Obama tax cuts start with a whimper

Even economists who are sold on the need for a big boost in government spending have said that because such spending may be slow in coming, a tax cut is needed to help lift the economy in the near term. Unfortunately, the proposed Obama tax cuts will start with a whimper.

The Joint Committee on Taxation analysis of the House-passed bill estimates that just $13 billion of the $145-billion Making Work Pay tax credit would be disbursed before the end of September.

What’s more, because the tax cut will come in the form of lower income-tax withholding, low-income workers who pay no income taxes wouldn’t receive their $500 tax cut until after they file their 2009 tax returns early next year. These are the people that economists say are most likely to spend any tax cut because they have so little wherewithal to save.

Three months and roughly 1.5 million job losses after the election, Congress is still trying to concoct stimulus medicine that increasingly looks like a brew of weak tea.

There is a reasonable case for stretching out a tax cut, rather than providing it all in one lump sum. But the economy needs much more of a tax-cut boost in the near-term than this one would provide.

Because the spending portion of the stimulus will take time to ramp up, it makes sense that any temporary tax cuts should start strong and ease back as government spending kicks in.

Perhaps the simplest way to achieve this would be to provide a near-term lump-sum payment similar to last year’s tax cut combined with immediately reduced withholding – but through the payroll tax, which would deliver needed cash to lower earners right away.

I’m troubled that the highly accomplished Obama economic team has produced such a listless tax cut and concerned that their coming approach to dealing with foreclosures will also lack the necessary forcefulness.

As I’ve written previously for RGE ( http://www.rgemonitor.com/financemarkets-monitor/255111/the_best_and_surest_way_to_end_foreclosures ), the bankruptcy cram-down and FDIC loan-modification plans that are popular among Democrats might only draw out the necessary mortgage restructuring and moderately reduce the number of foreclosures.

With forceful policy, we have an opportunity to bring a quick end to the foreclosure crisis, while boosting household cash flow and confidence.

My proposal for doing this would have the government buy a portion of home mortgages (at least the 50% ineligible for refinancing due to insufficient or negative equity) up to the foreclosure value of a home. On this fully collateralized portion of the loan (roughly 40% of the purchase price), the government would provide an ultra-low rate of 3.5%, interest-only for five years.

Household finances would benefit immediately, and as senior debt holder and the only investor with any reason to let a property go to foreclosure, the government would now have the leverage to achieve the most constructive outcome for loans that go bad, including renting to the current resident where appropriate.

Under my proposal, the government also would provide incentives for matching principal reduction. Importantly, the incentives would only apply for a short time, and they would be less generous for loans that are already in default. No other approach will do as much to bring about proactive principal reduction, while spreading the cost between private investors and the government.

For loans in default, the government could offer to match dollar-for-dollar all first-lien principal reduced and the first $20,000 of second-lien principal. For every $2 reduction in second-lien principal beyond $20,000, the government could match with $1.

For loans that are current, the government could cover two-thirds of principal reduction on first liens and the first $20,000 of second liens, and 50% of additional second-lien principal.

Essentially, this would give mortgage investors a narrow window of opportunity to hedge their bets and cut future losses on loans that may well be unsustainable in this economic climate. And the government would reward this proactive approach by taking on a sizable portion of losses.

If we are going to provide subsidies to banks – and most observers expect the Obama team’s new financial rescue plan to include implicit subsidies – then at least we should make sure they go to directly reducing household debt levels that are weighing on the consumer and the economy.

The longer it takes for our foreclosure crisis to end, and the longer it takes for homeowners to work off excess debt, the longer it will take for our economy to find a floor and begin to recover. This proposal offers a way of stepping on the gas.

One Response to "Obama tax cuts start with a whimper"

  1. IJ   February 6, 2009 at 5:42 am

    I struggle to see fairness in a plan which helps only the people who have large unaffordable mortgages. What about the prudent savers in the USA (of which, I agree, there would be only a minority)? Your proposal only helps the people who own have mortgages (arguable introducing another moral hazard for future generations) at the detriment to people who were more prudent. Is this fair? In order to foster an attitude towards prudence and a culture of savings, I think taxation on interest and dividends should be cut. These tax cuts would help many more people and foster a generation of people more accustomed to saving rather than spending.