"Tax Increases are Coming"

Sydney M. Williams

Thought of the Day

“Tax Increases are Coming”

July 8, 2010

Following the Group of 20 meeting in Toronto – a meeting which highlighted the differences between the U.S. and many of its allies in terms of deficits – President Obama was asked what he had planned for deficit reduction. His 4 minute, 19 second response included a host of initiatives he has already implemented (dubious), a promotional comment on the health care bill (?), the usual slap at Republicans and a promise that the Commission of Fiscal Responsibility and Reform will issue their report in November (after the mid-term elections). He added that he hopes that those who have been calling for deficit reduction will not back away from the commission’s recommendations. He said he would be “calling their bluff.”

Federal debt now stands at just under $13.2 trillion and is growing at the rate of a million dollars every 30 seconds – $2.88 billion every day. Something has to give. Liberals, like Paul Krugman, call for continued federal spending and an increase in taxes. Fiscal conservatives, like Niall Ferguson, suggest an approach that relies on the private sector and a reduction in taxes.

Barring some unforeseen legislation, on January 1, 2011 the United States will experience the largest tax increase in its history, as the Bush tax cuts roll off the books. Raising taxes, like draconian cuts to public spending, increasing interest rates, or restricting trade are no-no’s during a period of anemic economic growth. Mr. Obama needs cover for the tax increases that are coming and the Commission will be there for him.

According to IRS data, the top 1% of all wage earners in 2002 (before the 2003 Bush tax cuts) paid 33.71% of all personal income taxes. In 2007 (the last year for which I could find data), the top 1% paid 40.42% of all taxes. The top 5% of all earners (those who earned more than $160,041 in adjusted gross income) paid 60.63% of all taxes in 2007 versus 53.80% in 2002. In 2002 the bottom 50% of all wage earners paid 3.50% of all taxes. By 2007 that percent had declined to 2.89%.

The rich are paying a larger percentage of total taxes, suggesting that the “tax breaks for millionaires and billionaires” has not been detrimental to the Treasury. There is, however, a separate issue which the Administration has chosen to confuse with lower tax rates and that is the widening disparity in the earnings between the “rich” and the average worker. For example, using average gross income (AGI), the share of income earned by the top 1% has grown from 16.9% in 2002 to a 23.5% share in 2007. Average gross income is, of course, a pre-tax number and this trend has been in place for thirty years, through tax cuts and tax increases. For example, in 1982, the top 1% of earners generated 12.8% of all income in 1982. Understanding the cause of this expanding polarization is important. It reflects changes in technology and an education gap that has disadvantaged many of the poor. Bringing competition to the educational system, as charter schools and voucher systems do, is an important first step, something the powerful teacher’s unions have been fighting. This gap also reflects the dramatic increase in CEO pay versus the average worker over the past few decades. According to the Economic Policy Institute, the average CEO in 1965 earned 24 times more than a typical worker. By 2007 that number had risen to 275 times. The bulk of that expansion occurred since 1990 and, I would argue, was largely a function of a decision of the Clinton Administration in 1993 to limit the deductibility of executive salary compensation to a million dollars – a decision that had the unintended consequence of grossly expanding the use of options, which in turn led to a focus on short term results and fraudulent practices such as backdating.

Addressing this disparity is not a simple matter. While few would argue that rising inequality is a good thing, it is also important not to destroy the potential for wealth for those on the ladder. Candidate Obama’s vow to “spread the wealth” has not been well received. Mobility, up and down the income scale, is a deeply embedded American belief. Keep in mind that in a 2005 study of the Forbes 400, it was found that a vast majority – 294 – built their wealth through hard work and building businesses in insurance, oil, technology, consumer products, entertainment and real estate, while 40 inherited their wealth. Americans, more than others, have shown a willingness to accept a higher level of inequality in income, as they aspire to success.

Raising taxes on very high income ($10 million or more) may make good headlines, but won’t raise much revenue. Since the holding period for some high frequency traders is measured in milliseconds, and from what I can tell they serve no real economic purpose other than feathering their own nests, I could well support a draconian increase in the capital gains tax for such short term holding periods. But off-setting such an increase should be cuts (or elimination of) in capital gains for securities held for five years. Long term investing needs to be encouraged for the long term health of the country. The automatic increase from 15% to 20% next year will prove counter-productive, as will the virtually doubling of taxes on dividend income. (The increase on dividends may be limited to 20%, according to Treasury Secretary Timothy Geithner in an interview last night on CNBC.) It is consumption, not investing, that should be discouraged.

The National Bureau of Economic Research (NBER) is the official scorekeeper for recessions. According to their work, the current recession began in December 2007 and is now in its 32nd month, twice as long as the previous postwar recession record. (Keep in mind, though, when the NBER declares the recession over it will be long after the fact.) Nevertheless, while the recession began under President Bush, it now belongs to President Obama and it has become his to repair. The 1930s showed the folly of raising taxes, tightening money, attempting centralization and discouraging trade. Had the War never happened and had Roosevelt been a two-term President, his Presidency would be considered a failure. Hoover made serious mistakes in terms of raising taxes, attempting to balance the budget and signing Smoot-Hawley. FDR’s policies did not work either. It was the War that brought recovery to our economy.

Economic growth is the one elixir that will painlessly remove us from the abyss of debt Armageddon; so the question is how best to do it? From my perspective, the best answer is for government to provide an environment that encourages the private sector to invest and to hire, and that requires regulations that are simple, straight forward and easily complied with, and a tax policy that recognizes that many small businesses are sole proprietorships, so subject to individual tax rates. The pending tax increases scheduled for January 1st will prove counter-productive.