April 3, 2009

Opportunity for Tax Reform is Here: Will Obama Squander It?

(The following commentary originally appeared in the April 3, 2009 edition of the D.C. Examiner).

On February 26, 2009, President Obama unveiled his federal budget proposal. The 10-year outline sharply increases spending and borrowing from previous projections, with a total of over $9 trillion in new debt. The federal government’s share of the economy will hover around 25 percent, up from the last few decades’ average of somewhere between 18 and 20 percent. Nearly $1 trillion in new revenues will be raised over the next decade beyond the projected baseline, primarily (but not exclusively) from those making more than $250,000 per year.

That the proposal eliminates or reduces some deductions should not be mistaken for a move toward “broad base, low rate” fundamental tax reform. As The Economist succinctly put it a month ago:

“Mr Obama’s scattershot tax increases are a poor substitute for the wholesale reform America’s Byzantine tax code needs. Limiting high earners’ deductions for mortgage interest, local-government taxes and other things is certainly more efficient than raising their marginal tax rates even more. But it would be better to replace such deductions for everyone with targeted credits, abolish the alternative minimum tax (an absurd parallel tax system that ensnares a sizeable chunk of the upper middle class), and implement a broad sales tax. Rather than simply eliminating the sheltering of corporate income from abroad, Mr Obama could have broadened the corporate tax base and lowered the rate. In sum, Mr Obama could simultaneously raise more revenue and make the tax code simpler and more conducive to growth. But he hasn’t.”

We at the Tax Foundation have lots of ideas for broadening bases and lowering rates, which can help close the budget gap while moving toward a simple, neutral, transparent tax system. We will soon produce a report on the distributional impacts of the Obama budget, which we hope will inform a debate this country needs to have regarding how much income the federal budget should be transferring from one group to another. We also have much to say on the practical effects of trying to impose punitive taxes on high income earners, who tend to be entrepreneurial, highly mobile, and sensitive to hefty tax increases.

President Obama is not alone in insisting that high-income earners pay most of the cost of expanding the size and role of government. When President Obama’s budget came out, there were more than a few editorials who heralded a New Liberal Order (of proactive government and progressive taxes) that involved the death of the Reagan Revolution (of limited government and low taxes). Many state governors, struggling to close their own budget shortfalls, are turning to taxes on millionaires (and more recently, several-hundred-thousand-aires):

To seal a $132 billion budget, [New York Governor David] Paterson has called for raising the marginal tax rate to 7.85% for three years for single filers who earn $200,000 to $500,000 as well as married couples whose combined earnings total $300,000 to $500,000. A new 8.97% tax bracket would be levied on filers with $500,000 of taxable income. The state’s tax rate is 6.85% for everyone who earns more than $40,000. New York City levies a 3.6% marginal rate for earnings over $90,000.

A handful of states already had in place so-called millionaire’s taxes, but New Jersey is considering boosting for one year the tax on top earners to 10.25% from 8.97%. The proposal would provide an estimated $620 million to help close a $7 billion shortfall, said Thomas Vincz, a spokesman for the state treasury.

California already has a 10.3% tax on incomes above $1 million. The governor and Legislature agreed in February to raise the tax on all brackets by 0.25 percentage point in an effort to close a $42 billion deficit.

Last year, Maryland added a new 6.25% tax bracket for those with incomes of over $1 million. Other states are taking note: Wisconsin’s governor has pitched a new tax bracket for individuals making more than $225,000 a year or couples making $300,000. Delaware’s governor has suggested raising taxes on those who make more than $60,000 by one percentage point, to 6.95%.

Connecticut Gov. Jodi Rell, a Republican, has vowed not to raise taxes, but she is facing pressure from unions and advocates for the poor who have been pressing the Democrat-controlled Legislature to squeeze more revenue from residents earning more than $200,000 a year.

This revolution, if that is what it is, is built on sand. Again, The Economist put it better than I could:

“[B]y asking only the richest 2% of Americans to pay more, Mr Obama is building his vision of a more activist government on a shaky foundation…. [T]he recession is already undoing some of the rise in inequality as the capital gains, bonuses and Wall Street profits that fuelled much of the gains in top incomes turn to dust. This could further imperil Mr Obama’s revenue projections, if the rich people he is relying on to pay virtually all his bills end up a lot less rich than they were. Much as Mr Obama would like to shield the middle class, he needs to level with Americans: if they want a bigger government, one that will help them in all sorts of ways, they should be prepared to pay for it.”

Commentators sometimes shake their heads at how Americans seemingly demand low taxes but also lots of government services. Our complex, non-transparent, non-neutral tax code promotes that by transferring income simultaneously from poor to rich, rich to poor, poor to poor, and rich to rich, with direct and indirect taxes, some of which are paid by employers directly, and some of which are hidden in prices through business taxation. Who can accurately say what they pay in taxes?

With the costs hidden, dispersed, and sometimes shifted outright onto a minority of people, it’s no surprise Americans sometimes embrace expansion of government services. But as the federal and state governments begin relying more and more on high-income earners to fund programs and services for everyone, that Well will eventually run dry and we will be caught with lots of spending and no way to fund it. To avoid this, officials should consider this to be a golden opportunity to switch to a tax system that focuses just on raising revenue in the least distorting way possible.

Joseph Henchman is the director of state projects and tax counsel for the Tax Foundation, a nonpartisan, nonprofit organization that has monitored fiscal policy at the federal, state and local levels since 1937.