The Exchange

The Overtaxed Arguments Over Tax Rates

The Exchange

The political standoff over the U.S. government's fiscal future has so far proven mostly immune to reason and perspective when it comes to tax rates.

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Pimco chief investment officer Mohamed El-Erian can patiently explain to us that "this is about more than taxes." The Congressional Research Service offered a sober analysis of the unclear connection between tax rates and economic performance, before Senate Republicans forced the withdrawal of the report.

In an improbably lively New Yorker magazine essay, Harvard historian Jill Lepore framed current policy headlines as merely an extension of a centuries-long struggle of Americans to reconcile themselves to their government's revenue demands. And conscientious financial advisers everywhere are trying to warn clients not to get caught up in the tax implications of their business and saving decisions.

A Lively Tax Discourse

From one angle or another, these contributions to the tax discussion point out, appropriately, that the relatively modest shifts in tax rates now on the table as part of the "fiscal cliff" negotiations would not present a major swing factor for either economic growth or deficit reduction. Yet efforts to place into context the debate over nudging income- and investment-tax rates higher for well-off Americans are being drowned out by overheated rhetoric from folks on both sides of the divide.

[See Related Item: Buffett Is Right About What Being Rich Is, Wrong About Tax Increases]

Republicans would have us believe that allowing the top income-tax rate to rise from the from the current 35% to the 39.6% level that prevailed for most of the 1990s would be sufficient to suppress the otherwise lusty American appetite to take bold business risks. And having stock dividends and capital gains taxed at 20% or 25%, rather than the current 15%, would supposedly drive large-scale withdrawals from the equity markets and deprive excellent business ideas of enlivening capital.

Arguing past these points, President Obama and Democratic allies are digging in their heels on allowing those tax rates to climb for the top 1% or 2% of households, suggesting both that it is the right moral choice to have the wealthy pay more and that such changes will offer substantial help in reducing government deficits.

On both sides, the suggested outcomes are far overstated, which supports the suspicion that these are political gestures and call-outs to ideological supporters dressed up as principled adherence to good economic policy.

Cause + Effect = Close to Zero?

The Congressional Research Service report went a long way toward undermining the idea that particular tax-rate levels are associated with periods of faster or slower economic growth, mapping changes in top marginal tax rates against the country's gross domestic product trajectory since 1945 without finding strong cause and effect.

[See Related Story: Why Warren Buffett Is Right About Raising Taxes on the Rich]

Warnings against lifting the top tax bracket necessarily hinge on what it would mean for small business owners who pay at individual tax rates. Yet with fewer than 3% of those taxpayers portrayed as small businesses earning more than the $250,000 threshold for the top rate in Obama's proposal, and with a small minority of very successful startups accounting for all the net job creation from smaller companies, the linkage between a possible 4.6 percentage point rise in levies on small business profits hardly seems economically decisive.

The monthly National Federation of Independent Business survey, often invoked as a measure of entrepreneurs' policy anxiety, nonetheless continues to show that "poor sales" constitutes the "most important small business problem," named so by 22% of respondents. "Taxes" are also a serious concern for this group, but at its latest 20% response level, the issue is precisely at the mid-point of its long-term range over the history of the poll.

[See related story: Unemployment Benefits, Payroll Tax Cut Really at Risk of Going Over 'Cliff' ]

The Buffett Rule

In his Monday op-ed piece in the New York Times, which reiterated his support for a minimum federal tax rate on millionaires, Warren Buffett gets at the slipperiness of the notion that investors would forgo juicy profit opportunities to avoid a somewhat higher tax bill on the resulting gains. True, investors have clearly been quick to sell dividend plays such as utilities and telecommunications stocks in apparent anticipation of dividend taxes going higher. But this action seems short-sighted -- both because any likely tax increase won't significantly change the effective after-tax yield on these stocks, and because the same low-yield environment that made the stocks attractive in the first place means there are few smart alternatives for reinvesting the cash from these sales.

And do tax considerations really drive investment preferences over longer periods? Consider that some of the most popular investments made by wealthy individuals in recent years -- corporate bonds and real estate investment trusts -- are quite tax-inefficient for their owners, typically resulting in interest and dividends subject to taxation at the ordinary income rate.

From the other side, the case made by some Democrats that imposing modestly higher rates on a thin sliver of the public would significantly improve government finances is also suspect. By the Tax Policy Center's estimates, under the Obama proposal federal revenue would rise by less than $70 billion a year. Described as a "down payment" on deficit reduction, this qualifies as a pretty skimpy portion of the balance, given that the deficit is running near $1 trillion annually.

The course of the current domestic economic expansion is a much more important driver of future deficit levels than are higher prospective tax rates. With no help from Congress or the president, the cyclical recovery in economic output alone has cut the annual deficit from nearly 10.5% of GDP in 2009 to 7% this year, even with government tax revenue as a percentage of GDP sitting at historically depressed levels.

If the full fiscal cliff can be avoided, the economy will have a better chance to extend the improving performance evident in the housing, auto-sales, export and employment data. If only the reality were that the rigidly held positions on small differences in tax rates made an agreement to avert the cliff a foregone conclusion.

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