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NDN Memo: A Better Way to Avoid the Fiscal Cliff on Taxes
With the fiscal cliff now in sight, the nation’s pundits are breathing as heavily as they collectively can over the prospect of political warfare over the Bush tax cuts. Yet, a compromise between President Obama and congressional Republicans over taxes for the top 2 percent is already clear. We extend the Bush tax rates but also cap the value of tax preferences for those two-percenters – an idea borrowed from Mitt Romney – so they pay the same additional taxes they would have if the top rates had gone back to 36 percent and 39.6 percent. The President meets his commitment to ensure that well-to-do Americans pay more taxes, and congressional Republicans get to boast that they held the top rates at 33 percent and 35 percent. And if we do it right, it could also be the first real step in a generation to address growing income inequality.
Yes, the President has called on Congress to re-enact the Bush tax cuts without the rate cuts for the top 2 percent. But he has also said, sensibly enough, that compromise will be required to move away from the fiscal cliff, so we can assume that that his current position is not final. Similarly, House Speaker John Boehner has said no to new taxes, but yes to additional revenues. This compromise builds on that foundation, extends Romney’s idea of capping deductions to cover all tax preferences, and uses the revenues to pay down the deficit rather than fund more cuts in tax rates.
For progressives, this approach could also be a lot fairer than simply raising tax rates, if Congress and the President will just allocate a proportionate share of the new taxes to America’s truly rich households, by capping the value of all tax preferences. The key here is that the top income tax rate applies only to the labor income – wages and salaries – that doctors, lawyers, business people, and other well-paid professionals actually earn. Those top rates do not touch the capital gains and dividends that comprise most of the incomes of really wealthy people. In 2008, for example, nearly 75 percent of all capital gains and dividend income went to the top 1 percent – and 80 percent of that was reported by the richest one-tenth of one percent of Americans. That’s how Mitt Romney could legally pay a lower tax rate on his $20 million annual income than an average teacher pays on her annual $50,000 salary. Repeal the top Bush tax rates, and most of the income of the very rich will still be taxed at 15 percent.
Instead, let’s think about how a hybrid Obama-Romney tax reform might work. Repealing the Bush cuts for the top rates would raise about $800 billion over 10 years or an average of $80 billion per-year. (The interest savings would come to another $130 billion.) Our hybrid reform would allocate those additional taxes across the top 2 percent, based on income. For example, in 2008, everyone in America with taxable incomes of $200,000 or more reported a total of $2.06 trillion in taxable income. Some 3,470,000 households with incomes of $200,000 to $500,000 accounted for 38.3 percent of that total. So, they would have to come up with 38.3 percent of the additional $80 billion in annual taxes, or $30.64 billion per-year. That would come to about $9,000 per household.
As it happens, many people earning between $200,000 and $500,000 would still end up ahead, because they would retain an average of $12,000 in tax savings from the extension of the Bush rate cuts on income below $200,000. Now, consider what would happen to the very rich. Those reporting incomes of $10 million or more accounted for 16.9 percent of that $2.06 trillion in taxable income, or $339 billion. So, in fairness, they should bear 16.9 percent of the $80 billion annual tax bill or about $13.5 billion per-year. The 13,401 households responsible for that $339 billion in reported income would face additional taxes averaging about $1 million each.
The alternative – leave the big tax preferences for the wealthy untouched and just roll back the top two Bush rate cuts on labor income – would unfairly shift most of the burden to some 3 million or so affluent professionals. The irony is that according to the supply-side catechism, that would lead them to work less, depriving the economy of some of their valuable labor. Economists are still divided over whether those effects would be significant or modest. What is less controversial is that changes in capital gains taxes have little effect on how much people save and invest. That’s why Ronald Reagan was willing to tax capital gains (and dividends) at the same rate as wages and salaries. This new alternative, inspired by Mitt Romney himself, would leave unchanged the low marginal rates on capital gains and dividends, but limit the value of the benefits wealthy people can claim from those low rates. In the bargain, the President and Congress could cut $1 trillion from our deficits over the next ten years and make the first real progress in a generation towards containing today’s record-high income inequality.