Ask George W. Bush How to Avert a Double Dip

As the jobless recovery continues, President Barack Obama and his liberal supporters argue that the U.S. needs another stimulus or risks a double-dip recession. A look behind the numbers suggests that liberal policies will hand us a double dip whether we get a stimulus or not.

A major reason for the revival of sour economic news is the looming expiration of George W. Bush's tax cuts. The top marginal income-tax rate is set to increase on the first day of 2011 to 39.6 percent from 35 percent. The phase-out of itemized deductions will lift that, effectively, to 40.8 percent. In 2013, the 3.8 percent Obama health-care tax on investment income will kick in, making the top rate 44.6 percent.

This tax hike will push us into double-dip territory for two reasons.

It is no surprise, given the dramatic changes in taxation and the winding down of stimulus spending just over the horizon, that the U.S. economy is getting weaker.

First, it will hurt small businesses. In fact, it's already having that effect. While some of the income in the top bracket is wage and salary income of high earners, a big chunk of the money is the profit of small businesses. If you lift the top rate, you depress small-business activity, which in good times is often the engine of job growth.

According to the latest ADP National Employment Report, goods-producing small businesses--those with fewer than 50 employees--have reduced their total payroll employment by about 20,000 jobs each month this year, including in June. (A corresponding rise in jobs at small service businesses is less revealing, since people get haircuts in good times and bad.)

Shrinking Companies

So companies affected most by Obama's planned tax hike are shrinking, while big businesses--primarily subject to the corporate tax code--have been adding jobs.

Why are small businesses battening down the hatches? In May, the National Federation of Independent Business asked small business owners about the most important problem they face. Twenty-two percent named taxes, up from 19 percent a year earlier. Sales performance was the top worry, cited by 30 percent, unchanged from the prior year.

The other way the tax hike will rekindle the recession is through its treatment of dividends. Absent action by the Democratic majority in Congress, which seems increasingly unlikely, the current 15 percent top tax on dividends will rise to the top income tax rate --39.6 percent in 2011, which, again, will grow to 44.6 percent.

This massive increase will reduce the desirability of equities, significantly harming the stock market, while giving firms a powerful incentive to pay dividends this year, while the rate is lower. Businesses may well focus on paying out cash in the second half of this year--not a terrible thing, but not as helpful to the recovery as spending the money to expand their operations.

No Binging

If history is a guide, shareholders are unlikely to go on a consumption binge with their dividends--certainly not one big enough to compensate for the drop in business investment, which could well be enough to push growth in gross domestic product into negative territory in the second half of this year.

It is no surprise, given the dramatic changes in taxation and the winding down of stimulus spending just over the horizon, that the U.S. economy is getting weaker. The correct policy response is to extend the Bush tax cuts for all income levels, giving small businesses and shareholders cause for renewed optimism, while enacting spending cuts to preserve budget discipline.

The alternative idea, to tax the economy into oblivion and then try to revive it with more Keynesian spending, is tragically wrong-headed. As we've seen, the small businesses that are necessary to create a lasting recovery will be contracting while government reacts to any new stimulus.

Blown Chance

There are two ways to stimulate an economy that is in trouble: with tax cuts or with increased government spending. Declaring early and resolutely that he would extend the Bush tax cuts would have given Obama a chance to try both. Instead, Democrats hoped that higher government spending would offset the suffocating prospect of tax increases. It hasn't worked.

That fact may be too painful for some to admit. But we all better hope that some semblance of rationality creeps into the discussion before it is too late. The left's ideological opposition to the Bush tax cuts is poised to push the U.S. into a depression, regardless of whether we get another Keynesian stimulus.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.

Photo Credit: iStockphoto/mddphoto

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