue again in 2012, when he'll likely seek re-election. Senate Minority Leader Mitch McConnell, R-Ky., says he'll fight to make sure no one, regardless of income, would face a tax increase once any extended tax cuts expire.
Supporters say the economy is too fragile now to boost taxes even on the highest earners and risk causing them to spend less. At the same time, a temporary extension wouldn't necessarily swell the budget deficit over the long run.
OPTION THREE: Make the tax cuts permanent for everyone. This is the plan Republicans favor.
By Moody's calculations, the impact on unemployment, growth and the deficit in 2011 would be the same as in Option Two.
Still, renewing the tax cuts across the board would swell the debt over the next decade by nearly $4 trillion, the Congressional Budget Office says. That's even after accounting for the extra revenue that would flow to the government as permanently lower taxes boosted spending and growth.
Besides, many economists say high-income Americans tend to squirrel away most of the tax money they save. A report from the Congressional Budget Office agreed.
Mark Zandi, chief economist at Moody's Analytics, calculated that when higher earners get an extra dollar of after-tax income, they spend just 40 cents of it. Middle-income Americans spend 66 cents. The poor spend almost all of it. Even so, as higher earners chip in and spend, the economy benefits.
Allen Sinai, chief economist at Decision Economics, fears that letting the tax cuts for high-income Americans expire could reduce the flow of money into private equity firms, venture capital and other investments that "grease the wheels of entrepreneurship in the U.S. economy."
Under Sinai's estimates, extending the tax cuts for all would provide the biggest boost to spending and growth. People and businesses would know they could count on the money in the future.
Yet even if the tax cuts were extended for everyone, unemployment would still be expected to rise next year. Economic growth still wouldn't be robust enough to create enough jobs.