27 days to the fiscal cliff: Taxes versus tax rates

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WASHINGTON,  December 4, 2012 — The House Republican leadership has put a concrete proposal on the table to counter President Obama’s “laughable” first move to avoid the fiscal cliff: They’ll raise taxes, but not tax rates. This is expected to raise $800 billion in new tax revenue, about half of what the Obama Administration wants.

The Republicans claim that by making changes to the tax code, they can raise that money while actually reducing tax rates. Obama insists that marginal tax rates must rise. What some voters might ask is, can you really increase revenues while cutting tax rates, or is that just supply-side voodoo? Must tax rates go up to erase the deficit?

The answer to the first question is “yes” and “no”: Yes, you can increase revenues while cutting tax rates, and no, there’s nothing supply-side about it. “Supply-side” implies raising tax revenues as a result of cutting tax rates. What the Republicans propose is raising revenues by eliminating deductions, subsidies, and various incentives that we can collectively call “tax loopholes” and then cutting tax rates, but not enough to offset the new revenues. There is some supply-side thinking in wanting to reduce the tax rates, and that will be addressed later.

The U.S. tax code is a baroque and hideous monstrosity, thousands of pages of rules (which grew by 159 pages this week when the first new Obamacare regulations were added to the code), and it’s probably hard to earn over $100,000 and not have your tax return be in violation of at least one rule. Some rules are contradictory, so if your taxes are more complicated than can be calculated with a W-2, a pencil, and one pot of coffee, you are probably a law breaker. 

Because of its complexity, and because it’s full of goodies for whomever has the time and money to find them, the tax code can be very profitably “mined.” GE, one of the most profitable companies in the world, managed not only to pay no corporate income tax last year, but even got a rebate check from the U.S. Government. Mitt Romney and Warren Buffet paid only 14 percent or so in federal income tax, a lower rate than most college professors, and some fabulously wealthy people paid nothing.

Leona Helmsley famously remarked that she didn’t pay taxes, only “little people” pay taxes. She went to prison for tax fraud, but if she’d had a better accountant and the good sense not to say that in front of her maid, she probably would have avoided that indignity.

If the tax rate on the very wealthiest is 35 percent, if you raise it to 39 percent, and if the effective rate they pay is 14 percent, will that rate hike raise any money? No. The wealthy already aren’t paying the nominal rate, and they’ll continue to not pay it if you raise it. If you raise the top rate without doing anything else, you’re grandstanding for the crowd. 

If on the other hand you eliminate enough loopholes to raise the effective rate on the wealthy to 30 percent and cut their nominal rate to 30 percent, will you raise money? Yes; collections from the wealthy will double. 

Reforming the tax code could raise much more than $800 billion even if tax rates were cut. Cutting tax rates could actually help push up collections even without assuming supply-side effects. High tax rates encourage tax avoidance (which is legal and not to be confused with tax evasion). Not only do the wealthy hire accountants and lawyers to help them find loopholes, they aggressively shield their income. French millionaires are eyeing an exodus to Belgium if the harsh new tax rates there start to bite, American millionaires have been known to decamp from high-tax states to states with lower rates, John Kerry moved his yacht out of state, and Charles Rangel moved his to the Dominican Republic (and forgot to pay taxes on rent from his villa – the tax code is very complex, even for a member of the House Ways and Means Committee). Cut their tax rates and some of the wealthy will find it not worth the trouble to distort, shield, and hide their income. 

So can we eliminate the deficit and start paying down debt just by reforming the tax code? We could if rules were perfect and people were rational, but in the world of Washington politics, no. One man’s tax loophole is another man’s absolutely essential, job-creating provision to support and protect vital American interests, like the sugar subsidy, the angora subsidy, home mortgage deductions, “green energy” and so on. 

We have decades of social policy, special interests, patronage, and utopian dreams of “fairness” built into our tax code. It should be gutted and then thoroughly revamped, but just as architectural preservationists have taken to defending hideous monstrosities of 1960s architecture as essential parts of our cultural heritage rather than recognizing them as the dead hand of a misbegotten aesthetic and enormously bad taste, the tax code will be defended by a thousand political ankle-biters. Even if it were reformed, the odds are that it would return to all its former ugly complexity in fairly short order. (Remember, it grew by 159 pages just this week.)

Reforming the tax code could reduce tax avoidance, cut the costs of preparing tax returns, reduce the costs of administering and collecting taxes, and with the stimulatory effect of a rate cut, promote growth by creating a more stable, rational tax environment. That will happen when pigs fly, which is always possible if we apply enough thrust to the pig, but not likely, and likely to produce a bloody fight and a lot of pig feces if we try. So the politically realistic answer to the second of our starting questions is “yes”: Tax rates must rise if we’re going to erase the deficit.

The goal isn’t yet to erase the deficit, but only to seriously reduce it. Cutting loopholes is a good place to start, and that should happen before we raise tax rates. How serious Democrats and Republicans are about solving our underlying fiscal problems – and the fiscal cliff is not one of them – will be demonstrated in their zeal to close loopholes and clean up the tax code.

We should not be disappointed if they demonstrate the seriousness of a teenager in love. 


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Jim Picht

James Picht is the Senior Editor for Communities Politics and teaches economics and Russian at the Louisiana Scholars' College in Natchitoches, La. After earning his doctorate in economics, he spent several years working in Moscow and the new independent states of the former Soviet Union for the U.S. government, the Asian Development Bank, and as a private contractor. He returned to Ukraine recently to teach principles of constitutional law and criminal procedure at several Ukrainian law schools for a USAID legal development project. He has been writing at the Communities since 2009.

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