Gradual tax reform would best ease shock to system

In economics, taxes are the total of what you pay to the government. A tax cut, then, is when the total is less, and a tax increase is when you pay more. The rest of the talk is political smoke, mirrors and some other stuff best left unspecified.

The final “fiscal cliff” agreement, if there ever is one, will likely include some effort to increase government revenue without raising taxes on the middle class. This increases the probability that existing tax deductions will be addressed in some way, probably by shrinking them or eliminating them entirely. Even though eliminating a deduction is really a tax increase, it can be disguised by calling it “tax reform” or “closing loopholes.”

Major personal tax deductions like mortgage interest and charitable donations, for example, have extensive and well-established root systems in our economy. Changing them raises timing issues that have to be considered, addressed, and resolved.

Whoever first said, “Timing is everything” certainly understood how the world works. Timing is important in life, in business, in science and even in the arts.

Timing turns out to be more complicated than we might think, though, and this is nowhere more obvious than in comedy. Most of us aren’t experts, for example, but we can tell instinctively when the timing of a line in a TV sitcom is wrong. Timing, in fact, is one of the most difficult things for actors, directors and writers to get right. There is more art than science to it.

There is both art and science to economics, too, and, sometimes unintentional comedy, too. It is not surprising, then, that timing plays an important role in economic policy decisions.

What is surprising is that timing has not always been a major part of economic theory throughout its history and is still not fully integrated into economics to this day. Historically, economic theory has concentrated on the cause-and-effect forces and behavior patterns that explained how individuals, businesses and economies worked.

Time and timing became crucial factors in economics only when central governments began to take on responsibility for the maintenance of their countries’ economic engines — and economic forecasting became a critical determinant in economic policy decisions.

The Great Depression of the 1930s was a spur to economic thinking along these lines, and great strides were made in data collection. Economists recognized the need for time-based analysis and forecasting, of course, but at the time they lacked the mathematics and the data processing capabilities to do much about it.

Economic policies during the 1930s Great Depression and well into the 1950s were mostly restrained by a general principle that, “If you can’t explain it to your Aunt Hattie, forget about it.” As it turned out, Aunt Hattie was smarter than she let on — and certainly wiser than a lot of government bureaucrats — and things didn’t work out too badly. The growing level of responsibility that our federal government was taking for our economic welfare, though, gave it an insatiable appetite for data and forecasts.

Timing began to be incorporated into economic models and into economics training in the 1960s, precisely when computer-assisted data processing transformed econometric models and statistical analysis into practical realities.

These economic models really improved short-term forecasting, and were adopted eagerly not only by government but also by Wall Street, which has a notoriously short-term outlook. Our economic world is now flooded with data-driven econometric forecast models, prompting some to seek higher ground.

One of the timing questions left unanswered by math-driven economics is whether economic policies work best when implemented quickly or gradually. This is a matter of great concern and divided opinion as U.S. and European countries attempt to recover from recessions and unsustainable public debt.

In the U.S., since we know the government is going to do it one way or another, the basic question for economic policy makers is whether tax changes should be introduced over time, immediately, or even retroactively, an option beloved only by Congress.

The negative effect that ending the mortgage interest deduction would have on the housing industry, for example, just as it is recovering from a four-year bust, would make it a poor candidate for sudden, traumatic change. And the same is true for axing the charitable donation deduction, which would have disastrous effects on a broad range of activities, from education to health care and disaster relief.

If, in the face of this, the federal government is still determined to ignore its spending addiction and raise taxes, spreading the negative effects over time would be helpful. Individuals, households, businesses and institutions will be hurt, surely, but they will find ways to adjust, if we give them a chance. The American economy is good at that.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.

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