American economic policy will be set in a new political environment in 2007, with the Democratic Party controlling both chambers of the U.S. Congress. The tone of policy is likely to be altered, with a little more attention to fiscal responsibility and a little more emphasis on populism and economic nationalism. But, the economic impact of actual policy changes is likely to be limited.

Resident Scholar Alan D. Viard

One important part of economic policy will be largely unaffected--monetary policy will remain in the able and independent hands of Ben Bernanke and the Federal Reserve. To be sure, any move to explicit inflation targeting will probably be blocked by Democratic opposition. But, such a move seemed unlikely even before the election. And, with or without an official target, price stability will remain the Fed’s top priority. The Fed is likely to lower interest rates sometime in 2007, as the inflation threat fades.

One policy change is virtually certain. Democrats have given top priority to hiking the federal minimum wage from $5.15 to $7.25 per hour and President Bush has said that he expects to find common ground with them on this issue. Such an increase accords with public opinion; in November, voters in six states approved increases in their state-level minimum wages. Its policy merits are more questionable; economic evidence indicates that a minimum-wage hike will impede hiring of low-wage workers. But, its impact on overall unemployment and the national economy will be slight.

On tax and budget policy, it’s best to begin by listing three big things that aren’t likely to happen.

First, fundamental tax reform looks dead for 2007 and 2008. A report by a presidential panel on this topic a year ago landed with a thud.

Second, the Democrats don’t plan, at this point, to touch the 2001 and 2003 income tax cuts. Trying to roll back the tax cuts would bring a presidential veto that the Democrats wouldn’t be able to override. Besides, most Democrats support the parts of the tax cuts that are directed to moderate-income families.

Third, reform of the Social Security retirement program is highly unlikely. President Bush and the Republicans are committed to establishing personal savings accounts within the program, an idea that the Democrats refuse to discuss. A bipartisan agreement on a solvency package that combines benefit cuts and tax increases is conceivable, but must be considered a long shot at this point.

There will be changes in some aspects of tax and budget policy. Notably, Democrats have pledged to restore “pay-go” budget rules requiring that certain tax and spending changes not enlarge the deficit. After six years of unrestrained spending increases and tax cuts, this will be a welcome step toward fiscal responsibility. Of course, living by these rules will require some tough decisions.

Decision time may arrive when Democrats address the alternative minimum tax, a parallel tax levy that Americans are required to pay when it exceeds their regular income tax. Without Congressional action, this tax will spread to 23 million Americans in 2007, up from fewer than 4 million in 2006. Both parties are determined to forestall this outcome. But, even a one-year fix to the problem carries a price tag of $40 billion. Under the pay-go rules, the Democrats will seek to recover this amount elsewhere in the tax system.

Some Democrats hope to find the needed money by narrowing the “tax gap,” the difference between taxes owed and taxes paid. That hope is likely to prove forlorn; tax cheaters are more of a rhetorical target than a realistic revenue source. The tax gap is a genuine problem, but there are no quick and easy ways to significantly narrow it.

The Democrats have outlined two other revenue-raising ideas, pledging to end “tax giveaways to Big Oil companies” and “tax giveaways that reward companies for moving American jobs overseas.” The populist and nationalist overtones of these pledges will not be conducive to sound policy.

Specific changes in the taxation of oil companies should be evaluated on their merits. But, basing tax policy on hostility toward an unpopular industry is a pernicious strategy.

U.S.-based multinationals will join oil companies in the Democrats’ cross hairs. Two years ago, Congress tweaked the complicated international tax rules to allow multinationals to claim U.S. tax credits for more of their foreign tax payments and to defer U.S. tax on more of their unrepatriated foreign income. The Democrats have proposed undoing some of those changes.

While such proposals would have limited economic impact, they reflect a misguided philosophy about how to promote capital accumulation and job creation in the United States. They punish American firms for pursuing business opportunities abroad, rather than fostering an attractive investment climate for both American and foreign firms in the United States.

Trade policy may also be affected by increased economic nationalism. Of course, there are Democrats who support free trade and Republicans who oppose it. On balance, though, Democrats tend to be less enthusiastic about open international competition. President Bush may have a harder time getting free-trade agreements through the new Congress.

Policy changes that inhibit trade and cross-border investment can hardly be good for world growth. But, any impact is likely to be quite small, relative to the many other developments continually affecting the world economy.

Congressional Democrats will try to set a new course for American economic policy in 2007. But, they are more likely to nudge policy into the next lane than to make a sharp U-turn.

Alan D. Viard is a resident scholar at AEI.