Commentary

Tax Delusions

Hillary Clinton and Barack Obama both propose to “turn the economy around” in a novel way - by raising tax rates on small businesses, working couples and stockholders in general, including retirees.

Of course, their plans are also meant to raise revenue for their various hundreds of billions in new spending - but the move would fall flat on that front, too.

Start with the deficit. The Bush administration predicts a $409 billion budget shortfall for fiscal 2009. But that rests on absurd assumptions - a sudden $104 billion drop in the price of war in Iraq and Afghanistan, a freeze in non-security discretionary spending - and a speeding up of economic growth.

In fact, this election year’s “stimulus” bills are likelier to slow things down in 2009. Seven of the 10 postwar recessions began in the year after a presidential race, including 2001 and 1981.

So, with luck, the next president may start out with an economy that is only fragile or feeble and a deficit not much above $500 billion.

Now, on to tax hikes.

Higher tax rates on dividends and capital gains would crash the stock market yet do absolutely nothing to cut the deficit.”

The federal government now takes 33 percent of taxable income above $200,000 on a joint return and 35 percent of income above $357,700. Both Democrats would raise those tax rates to 36 percent and 39.6 percent, respectively.

Even the Tax Policy Center (a think tank famously friendly to tax hikes and Democrats) estimates that raising the top two tax rates might bring in a mere $32 billion in 2010. That’s 6 percent of the likely deficit - not a license to start a dozen new programs.

To squeeze a few more pennies from top taxpayers, Clinton and Obama would also phase out all personal exemptions at $250,000. That means large families would pay higher taxes than childless couples with the same income. They’d also phase out itemized deductions - which would force two-earner families in New York and California to pay more federal tax than those living in Texas and Florida.

And this politically suicidal tax discrimination against New Yorkers, Californians and big families would bring in only an extra $15 billion a year.

All in all, these tax hikes add up to, at most, $47 billion a year - only 1.5 percent of federal spending and 0.3 percent of GDP.

And even that assumes nobody makes the slightest effort to avoid the increased taxes. In reality, many two-earner families would become one-earner families; doctors would play more golf; some folks would quit working long hours and others would retire early. Top-bracket taxpayers would maximize deductions (take out a bigger mortgage, put more in the 401k) and minimize taxable income (buy municipal bonds or just spend rather than invest).

Such tax avoidance alone would cut the estimated revenue in half. The tax hikes’ adverse effects on the stock market and the economy would more than eliminate the other half.

Meanwhile, both candidates are eager to spend more tens of billions a year on health-insurance subsidies, billions more for biofuels and (in Obama’s case, at least) tens of billions more for several more refundable tax credits - checks to people who don’t pay income tax. All these shameless vote-buying schemes would only worsen the real budget problem - which is runaway spending, not taxes.

Marginal tax rates are now much lower than they were in 1993 to 1996 on all incomes, large or small. And tax rates are much lower on dividends and capital gains. Yet the individual income tax brought in 8.5 percent of GDP last year - the same as in 1996 and much more than under the higher tax rates of ‘93-95.

Why do lower rates bring in as much money? In part because people do less to avoid taxes once rates are cut, in part because lower rates promote economic growth.

But the Democrats have an ideological bias against recognizing these clear facts - a naive faith in higher tax rates and an aversion to confronting excess spending. So they plan on two more tax hikes that won’t work.

Obama wants to bring back the 28 percent tax on capital gains. In fact, our experience in the first Clinton administration proves that this would lose a lot of revenue: Investors would sit on stocks rather than sell and pay the tax.

The cap-gains tax dropped from 28 percent to 20 percent in 1997 - and revenues from that tax alone accounted for 12 percent of all individual income-tax payments from 1997 to 2000 - up from just 7.9 percent from 1993 to 1996.

Obama and Clinton also want to raise the tax on dividends from 15 percent to 39.6 percent. But that would just compel investors to liquidate blue-chip stocks at distress-sale prices and get back into tax-exempt bonds, cutting revenues further.

Higher tax rates on dividends and capital gains would crash the stock market yet do absolutely nothing to cut the deficit.

Other presidents have tried and failed to tax their way out of a budget squeeze. During the 1990 recession, the first President George Bush raised tax rates on “the rich,” mostly by ending their deductions and exemptions. It didn’t work: Individual income taxes brought in 8.3 percent of GDP in 1989 and just 7.6 percent of GDP by 1992.

President Bill Clinton then piled on another layer of high tax rates, 36 percent and 39.6 percent, while also greatly hiking taxes on Social Security benefits of working seniors. That failed, too: Individual income taxes brought in only 7.8 percent of GDP in 1993 and ‘94, 8.1 percent in 1995.

Federal revenues did not get much above the 1989 level until 1997 - when they rose because the capital-gains tax was cut.

In short, Obama is a “tax-and-spend” liberal, while Hillary is a “spend-and-tax” liberal. If either actually launched their gargantuan spending plans on the basis of imaginary revenues expected from taxing the rich, he or she would quickly end up having to tax the stuffing out of the middle class.

Alan Reynolds is a senior fellow and author of Income and Wealth (Greenwood Press, 2006).