To Clinton, and Beyond!

By Alan Viard 

The president’s statement that ‘these tax cuts for the wealthiest Americans are also the tax cuts that are least likely to promote growth’ has no validity unless ‘growth’ is defined as short-run business cycle improvement.

In his remarks on Monday, President Obama reignited the debate about the fate of the 2001 and 2003 tax cuts. The president reiterated his support for letting the high-income rate reductions included in the tax cuts expire at the end of this year, ignoring the economic damage that higher marginal tax rates will do to saving and investment. The president touted raising high-income tax rates as a way to reduce the deficit, even as he reaffirmed his support for more costly middle-class tax cuts and ignored the even more costly growth of entitlement spending.

As he has in the past, President Obama asserted that he is merely calling for high-income taxpayers to “go back to the income tax rates we were paying under Bill Clinton.” In reality, though, the president’s proposal will leave high-income households facing additional levies that did not exist during the Clinton years. Pursuant to the healthcare law, they will pay a new 3.8 percent Unearned Income Medicare Contribution tax on their interest, dividends, and capital gains, as well as a 0.9-percentage-point increase in the Medicare payroll tax on their wages and self-employment earnings.
President Obama also emphasized that we “can’t afford” the high-income rate reductions, labeling them a “major driver” of the deficit. Yet, while highlighting the $850 billion revenue loss from these rate reductions over the next decade, the president reiterated his support for the middle-class portion of the 2001 and 2003 tax cuts, which will cost $2.1 trillion over the same time period.  And he said not a word about the relentless growth of Medicare, Medicaid, and Social Security spending, which is the real driver of the long-term fiscal imbalance. Numerous economists and other commentators across the ideological spectrum have recognized that raising taxes on the rich will not be enough, by itself, to close the long-run fiscal gap.

Gauging a tax increase’s impact on business investment by counting the number of affected owners or firms is little more than numerology.

The president also downplayed the impact of high-income tax rates on business investment, citing the fact that “97 percent of all small business owners in America” fall below the income thresholds at which those rates apply. But gauging a tax increase’s impact on business investment by counting the number of affected owners or firms is little more than numerology. The investment impact of a tax increase depends upon the fraction of business income that is subject to the higher tax rates. On that front, the Joint Committee on Taxation recently reported that the president’s proposed higher tax rates would apply to 53 percent of non-corporate business income.
To be sure, the president is right to suggest that some commentators have overstated the impact of high-income tax rates on small businesses. Given that 3 percent of non-corporate business owners earn more than half of non-corporate business income, there can be little doubt that many of them own large enterprises.
Politics aside, though, the size of the firms has no relevance. Economic theory and evidence make clear that investment by large non-corporate firms offers the same benefits as investment by small firms. As does investment by corporations, for that matter. On that point, the president failed to mention that the expiration of the high-income rate reductions would nearly triple the top tax rate on dividends, a big disincentive for corporate investment.

The Joint Committee on Taxation recently reported that the president’s proposed higher tax rates would apply to 53 percent of non-corporate business income.

The president’s statement that “these tax cuts for the wealthiest Americans are also the tax cuts that are least likely to promote growth” is off-base unless “growth” is defined as short-run business cycle improvement. High-income tax cuts may well be less effective than other fiscal and monetary policy measures at giving the economy a quick jolt of Keynesian demand stimulus. But reducing the marginal tax rate on saving, particularly for the high-income households that are in the best position to save, is precisely the right prescription to encourage the saving and investment that drive long-run growth. The best course is to use temporary demand-based policies to jump-start the sluggish recovery and restore jobs, while also adopting incentive-based tax policies, such as marginal tax rate reductions, for the longer term.
Addressing the fiscal imbalance will force us to make some hard decisions about taxes and spending. When those decisions are made, probably as part of a bipartisan budget agreement, measures to collect more revenue from high-income households will undoubtedly be on the table. But such measures should be designed in ways that minimize tax burdens on saving and investment. They should also be accompanied by broader tax increases and, above all, by reforms that restrain the growth of entitlement spending. The president’s call to raise tax rates on saving and investment, while ignoring the real sources of our fiscal problems, is a prescription for disaster.
Alan D. Viard is a resident scholar at the American Enterprise Institute.