By Edward Conard | December 12, 2012
To accelerate private-sector growth, Republicans will need all their negotiating leverage to minimize taxes on investors by maximizing spending cuts. In a world where the majority of voters garner benefits from spending and see little cost to taxing investors, that’s never been easy. But the current circumstances make it much more precarious.
Lawmakers have increased government spending 30 percent since 2007 — from 20 percent of gross domestic product historically to 24 percent — on flat tax revenues. That has opened up an unprecedented $1.1 trillion-a-year deficit. The resulting unsustainable rise in debt coupled with near-zero interest rates have shielded spending advocates from voters realizing that draconian across-the-board tax increases are needed to support the proposed level of spending. Instead, many voters mistakenly believe that raising taxes on upper-income taxpayers provides enough revenue to bring taxes and spending into balance. As a result of these misunderstandings, most voters blame Republicans, not Democrats, for refusing to compromise on the deficit by agreeing to raise taxes on investors. These misunderstandings have given the president an opportunity for two bites at tax-the-investors apple — one by the end of the year to avoid the fiscal cliff and another when a comprehensive solution to the deficit is finally negotiated. Republicans must be shrewd to avoid this piecemeal negotiating trap.
Debt can’t continue to rise relative to GDP forever. To hold it constant, we can sustain deficits of about $200 billion a year. Today, that leaves a $900 billion-a-year gap between revenues and spending. Letting the Bush tax cuts expire on upper-income taxpayers raises less than $50 billion a year. Limiting deductions to 28 percent of income for upper-income taxpayers, raising capital gains and dividend tax rates to ordinary income tax rates and raising estates taxes together would raise less than $100 billion a year more. Reasonable changes to Medicare and Social Security, such as raising the retirement age and raising upper-income Medicare premiums, would raise much less than $50 billion a year more. It’s true that ending the Afghanistan war saves about $150 billion a year. But Obamacare increases spending by a similar amount — even after its tax increases and Medicare cuts. And government spending as a percentage of GDP is projected to continue rising as the number of workers per retiree drops from 3-to-1, currently, to 2-to-1.
In truth, the president can’t pay for his proposed spending without draconian across-the-board tax increases. Even the fiscal cliff — which would raise middle-class taxes hundreds of millions of dollars a year by letting the Bush tax cuts expire for all taxpayers, expose them to the alternative minimum tax and end the payroll tax holiday — would close only two-thirds of the fiscal gap.
The need for dramatically higher revenues makes the president’s threat to veto any legislation that does not raise taxes on investors by the end of the year credible. How better to raise taxes on the middle class than by going over the fiscal cliff and successfully blaming the resulting tax increases on Republicans?
As if their negotiating position was not precarious enough, it will grow increasingly difficult for Republicans to hold the line on tax increases. When the middle class and seniors realize the truth, they are going to fight hard to maintain their incomes by increasing taxes on investors even further. Investors who thought a 39 percent tax rate was acceptable are in for a rude awakening. Even with tax increases and spending cuts from the fiscal cliff, we still would need a 70 percent marginal tax rate to close the $900 billion-a-year gap. Recent history shows that’s hardly outside the realm of possibility. Not but 30 years ago, marginal tax rates were that high.
Raising taxes on upper-income taxpayers, whether at the margin or on average, would redistribute and consume income that would otherwise be invested. That would slow growth and employment. Nevertheless, Republicans are under enormous pressure to agree to tax increases on investors by year-end in order to gain time needed to hammer out compromises that reduce spending to sustainable levels. They risk losing the House if they are successfully blamed for being unreasonable. If that happens, the damage to our economy will be much worse. Under these circumstances, a better alternative than agreeing to tax increases piecemeal is accepting a rollback of the Bush tax cuts on upper-income taxpayers conditioned upon Congress taking all the actions necessary to stop debt from growing relative to GDP. Capping deductions is a less damaging way to raise revenues than taxing income at the margin, but neither is good for growth.
Ed Conard, a former managing director of Bain Capital, is an American Enterprise Institute visiting scholar and the author of “Unintended Consequences: Why Everything You’ve Been Told About the Economy Is Wrong” (Portfolio, 2012).