Getting Rational about Taxes: Should Bush-43’s Tax Cuts Expire?

The Bush-43 tax cuts are due to expire automatically on January 1, 2011.  In the midst of huge and escalating deficits, this is one area in which activists President Obama and his Democrat Congress appear content to remain passive.  So tax rates on the “rich” are likely to increase. The maximum rate on capital gains will go back to 20% from 15%, and dividends will be taxed as if they’re regular income, no longer at special rates capped at 15%.  These large percentage increases are scheduled to occur even though we’re still in the midst of recession, with persistently high rates of unemployment – an environment that Keynesians believe calls not for increases in taxes, not even for stability in taxes, but rather for substantial, if temporary, reductions therein.

As is the case with so much within the Beltway these days, reaction to the expiration is predictably partisan.  Unfortunately, discussion is as partial in its facts as it is in its perspectives.

Presidential-Candidate Obama advocated restoring the maximum capital-gains tax to 20% from Bush’s 15%, and he held firm, simply not answering a barrage of repeated questions from Charlie Gibson about why anyone would raise a rate when the lower level has yielded higher revenue in the last few years.  This viewer was left with the impression that Obama wanted to soak the rich, and was more interested in revenge than in revenue.  Otherwise, he could have dispatched of Gibson’s returns in at least two different ways: (1)  “Ah, but Charlie, you’re acting as if the only variable was the change in tax rates.  What if it’s the bull market of recent times that’s responsible for revenue increases?” and (2) “Charlie, you know as well as I do that a goodly amount of all this rise in revenue is because people are selling stocks early, before the rates increase in 2011.  In other words, the revenue is just getting bunched, not increased in the long run.”

Some of the confusion can be cleaned up by more careful use of vocabulary.  Instead of talking about “taxes”, we should talk about “tax rates” and “tax revenues”.  Tax rates and tax revenues don’t necessarily move in the same direction.  An increase in rates, for example, is likely to decrease the tax base by changing incentives and, with them, choices.  The question is how sensitive or “elastic” the base is.  In some cases, at least hypothetically, the base will contract so much that the increase in rates will actually decrease revenues.  This possibility is at the heart of “supply-side economics”.  It’s particularly interesting in the case of capital-gains taxes.

The rationale for taxing dividends at a lower rate than most earned income is that dividends have already been taxed at the corporate level.  “Even though it’s still a double tax on profits,” adherents to this approach would argue, “at least we’ve reduced the total.”  The problem is that they’ve also increased equity concerns.  With the Bush cuts, someone “clipping coupons” worth $300,000 would pay much less in income taxes than someone working hard to make the equivalent salary.

Some of this disparity will be eliminated by Obama’s plans to extend Medicare taxes to “unearned income”.  Doing so, however, raises another equity concern:  Weren’t Medicare taxes set up in the context of tying health insurance to employment and therefore forcing people to save for medical expenses when they were too old to work?  Now what?  Populist redistribution?  People are so happy being angry at that legal fiction, a corporate entity, that taxing only flow-through income, with corporate taxes of zero, is unthinkable – or, at least, undoable.  Few, therefore, are talking about this possible “reform”.

Nor are many talking about the effect of inflation on capital gains.  When stocks have been held for a long time, a lot of the increase in their “paper value” is due to the cumulative effect of inflation.  Surely capital gains should be indexed for inflation?

In response to increases in tax rates, politicians from states like New York are calling for the brackets to be indexed not just by inflation but also by differential costs.  “An income that would make one rich in rural Alabama doesn’t cut it in New York City,” they properly note.  But shouldn’t they run the same analysis on minimum wages?  And wouldn’t making real cost distinctions unduly complicate the already detail-ridden tax code?  How many different cost zones would there be in the state of New York alone?

The Wall Street Journal adds its complaints that the deductibility of state taxes on federal tax forms already subsidizes state excesses.  It neglects to mention that more and more of us run afoul of alternative-minimum taxes (AMT), where these deductions are added back into the taxable base.  So much for state and local subsidies.

Art Laffer is considered to have invented “supply-side economics”, with a little graph on a paper napkin.  He didn’t – invent it, that is: the napkin part of the story is true.  He just popularized the concept of elasticity, with a focus on taxes. Laffer is certainly correct that the rich are clever at avoiding taxes – legally with the help of lawyers, illegally with chicanery of the sort practiced by Sen. John Kerry in endeavoring to shelter his yacht from state taxes by docking it in Rhode Island rather than his home state of “Taxachusetts”.

There should be little doubt that the change in capital-gains and dividend taxes will make stock markets less attractive than it used to be relative to bonds and t-bills, and, within stock markets, the dividend-paying stocks relatively less attractive than zero-dividend growth stocks. What we really need is studies on how private decisions based on reducing taxes affect the overall economy as well as the stock market.  Efficiency must suffer.  The question is “How much?”

In his “The Soak-the-Rich Catch-22” opinion piece in August 2’s Wall Street Journal, Laffer continues to run with his signature theme “Higher Taxes, Lower Revenue”.  Over and over again, he compares tax rates on “the top 1% of income earners” with tax revenues over different periods, showing that they’re negatively correlated.  Never does he tell his readers what “income earners” means.  Is it just wage income?  Or does it also include interest and dividends earned on wage income saved decades ago?  How about gains from the sale of real estate?

Laffer delights in demonstrating that the percentage of tax revenues paid by the top 1% have risen as their tax rates have fallen, he fails ever to tell us whether or not the percentage of their income in GDP has also gone up.  If the top 1% earns a much higher fraction of total US income now than before the Bush 43 cuts, this factor must be incorporated into any tax analysis, whether the argument is based on efficiency or equity grounds.

And that brings us to yet another issue.   When discussing taxes and the actual and proper distribution of their burden, shouldn’t we also discuss government spending and the actual and proper distribution of benefits – both on the three levels of federal, state and local?  There’s plenty of work to be done, and it should all be bipartisan and factual.

Taxes should not be based on envy and politics, but on economics and data.  The time for rationality is now.  We have some tough questions to ask, and we must answer them with facts rather than emotional convictions.