The Heritage Foundation recently published an evaluation of the candidates’ tax plans. This analysis assumed the tax reductions of 2001 and 2003 expired on schedule, or at the end of 2010, and that each tax plan reacted to what would be a very large tax increase if Congress and the president do nothing. Our paper finds that John McCain’s tax plan, which makes all of the tax reductions permanent (among other things), produces more than twice as much economic activity as Barack Obama’s plan, which makes those tax reductions permanent only for taxpayers with incomes below $250,000.

The current law baseline that we used in this recently published analysis is not the only baseline that analysts employ to study the effects of policy change. Many, including other members of Heritage’s budget team (see JD Foster’s work here and here) and analysts on the Obama campaign staff, sometimes use a “current policy” baseline. That baseline assumes that current policies, like the Bush tax reductions, continue forward. Obama assumes “current policy” on spending and “current law” on tax policy.

I frequently have been asked since that publication what difference it would make to both plans if an alternative assumption is made about the fate of the Bush tax cuts. Specifically, what would be the likely economic effects of Obama’s tax plan if one assumed the current policy baseline, or that the Bush tax reductions were made permanent, say this year? For McCain, that alternative assumption means the principal remaining change to tax policy is his massive reduction in the corporate profits tax, from the current level of 35% to 25%. That tax reduction alone raises employment by an annual average of 182,000 and economic output by an average of $35 billion. However, the rest of his tax plan is, in fact, making the Bush tax cuts permanent, which the alternative scenario assumes that Congress already has done.

For Obama, however, the effects are quite different. Some of his current plan is covered under the alternative assumption: most of the Bush tax reductions are made permanent for taxpayers under $250,000. However, Obama raises ordinary income tax rates for taxpayers above $250,000 and also raises the tax rates on dividend and capital gains income as well as federal death taxes. In addition, he creates a number of new and expanded credits and deductions for taxpayers below that income level that are not contained in the Bush tax program.

The tax increases, however, overwhelm the expanded credits and deductions. The upshot is much slower output and employment growth than in an economic world where the Bush tax reductions are the permanent law. For example, over the 10-year forecast period, 2009-2018:

  • Inflation-adjusted Gross Domestic Product falls by an annual average of $90 billion below what it would be without the combined effects of Senator Obama’s tax increases and tax credits;
  • Total employment falls by an annual average of 589,000;
  • The after-tax, inflation-adjusted disposable income for a four-person family declines by $1,565;
  • Inflation-adjusted personal consumption spending drops by an average of $66 billion per year, and personal savings drops by an annual average of $54 billion;
  • Business borrowing costs rise, even though we allowed the Federal Reserve to react to this worsening economic situation by cutting the Fed’s federal funds rate.

The Obama tax increases hit capital costs particularly hard, which reduces investment and creates significantly higher borrowing costs for businesses at all levels. These effects combine with declines in savings, consumption, and labor effort to produce significant economic consequences outside of the targeted class of taxpayers. Thus, families whose incomes exempt them from the higher Obama taxes still feel the pinch of these taxes through a slower job market an increasingly sluggish income.

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