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Grand bargain failure--and folly of high taxes

Associated Press Published: March 18, 2012

The Washington Post has a long front-page story today on the failure last summer of Barack Obama and Republican congressional leaders to agree on a “grand bargain” on the budget and entitlement programs. Reporters Peter Wallsten, Lori Montgomery and Scott Wilson make it clear that Speaker John Boehner is correct in his claim that negotiations broke down when Obama raised the amount of revenue increases he demanded by 50%. Here’s a quote from the article:

“His plan backed away from earlier positions on taxes in a number of ways, including pushing the top rate below 35 percent. But there was a deal-breaker for the Republicans — a demand for additional tax increases to match proposed cuts to Medicare and Medicaid. To keep the health-care cuts, a critical component of the deal for the GOP, Republicans would have to swallow about $400 billion more in tax hikes — a 50 percent jump from the figure that had been under discussion.”

White House sources, according to the Post article, say the president had to make that increase because simultaneous negotiations going on among the Senate’s bipartisan “Gang of Six” were heading toward an even larger revenue increase and congressional Democrats would insist on something more than the previous figure of $800 billion which Obama and Boehner had been talking about.

The Obama Democrats have been preoccupied by their quest to raise taxes on high earners, from the current 35% back up to the Clinton years rate of 39.6% plus the additional Medicare tax to be imposed on high earners by Obamacare. And they, like other administrations, have resisted dynamic scoring—taking into account the depressive effect of higher tax rates in generating revenue. But economist Timothy Taylor, citing research published by the Tax Policy Center, points out that “the share of income tax revenue collected by those in the top brackets for 2009–that is, the 29-35% category, is larger than the rate collected by all marginal tax brackets above 29% back in the 1960s.” The comparisons go back to 1959, when the top tax rate was 91%--hugely higher than the rates anyone is talking about today. (I found this in Tyler Cowen’s always fascinating Marginal Revolution blog.)

Why do lower tax rates result in high earners providing a larger share of the revenue than much higher tax rates did? One reason is that high tax rates incentivize tax avoidance. Detroit Three auto executives didn’t buy their own cars in 1959; they got free cars from the companies, thus avoiding the tax on the income they could use to buy their own cars. (I know this from direct evidence, since at the time I was attending a school with many Detroit Three executives’ children.) Company perks proliferate when individual tax rates are high and peter out when they are lowered (all other things being equal, people like to pick out their own cars).

I have long held a theory, which some economists have told me may have some merit, that when you raise tax rates above a certain level the focus of the animal spirits of high earners moves away from productive investment and work and toward tax avoidance. I can remember conversations among rich men in the late 1970s, when the top rate on investment income was 70% and the top rate on wage and salary income was 50%, that took the form of “My tax shelter is bigger than your tax shelter.” When the high tax rate was cut during the 1980s to 28%, the interest in tax shelters flagged and the economy boomed. Yes, high earners reported a higher share of total personal income, in part because they didn’t bother to shelter it or take it in the form of company perks any more; but they also paid a higher share of total tax revenues.

In the 1990s I prediction that when the Clinton Democrats raised the top rate to 39.6% we would see the animal spirits shift focus from productive economic activity. That prediction turned out to be wrong. In retrospect, I think the Clinton folks hit on a sweet spot by choosing a number that began with a 3 rather than a 4. High earners looking at the 39.6% rate evidently thought, “Well, it’s a little more than a third, but I get to keep nearly two-thirds of my income, so why bother worrying about tax shelters?” I think the Obama Democrats are at risk of overshooting this sweet spot, because with the Obamacare Medicare increase they would be setting a rate than begins with a 4, and because states like New York, New Jersey, Connecticut and California, home to many high earners, have state and city income taxes that raise the total take up toward 50%. I fear that the response from high earners will be something like this: “Hey, if they’re taking nearly half of my income, I need to shield some of it from the tax collector and the public employee unions. Gimme shelter.” That kind of attitude tends to produce the sluggish, stagnant and uncreative economy we had in the late 1970s. Do we really want to go there again?

For more thoughts on the Obama Democrats' Ahab-like quest for higher tax rates, see my February 29 Examiner column.

Click to read full article at Washington Examiner


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