Overtime Tax Exemption: Pros and Cons

Former President Trump has proposed exempting overtime income from taxation. Is this a good idea? Some economists may point out that exempting overtime hours from taxation targets marginal labor supply. Increasing marginal take home pay from taxes encourages work, can increase aggregate supply and economic growth.

Other economists may point out that overtime hours are highly cyclical; tax revenue from overtime hours rises during economic booms and falls during recessions. What this means is that exempting overtime hours from taxation automatically increases budget deficits leading into a recession, and automatically decreases budget deficits going into an economic boom. Economists who still cling to the Demand Side theory of John Maynard Keynes refer to this as an “automatic stabilizer”. The Demand Side Economists insist that properly timed changes and the Federal deficit can reduce the severity of aggregate economic fluctuations. Deliberate Demand Side policy is often poorly timed, thanks to the lethargic nature of the congressional legislative process. Demand side policies that kick in automatically don’t depend on the efficiency of the legislative process.

There is a third perspective on this debate, one that receives too little attention in the popular press. The Federal government has been running deficits continuously for decades now. The national debt is now greater than annual gdp in the United States. Proposals for tax cuts might be good election year rhetoric, but a rising national debt does crowd out productive private investment, and could lead to national bankruptcy.

The major candidates in this year’s election have each promised tax relief to at least part of the American public. Some Supply Side Economists say that tax incentives that increase labor supply are self-financing- generating more tax revenue immediately. There is little evidence behind this theory. It takes time for tax incentives to deliver more economic growth. The Demand Side theory indicates that the Congress should have raised taxes recently- this theory states that fiscal surpluses should be used to moderate booms while unemployment rates are low, to “reload the fiscal canon”, as economist Larry Summers put it recently.

The most obvious problem that we face is twofold. First, one Presidential candidate takes economic advice from economists who exaggerate the supply side effects of tax cuts. Second, the party of the other candidate takes economic advice from charlatans. The underlying problem though is that many voters respond favorably to calls to cut taxes because this sounds better than it really is. Pursuit of tax cuts without spending cuts leads to continuous debt accumulation, which is really just as bad as higher than necessary tax rates.

Originally published at “On the Other Hand...”