Not a Member?

February 26, 2009

Tax hikes arrive

I hope you didn't think that simply allowing the Bush tax cuts to expire was going to be the extent of President Obama's tax hikes.

In his 2010 budget proposal announced today, Obama addresses a couple of his chief priorities: health care reform and the energy/environmental outlook. Throw in a dose of "restoring fairness to the tax code" and you've got a hat trick (that's a hockey term for you non-Northerners).

First, to raise money for revamping the health care system, there's a significant new tax hike for the "affluent." In a nutshell, this change would reduce the value of itemized deductions for everyone in the 35% marginal tax bracket as well as many of those in the 33% bracket, by only allowing these taxpayers to deduct 28% of the value of their deductions rather than the 33% or 35% they can deduct now. For every $10,000 in deductions then, someone in the 35% tax bracket would pay $700 more in tax.

Here's how the administration expects this to play out, as related by this article from today's New York Times:

The officials said the resulting increase in revenues, estimated at $318 billion over 10 years, would account for about half of a $634 billion "reserve fund"? that Mr. Obama will set aside in his budget to address changes in the health care system. The other half would come from proposed cost savings in Medicare, Medicaid and other health programs.

If only the real world was so simple. The problem is that this type of estimate completely ignores the fact that people change their behavior when their tax incentives change. To assume they won't is simply naive.

Allow me to paint an extreme example to illustrate the point. You're a "rich" person with an extra $50,000 laying around. You have many options of what to do with that money, obviously. But two extremes of the risk/reward spectrum would be buying T-bills, which would be completely safe but not earn very much, and starting a new business, which would be very risky but potentially very rewarding.

When tax rates are very low, the idea of taking the risk to start a business is appealing, because you know you'll get to keep most of the reward if the business succeeds. When tax rates are very high, there's little incentive to take the risk of losing your capital, since you won't get to keep much more of the profit than you would if you simply kept your money safe in T-bills.

Now nobody is saying these tax changes, in and of themselves, are going to cause everyone to suddenly stop starting businesses (or expanding the ones they currently operate). But there's a continuum here. And each tax increase pushes people a little further down that risk/reward continuum. Different people, different ideas - they all have different tipping points along that continuum. Let the Bush tax cuts expire? A few percent tip over from risk-taking to playing it safe. Cut itemized deductions? A few more tip over. Implement a cap and trade tax on businesses? A few more.

The problem isn't so much that those individual taxpayers will pay less taxes themselves as a result of becoming more conservative in their economic decision making, though that's certainly a factor. It's that the group we're talking about includes 45%-55% of the small- and medium-sized businesses in America, who happen to be the nation's primary employers. As they tip over, job creation slows, business growth slows, GDP slows, and so do tax revenues.

If that sounds like theoretical, "supply side" thinking, check out the following table illustrating "Hauser's Law." It illustrates that over the past 60 years, Federal tax revenue has stayed almost exactly at 19.5% of GDP, despite marginal tax rates fluctuating from 90% to 28% during that period. The point:

What happens if we instead raise tax rates? Economists of all persuasions accept that a tax rate hike will reduce GDP, in which case Hauser's Law says it will also lower tax revenue. That's a highly inconvenient truth for redistributive tax policy, and it flies in the face of deeply felt beliefs about social justice.

Moving on, Obama's concern regarding traditional energy sources causing global warming is addressed with a "Cap and Trade" proposal. This environmental priority will generate revenue by forcing companies to buy permits to exceed pollution emission caps. There are lots of issues rolled into one here, but we'll leave those aside for another day to focus squarely on the economics of this.

It's basic, although often demagogued by politicians and misunderstood by the public, that corporations don't pay taxes - individuals do. That is, corporations take their tax expenses into account, just like all their other expense, when setting prices.

In a stunning back-handed admission of this, the administration isn't pretending that most of the billions of dollars in cap/trade revenue will go to researching and promoting alternative energy sources. Rather, they recognize that the billions in taxes paid by businesses will ultimately be passed on to consumers in the form of higher energy (and other) bills. So the administration is planning to take the money from this tax to extend and increase the "Making Work Pay" tax credit.

In other words, government is going to collect an energy tax from all citizens, then give that money back to low- and middle-income citizens. A very small amount gets siphoned off for alternative energy research. But this is primarily a tool to accomplish two goals: (1) redistribute wealth, and (2) make renewable energy sources more competitive with traditional "carbon" energy sources. (Though it's worth noting they won't be making renewable energy more competitive by lowering its price, they'll be doing so by artificially raising the price of traditional energy.)

The New York Times article sums it up pretty well:

The combined effect of the two revenue-raising proposals, on top of Mr. Obama's existing plan to roll back the Bush-era income tax reductions on households with income exceeding $250,000 a year, would be a pronounced move to redistribute wealth by reimposing a larger share of the tax burden on corporations and the most affluent taxpayers.

I'll say. But here's the real kicker:

Behind the numbers in Mr. Obama's first budget is one of the most far-reaching domestic agendas in years, and at a time when the president and Congress are already grappling with an economic crisis worse than any in decades.

That's really the rub. During normal economic times, I can get my brain around something like the cap and trade proposal. I wouldn't like it or agree with it, but I could understand the desire to promote renewable energy sources, with the hope that the artificially level playing field might lead to breakthroughs that could help solve the long-term energy needs of the country. I get that. But now? In the face of this economic crisis, with all the other tax increases already on the table? Don't tell me this is okay because they won't kick in until 2012: wealthy people usually got that way by being forward-thinking. You better believe they are making financial decisions today based on what's coming down the road 2-3 years from now.

There's plenty more: a dramatic tax increase on foreign profits of U.S. businesses, a repeal of oil company tax "breaks", excise taxes on oil, and so on. These are part of a package that will supposedly raise taxes on business by more than $350 billion over the next 10 years.

"The budget also begins to restore a basic sense of fairness to the tax code, eliminating incentives for companies that ship jobs overseas and giving a generous package of tax cuts to 95% of working families," Mr. Obama said in his budget message.

All well and good, except for the two points made earlier. Businesses don't pay taxes, individuals do as those costs are passed on to them. And individuals (who often own or influence business decisions) change their behavior in response to tax incentives.

We haven't touched on what the cumulative impact of these proposals does to the calculus surrounding where businesses will want to locate - here in the U.S. where they'll already be subject to one of the highest corporate tax rates in the world plus all these new extras, vs. other countries where they won't. But we've probably covered enough ground for one day.