Commentary

Zero in on 2011’s Tax Time Bomb and Leave 10-Year Plans for Later

President Obama will soon meet with the congressional leadership of both parties to reach some agreement about whether or not several critical tax rates will suddenly increase on Jan. 1. He says his “first priority is to make the middle-class tax cuts permanent.” Those words conceal a well-crafted trap for Republicans.

The president can’t possibly make any tax change permanent, since his term of office ends in two years. The lame-duck Congress can’t possibly bind even the next Congress, much less all future ones.

Huge changes in tax policy have been enacted every few years — in 1981, 1986, 1990, 1993, 1997, 2001 and 2003. Chanting the magic word “permanent” won’t change that. It is quixotic and oddly unambitious for Republicans to keep talking as though 2003 tax policy should be enshrined for all time — as if that is the best tax reform that anyone could possibly imagine.

Personally, I’d prefer individual tax rates of 15%, 20%, 25% and 30% with a low flat rate on dividends, capital gains and estates and a 25% rate on corporate profits. But even such a modest move in the right direction would be ruled out if current law could somehow be made permanent.

By partially co-opting the banal Republican talking point about “making the Bush tax cuts permanent” Obama is really trying to cram through his own tax policy proposals from the moribund 2011 budget. He is belatedly pushing the same proposals from the same budget that Obama and a Democrat-controlled Congress have totally ignored since February.

It’s Welfare
By postponing his proposed tax hikes until the end of the year, which is unconscionable and dangerous, the president has surrendered all credibility on next year’s tax policy. He is in no position to suddenly insist, after 10 months of doing nothing, that it’s his way or the highway.

When Obama talks about “permanent tax cuts for the middle class,” he surely plans to include a permanent extension of his budget-busting “Making Work Pay” tax credits (up to $800 per couple) that he snuck into the stimulus bill.

The credits operate like a payroll tax refund to relieve couples earning up to $150,000 from paying for their own Social Security benefits. Because these irresponsible tax credits are refundable, many among the half of Americans who pay no income tax received a welfare check disguised as a tax credit. Calling such proliferating giveaways a “tax cut” is part of the president’s bait-and-switch marketing.

Since he may not trap Republicans with their own rhetoric about permanent tax cuts, the president also raises flaky 10-year revenue estimates to change the subject. The lame-duck Congress has a short-term emergency to deal with in very little time. If they do not extend current tax law for another year or two, the economy will suddenly be hammered with big tax increases on well-educated two-earner couples, businesses organized as partnerships or Subchapter S corporations, dividends and capital gains.

The issue now urgently before Congress is a tax shock to next year’s economy. Yet the president repeatedly changes the subject to 10-year revenue estimates. Why? Because his insistence on raising the top two tax rates in 2011 involves ridiculously tiny amounts of revenue, and even those sums are phony.

Taxpayers Aren’t Lambs
If Republicans would simply shut up about permanent tax cuts and focus on next year, the president’s 10-year ploy would be revealed as the irrelevant nonsense that it is. Nobody with any common sense will be trying to set tax policy for the next 10 years by the end of 2010. The last time some fools tried doing that, we ended up with the tax time bomb we currently face.

In all the months since President Obama presented his tax proposals in the phantom 2011 budget on Feb. 1, the 111th Congress apparently never bothered to glance at those plans. The related Treasury Green Book estimated that the centerpiece of the plan — raising the top two tax rates — would raise just $14.5 billion in fiscal 2011.

Even that paltry sum is pure illusion. It assumes that higher tax rates do literally no harm to the economy, even though the targets of Obama’s tax crusade account for a fourth of consumer spending and a much larger share of investment, entrepreneurship and GDP.

It also assumes that the intended victims are docile lambs waiting to be shorn. On the contrary, the evidence is overwhelming that high-income taxpayers easily find ways to earn or report less income when marginal tax rates turn punitive, and likewise readily report more income when tax rates are more reasonable.

As a byproduct of my ongoing research into the income distribution estimates of Thomas Piketty and Emmanuel Saez, I found that the top 1% of taxpayers reported average dividend income of only $30,673 in 2002 before the tax rate on dividends fell to 15% (all of these figures are in 2008 dollars).

After the dividend tax rate came down, average dividends among the top 1% surged to $52,814 in 2004 and $83,072 by 2007. Reported dividends of the top 1% in 2007 were twice as large as the previous peak in 2000. That can’t be coincidence.

Since 15% of $83,072 is larger than 38.6% of $30,673, even that drastically reduced tax rate on dividends did not significantly reduce average revenues collected from the top 1.4 million taxpayers. But the lower dividend tax clearly did result in high-income taxpayers holding more dividend-paying stocks than ever before in taxable accounts.

Although that creates a statistical impression of higher investment income among the top 1% (whose average salary income fell from $551,873 in 2000 to $513,438 in 2007 and $504,402 in 2008), it probably just means they held fewer tax-exempt bonds than before, or kept a smaller share of their stocks inside IRAs.

A similar story can be told about the amount of capital gains reported by the top 1% after that tax rate dropped to 15% in 2003. Average capital gains among the top 1% rose from $145,433 in 2002 (in 2008 dollars) to a record $427,930 in 2007. Since stock prices certainly did not triple in those years, much of that increase in taxable gains had to reflect greater incentives to realize gains more frequently when taxed at 15% rather than 20%.

President Obama imagines that putting the capital gains tax rate back to 20% would raise more revenues, because his bookkeepers tell him so. Yet it is quite doubtful that the top 1% would have reported such huge gains from 2004 to 2007 if the tax rate had been a third higher.

Over time, sustained growth of tax revenues depends almost entirely on growth of the tax base — salaries, profits and related dividends and capital gains. Raising tax rates will not help if it slows the growth of taxable incomes, or discourage investors from holding dividend-paying stocks or from realizing taxable capital gains.

Party Crasher
No economist (other than those on Obama’s payroll) could seriously argue that increasing the highest, most damaging tax rates in 2011 would not do very serious harm to both the demand side and the supply side of the economy. If Obama got even half of what he’s asking for on tax policy, the stock market and economy would head downhill fast, pulling down tax revenues and the Democratic Party in the process.

A few sensible Democrats in Congress could protect the president from himself by simply making the logical decision to keep the current tax regime in place for at least a year, to allow time to treat serious tax issues more seriously.

Republicans, for their part, must beware the twin traps — the president’s false promise of “permanent” tax cuts and his pretense of grappling with 10-year budget plans in a few weeks. The Republicans need to keep a firm grasp on the difference between making a compromise and becoming totally compromised.

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