More Thoughts on the Fiscal Cliff Deal

January 2, 2013

Like everyone in Washington, Tax Foundation staff has been musing over the last-minute deal struck to avoid the full effects of the Fiscal Cliff. Here are some of our thoughts:

It undermines economic growth: On a purely economic level, the deal is a Pyrrhic Victory for America. As our analysis showed, while the deal saved us from going over the Fiscal Cliff, the compromise will undermine long-term economic growth. Moreover, it will lower wages and business investment which means that it will not raise as much new tax revenues as is predicted – about two-thirds less in fact. We find that for every new dollar of revenues that the plan will raise, it will lower GDP by $8.50. That’s a pretty bad deal for the economy.

All taxpayers pay a price: When the tax bill is measured on a purely static basis, it hits only high-income Americans as advertised. However, when we take into account the economic effects on other taxpayers, everyone will suffer lower after-tax incomes as a result – about 1.4% lower incomes for the poor and middle-class. (Our distributional tables here).

The Obama tax code: The deal ends the era of the “Bush Tax Cuts.” The tax code is now President Obama’s and he owns all of its effects, for better or worse. One good aspect of the deal is that it made most of the tax code permanent (except for the “extenders” of course). One immediate benefit is that we now have certainty over the revenue baseline, which means that there will be a common vocabulary over what is a tax cut and what is a tax increase. We will also have more clarity over what the actual deficit projections are and what is causing them – spending or revenues.

Lots of added complexity: The deal violates almost all of the principles of sound tax policy that we hold dear. The deal reinstated the limitations on personal exemptions and itemized deductions known as the Personal Exemption Phase-Out (PEP) and the Pease provision. The intent of these provisions is to limit write-offs for high-income taxpayers, which is what the Alternative Minimum Tax was also supposed to do.

The deal also adds another tax bracket to the code, increasing the number of brackets to seven from the current level of six. This is a far cry from the two brackets that were in place between 1988 and 1990, and takes us back to the pre-1986 days when there were 15 brackets. The deal also added a third 20 percent bracket to capital gains and dividends (the rates are now 0%, 15%, and 20%). For some high-income taxpayers, the top rates are actually 18.8% and 23.8% when the Obamacare surtax is included.

What about growth? President Obama can declare victory in his effort to make the tax code more progressive. But it is well known that there is a tradeoff between progressivity and economic growth. As our model shows, the tax hike will slow economic growth. So what is going to be done to grow the economy? Tax reform was to be the vehicle for growing the economy, but…

A setback for tax reform: The deal is clearly a setback for fundamental tax reform. Since the goal of pro-growth tax reform is to broaden the tax base while lowering tax rates, this will be more difficult to achieve now that the top rate has been boosted to Clinton-era levels and all of the worst elements of the current system (such as refundable tax credits) have been left in place.

So what now? Since it is likely that the new taxes on the rich will fail to provide enough new revenue to make a meaningful dent in the deficit, our guess is that tax reform becomes a vehicle for raising the revenues that Obama and the Democrats failed to get in the Fiscal Cliff deal. The definition for what constitutes “tax reform” will be altered to be about closing loopholes and broadening the tax base, and not about lowering tax rates or wringing the dead-weight losses out of the tax system.

Perhaps we will even begin to see some renewed calls for a carbon tax or Value Added Tax.

Nonpayers: The deal leaves in place all of the various tax credits that have knocked a record 58 million Americans off of the tax rolls. According to the Joint Committee on Taxation estimate of the bill, the refundable "outlay effects" of the various measures in the bill (such as the Earned Income Credit, Child Credit, American Opportunity Credit) total $276.5 billion over the next ten years.

Including the non-filers, roughly half of all households pay no income taxes and many of these households benefit from the more than $100 billion in refundable credits that are currently dispensed each year by the IRS to those who own no income taxes. The nonpayer issue will remain a serious problem for years to come.

Inequality: Despite the boost in top tax rates, inequality will continue to grow in America. That is because the tax system has little to do with the current level of inequality. Disparities in educational attainment are having a much bigger effect on inequality and the higher tax rates will not substantially reduce the economic returns from higher education. Our question is, what will the White House say when their tax increase fails to stem the rise in inequality? Our guess is that issue of inequality falls off the radar screen for the next couple of years.

Corporate tax reform: We’re not sure how the deal effects the movement corporate tax reform. Nothing in the deal changes the fact that the U.S. has the highest corporate tax rate in the industrialized world and has an obsolete “worldwide” corporate tax system that is undermining American competitiveness. The deal does, however, create a disparity in the marginal rates in which business forms are taxed. While we are big proponents of cutting the corporate tax rate, we worry about having too big of a disparity between the rates paid by corporate and non-corporate businesses. We certainly don’t need to be reminded of the double-tax on corporate income, but we still think it would be a problem if the tax rate for S-corporations and LLCs was stuck at 39.6%, while the rate for multi-national C-corporations was lowered to say 28% as some have suggested.

No doubt, we will be struck with other thoughts about the deal as time passes. We’ll post those as we digest the full impact of the legislation.

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