A Tax Hike is a Terrible Thing to Waste

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For weeks, Democrats and Republicans have been locked in a bitter dispute over the so-called “millionaires tax” – an income tax surcharge targeting wealthy taxpayers. Democrats want to use it to pay for an extension of the payroll tax cut, but Republicans say it will slow the economy. “It simply does not make sense to extend the payroll tax cut by raising taxes on American job creators,” complained Speaker of the House John Boehner, R-Ohio.

The GOP seems likely to win this fight; Democrats signaled yesterday that they plan to abandon the surcharge. It’s the right decision, but they’re making it for the wrong reasons.

Democrats really like the idea of raising taxes on the rich, and they’ve tried repeatedly to do it. During his campaign for the White House, Barack Obama promised to let the Bush tax cuts expire for anyone making more than a quarter million dollars a year. And during the health care debate, Democrats suggested an income tax surcharge to help cover the cost.

(MOREThe Tragic Death of the Temporary Tax Cut)

It’s easy to understand why Democrats like high-end tax hikes: Rich Americans can afford them. Rates have been declining for years, especially for those at the top of the income scale. Between 1995 and 2008 (the latest year for which the IRS provides data), the effective rate on the 400 richest taxpayers fell from 29.93% to just 18.11%.

Rates for everyone else have been falling, too, at least since the late 1970s. But the richest taxpayers have done the best. And while their rates have fallen, their incomes have risen dramatically. That combination leaves them well suited for a tax hike.

But the real question is when to raise taxes on the rich, not whether to do it at all. History would suggest that progressive tax hikes are most useful when they’re part of a larger fiscal reform. The kind of reform that many people today like to call a grand bargain. America, in short, needs a big fiscal reckoning. Our real problem is not the deficits we’ve been running in recent years; in the midst of a sluggish economy, unbalanced budgets actually encourage growth, which in turn raises overall tax revenue.

What we should be worrying about instead is that entitlement spending threatens to overwhelm the federal budget, creating huge and persistent deficits that won’t go away with growth. And taxes are part of the problem, too. Between 2001 and 2010, taxes as a share of gross domestic product fell from 19.5% to just 14.9%.

The solution is obvious: a combination of spending cuts and tax hikes. This policy mix will be painful for everyone. But it will be especially hard on the poor and middle class, since they depend on the entitlement programs that are certain to be cut. They’re also likely to see their taxes go up, either through increases in existing taxes or the introduction of some new levy, like a value-added tax.

To help spread the sacrifice, rich Americans should be asked to pay more, too. Raising their taxes, moreover, isn’t just morally right – it’s also an American tradition.

This year marks the 150th anniversary of the federal income tax. First enacted in 1861 to pay for the Civil War, lawmakers created it to ensure that rich Americans paid their fair share. Existing taxes on consumption were extremely regressive. To balance the scales of fiscal justice, Congress ask rich Americans to pay a new tax on income.

“I am inclined very much to favor the idea of a tax upon incomes,” explained Sen. William Fessenden, R-Maine. “I believe the burdens will be more equalized on all classes of the community, more especially on those who are able to bear them.”

(MOREDems Drop Millionaires Tax in Dispute)

Fessenden and his colleagues knew something that many of today’s lawmakers seem to have forgotten. In the face of national crisis, sacrifice should be shared by everyone, rich and poor alike.

Tax hikes on the rich are an important part of that shared sacrifice. But that’s why they shouldn’t be squandered. Left to their own devices, Democrats would use them to meet almost every fiscal need.

But if lawmakers use high-end tax hikes to pay for small-bore initiatives (like extending the payroll tax cut) or as a minor funding source for major new programs (like health care reform), then we won’t have those hikes available when the time comes for a grand bargain.

Tax hikes on the rich should be held in reserve until Washington gets serious about fixing our long-term fiscal problems. When that finally happens, we’ll need those hikes to make the overall package fair.

Joseph J. Thorndike is director of the Tax History Project at Tax Analysts and a Visiting Scholar in History at the University of Virginia. His new book, Their Fair Share: Why Americans Tax the Rich, will be published next year. He blogs at tax.com