The 2% Illusion

This Op-Ed in today's Wall Street Journal is a good discussion of the folly of trying to pay for big government by taxing only the richest Americans. This strategy will never work, for two main reasons:

1. There isn't enough revenue potential in just raising taxes on the rich. As the editorial states, using an extreme example, even if the government had confiscated 100% of the income of those making over $500,000/yr in 2006, they would only have gained an extra $1.3 trillion in tax revenue. Assuming that raising rates by 65% (from 35% to 100%) would have raised $1.3 trillion, raising rates by the 6.6% Obama proposes (a combination of the expiration of the Bush tax cuts and the backdoor tax rate increase caused by the proposed disallowance of itemized deductions) would have raised about $130 billion. Add in the extra revenue from raising rates on those making over $250,000, which is where Obama has said the higher rates will be assessed, and you might have a total of $200 to $250 billion in extra tax revenue, a drop in the bucket compared to the proposed new spending in excess of $1 trillion annually. But here is the kicker. That is using a static revenue model, which leads to Point #2.

2. Raising marginal tax rates never yields as much revenue as the Congressional Budget Office estimates, because the CBO uses a static estimation method, i.e. it assumes no change in economic behavior due to the change in tax rates. This assumption has been proven invalid time and time again, and yet the CBO continues to use static analyis when estimating the tax revenue effects of increases or decreases in marginal rates.

The static method is especially egregious in the case of capital gains tax rates, where experience has shown that lowering the capital gains rate has actually increased tax revenue. It is also inaccurate for marginal rates on earned income. One need look no further than 2004-2006, when tax revenue actually increased by about 15% per year.

The storyline that the Bush tax cuts caused the deficit to explode was a fallacy. The deficit increased in the first couple of years of the Bush Presidency for three reasons:

1. The popping of the tech equity bubble and the subsequent recession in 2001-2002, which caused a major reduction in tax revenues.

2. An explosion of domestic spending, one of the big mistakes of the Bush Presidency.

3. The fact that when the first Bush tax cuts were enacted in 2001, the lower rates were phased in over a number of years, causing economic activity to be delayed until the lower rates were in effect.

The second round of tax cuts in 2003 corrected the phase-in problem by making the lower rates effective immediately, which led to growth in tax revenue and a reduction in the budget deficit in 2004-2006 as the economy expanded.

Unfortunately, the sunset provision ending the tax cuts after 2010 was not eliminated by the 2003 Tax Act. If the economy begins to recover in 2010 (a big if), rest assured it will run into a brick wall in 2011 when the Bush tax cuts expire and Obama's additional proposed tax hikes presumably take effect. But at least we'll have government-run health care!

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