As the Economy Sinks, So Do Odds of a Tax Cut

One of the riskiest financial moves you make this year could be listening to the presidential candidates—and banking on a tax cut after the November elections.

John McCain and Barack Obama both promise that widespread tax cuts will be one major way they'll revive the economy and help lift consumers' sagging spirits. They differ, of course, on who should enjoy the largesse. McCain wants to cut estate and corporate income taxes, and extend broad-based tax cuts that were enacted earlier this decade. Obama agrees about extending some of those Bush era tax cuts, while offering lots of other relief to people earning less than $250,000 and raising taxes on the wealthy.

But here's what you're not likely to hear either candidate say before Election Day on November 4: There's no money left for tax cuts. And a slumping economy—now almost certainly in recession— will make it hard to pass tax cuts for the next couple of years, and maybe longer.

One obvious reason is the huge, unexpected bill for bailing out banks and other firms saddled with bad debts. All told, the government has committed more than $1 trillion in public funds to help the financial sector get back on its feet. That's more than one third of the government's entire budget in a given year. The feds (and the taxpayers) might get some of the money back—but nobody will know for years.

Meanwhile, the Congressional Budget Office recently took a much gloomier view of the future, casting a cloud over both candidates' tax-cut plans. For most of the year, CBO had been projecting that government revenues would be more or less in line with spending over the next 10 years. But with the economy spiraling into recession, CBO now projects that the government will spend $2.3 trillion more than it brings in over the next decade. And that's before accounting for any bailout costs.

Such huge deficits will make it hard for Congress to justify any additional funding for tax cuts. "The next president is going to be strongly tied by what's happened over the last year," says Tom Cooley, dean of New York University's Stern School of Business. "It's dubious that any of these tax-cut plans will get through."

Here are the prospects for a variety of scenarios:

If McCain gets elected. The estimated cost of McCain's tax cuts over five years is $1.48 trillion, according to the nonpartisan Tax Policy Center. The most costly part of McCain's plan would be the permanent extension of the Bush tax cuts from 2001 and 2003, which lowered taxes for most Americans. Those extensions would amount to $585 billion of lost government revenue, compared to letting tax rates go back to their earlier levels. And if there's any good news for taxpayers, it's that most of the Bush tax cuts are likely to stay in place, regardless of who wins in November. "Resetting them would amount to raising taxes when the economy is not doing so well," says Roberton Williams of the Tax Policy Center. "That harkens back to Herbert Hoover and the Great Depression." If the Bush cuts do become permanent, most workers won't notice—their paychecks will stay the same.

McCain's other ideas—like lowering the estate tax and making other changes in the tax code that would favor higher earners—would probably meet a tough audience in Congress. By most projections, both houses of Congress will remain in Democratic hands, and there won't be much of a welcome mat for a Republican president hoping to lower taxes on the wealthy.

If Obama gets elected. The estimated cost of Obama's tax cuts over five years is $967 billion, according to the Tax Policy Center. Obama also favors the extension of many of the Bush tax cuts, though he'd repeal some that benefit higher earners. In addition, Obama frequently says that under his plan, many people who earn less than $250,000 will pay lower taxes through a variety of credits that target groups like working parents with kids and seniors who make less than $50,000.

The problem with Obama's plan is that once it gets to Congress, choosing from a long list of targeted tax credits would fuel bitter fights over who deserves help and who doesn't. Even with Democrats in charge on Capitol Hill, there are fiscal conservatives in both parties sure to oppose the passage of Obama's expensive tax cuts in full. And some of his ideas—like rebates for people who don't even earn enough to pay taxes—are controversial even among Democrats.

With the economy rapidly deteriorating in the last months of the campaign, some analysts foresee the next president holding a 21st century fireside chat to explain the dire reality to his fellow Americans. "He could say, 'The economic situation is a lot worse than I expected, and we're going to have to put this off,' " predicts Williams of the Tax Policy Center. "Nobody's going to say that in the campaign, but I think that will be the first speech either one of them gives in office." That would still leave time for the next president to cut taxes later in his first term—allowing him to save face and still say he fulfilled his tax-cut promises.

No matter who gets elected, a second stimulus plan is starting to look more plausible than a quick round of permanent tax cuts. Democratic House Speaker Nancy Pelosi has already called for a second set of rebate checks to be sent to consumers, matching the $150 billion worth of checks sent out earlier this year. That won't happen before the election, because Congress isn't in session, but it could happen right afterward, even before the next president takes the oath in January. Pelosi's plan coincides with a smaller stimulus plan that Obama is calling for, and McCain, like Obama, favored the first stimulus plan. So, it's plausible that instead of tax cuts, many Americans could find another $600 or $1,200 check in their mailboxes sometime next spring.

If there are no meaningful tax cuts, then the wealthy could be the unintended beneficiaries of Washington's red ink, at least for a while. If there are no middle-class tax cuts, then there's no need to raise taxes on the wealthy in order to pay for them, as Obama's plan calls for. Obama, if elected, could still burnish his populist credentials by calling for some sort of tax hike on corporations or the top 1 percent of earners. But odds are he'd get shouted down. In the midst of a scary recession, many economists have already been pointing out the devastating effects of Herbert Hoover's 1932 tax increases, widely blamed for deepening the Depression. By next January, the economy will be scary enough. No president will want to risk making it worse.