In all the negotiations to prevent the fiscal cliff from hurting the economy, potential compromises keep coming apart over the issue of raising income tax rates, especially on high earners. Income taxes stir up strong feelings among voters because of concerns about fairness — and politicians exploit those emotions, whichever party they belong to. As a result, the broader budget discussion keeps getting diverted to focus on tax rates, which actually play only a small role among the causes of current U.S. financial troubles.
In fact, there are really two different budget problems that often get mixed together. One is the current deficit, which totaled more than $1.1 trillion last year, almost double the amount that the U.S. economy can comfortably carry. The other is the long-term accumulation of debt. Even after the U.S. economy fully recovers from the effects of the recession, the federal deficit is projected to remain too high. As a result, the national debt is on course to keep rising as a percentage of GDP until it reaches dangerous levels.
While everyone agrees that growth of the national debt needs to be slowed over the long term, experts are divided over how much the current deficit should be cut. Some commentators even argue that the short-term deficit should be allowed to continue for another year or so to stimulate the sluggish economy.
The best solution to both these problems would be a grand bargain that limits the growth of debt over the long term while trimming the immediate deficit just enough to show that policy is heading in the right direction. What keeps getting in the way are a bunch of misconceptions, chiefly about tax rates. Here are the four biggest:
The Bush cuts in tax rates caused the deficit. Some economists argue that Bush Administration policies taken as a whole, including costly wars in Iraq and Afghanistan, caused much of the borrowing beyond what the U.S. economy can sustain. More often, though, the blame is focused specifically on the cuts in tax rates. Those rate reductions, however, account for only about a fifth of last year’s $1.1 trillion deficit.
Where did the rest come from? The temporary cut in payroll taxes for Social Security, introduced in 2010 to bolster the economy, reduced revenues by more than $100 billion in 2012. In addition, federal spending as a percentage of GDP has climbed from 20.8% in 2008 to 24.3% last year. Some of that is because of persistently high joblessness that has resulted in more spending on unemployment benefits and less income tax revenue.
Taxes are lower than they used to be. It’s true that the top tax bracket has come down substantially over the past half-century — from 91% when President Kennedy took office, 70% when President Reagan took office and 39.6% when President George W. Bush took office to 35% today. But rates are only one element of income tax policy — the rules for what counts as income and what deductions are allowed are just as important. Mitt Romney enjoyed a low effective tax rate, for instance, because he received much of his income in the form of capital gains.
In the end what really matters is how much revenue the tax system raises. That amount, measured as a percentage of GDP, normally drops during recessions, as it did recently. But once the economy fully recovers, federal revenues are projected to be about the same as they have been for the past half-century.
U.S. income taxes aren’t very progressive. In fact, U.S. income taxes are among the most progressive in the industrialized world. Indeed, 46% of households pay no income tax at all. In many other countries, by contrast, income tax begins at lower income levels than in does in the U.S., on the theory that everyone should pay something.
The high progressivity of the U.S. income tax system is offset, however, by relatively flat taxes for Social Security and Medicare, and by the fact that state and local authorities rely on ways to raise revenue that aren’t progressive at all (e.g., sales tax). While the U.S. tax system may be less progressive overall than it used to be, that isn’t because of federal income tax but because of other types of taxes.
Raising tax rates will fix America’s budget problems. Raising tax rates on households with incomes above $250,000 would produce revenues equal to only 4% of the 2012 deficit. Higher taxes on capital gains and dividends, plus higher estate taxes would produce an additional 4%. A few other current provisions that favor the wealthy are equivalent to 2% of the deficit. So all together, higher tax rates for the rich would reduce the deficit by no more than 10%.
The vast bulk of the money that would be raised by the full fiscal-cliff tax hikes, however, would come from the middle class — and that increase could make a big dent in the current deficit. But it wouldn’t permanently solve the long-term budget problem: after five years or so, the relentless growth of health care spending would eat up all the additional revenue.
These misconceptions aren’t just academic questions. Intense debate over tax rates has diverted the discussion from the most important budget issues to factors that are only a small part of the equation. Unfortunately, this is a really bad time to be missing the big picture. The fiscal cliff risks tipping the economy back into recession short term, while not really doing much about long-term problems. Any real solution will have to look out beyond 2013 and focus instead on comprehensive reform of both the overall tax system and long-term entitlements.