Why Higher Tax Rates are the Wrong Way To Go — 10 December 2012

It seems at times that these arguments over the impending fiscal cliff are little more than stubborn little boys in a wrestling match, each trying to get the other to cry “uncle.”

President Obama makes it sound as though a deal could be inked in a matter of days if Republicans wouldn’t insist on shielding their rich friends from a tax increase.  House Republicans, for their part, seem to have conceded the tax issue but won’t agree to Obama’s preferred form of tax increase out of sheer cussedness.

In reality, this dispute is in deadly earnest.  It matters a great deal what form any tax increase takes, and it matters a great deal – an even greater deal – what kind of spending constraint accompanies any deal.

As I said last week, the Achilles heel of our economy is our government spending.  Not only are we currently spending $3 billion every single day more than we take in tax revenue, but the long-term unfunded obligations of our federal government would need a contribution of $7 trillion a year – twice the current federal budget for everything! – just to make good on our promises.

In recognition of that, President Obama’s proposal is to… borrow and spend some more, and sometime in the future get really serious about cutting back on the spending gusher.  This is the classic Democratic approach to fiscal problems.  Tax now, promise to get disciplined about spending later.  Even Ronald Reagan, who came closest to getting a handle on the spending/taxing nexus, never got the spending cuts Tip O’Neill promised.

Even if we confiscated every dime possessed by the wealthy, it would not come close to closing the gap.  But despite Obama’s professed willingness to compromise, he has not in four years put a credible spending plan on the table.  He has had two straight budgets rejected unanimously, and his current proposal was literally laughed out of the hall.

But the tax side of things is critically important, and that is why Speaker Boehner has been adamantly against a return to the Clinton-era rates.  Right after the election, the GOP offered $800 billion in increased revenues, achieved through limiting deductions rather than higher rates.  This is the dollar figure that the near-deal from summer 2011 focused upon, and at the time, the President himself was saying the best way to achieve that was through deductions – “tax expenditures” – rather than through higher rates.

Now, Obama is saying it won’t raise enough revenue, and giving that he has just doubled his demand to $1.6 trillion, he may be right.  But it is still the better way to boost the revenue side, and here’s why: small business.

Over half of the workers in the US work for firms with less than 500 employees.  Most of those firms’ owners report company income through their personal tax returns; and the vast majority of those workers are employed by firms whose owners would be counted among the “top 2%” that Obama is targeting for higher rates.  Democrats claimed during the campaign that only a small percentage of firms would fall into that category – true, perhaps, but they are the ones big enough to employ the greatest number.

Higher rates will hit these owners hard.  In a very competitive global economy, there is not a lot of excess cash lying around with which to pay higher rates.  Not only that, the money that upstreams to the owners is not going to pay for their Rolls-Royces.  This is the return on capital from which new investment into the firm, new business opportunities, and new hires are made.  Raising the tax on that will just diminish the cash available to grow the economy.

This is what the Republicans mean when they say the higher rates will hurt the economy. They’re not talking about Philpot G. Plutocrat III, merrily squandering his trust fund (although I would argue that that, too, would benefit the economy – see my post about Beyonce and Jay-Z and their baby extravagances).

By comparison, limiting deductions would affect these taxpayers relatively less.  Small business owners are not the ones taking big deductions for second mortgages on vacation homes in the Hamptons.  Deductions have always been a tool by which the wealthy get to keep more of their money – 70% of American taxpayers eschew itemized deductions in favor of the simplicity of the standard deduction.  Given that there are no limits on deductions for, say, mortgage interest, this is a splendid way for the taxpayer to subsidize the purchase of some junior tycoon’s McMansion.  If President Obama wants to share some of that wealth, going the deduction route is much more economy-friendly than raising rates on business owners.

So why is he insistent on higher rates?  It’s not the economy.  It’s not the revenue.  It’s the politics.  Ever since Grover Norquist got Republicans to start signing the No Tax Pledge twenty years ago, resisting tax increases has been part of the Republican brand.  As I have argued, having that formal commitment is very useful in Washington, because the pressure to raise taxes repeatedly to ratify – and pay for – ever-increasing spending is as strong as gravity.  Obama believes that if he can get the Republicans to yield on tax rates, it will split the party and ensure a political generation of Democratic dominance.

Already there are serious cracks on the GOP side.  Tea partiers are incensed that Boehner has yielded as much as he has, given that the President’s return offer had not a crumb of a  concession on spending.  On the other hand, certain Republicans – interestingly, mostly on the Senate side, who are largely bystanders in this arm-wrestling match – have come out to suggest conceding on tax rates, in the hope that once that is agreed, a serious discussion of entitlements can ensue.

All this disunity puts Speaker Boehner in a spot, and it is terrible political strategy.  This is a President who is adept at using the bully pulpit to demagogue his opponents, and is ruthless in negotiating.  He seems totally unmindful of the difficulty he is making for the rest of his term by denying the Republicans even a fig-leaf of concession.  Against that opponent, Republicans should not negotiate among themselves and submit free concessions.  We’ve had too much experience with these talks to stumble into that kind of trap.

And yet, here we go.

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