Tax rates are always a hot topic in an election year. Talking rates is an easy way to make promises, assign blame, promote cures, demonize opponents, and duck tougher issues.
This year the rate talk is off the chart for a number of reasons. We’ve had no rate stability for nearly five years because temporary extension has been the name of the game. We face huge across-the-board rate hikes in just four month if our stalled Congress doesn’t make a deal by year end. And we’ve reached a point of unprecedented weakness as our leaders wrestle with a chronically sick economy, over 20 million people being out of work or badly underemployed, the need to borrow 40 cents on every dollar that is spent, and an insane fiscal mess that grows worse every day.
As always, there’s a strong temptation to promote three rate myths as the dialogue heats up. In trying to sort the substance from the hype, it helps to have a perspective on the myths.
Myth 1: Tax Rates Caused Our Problems
Some passionately argue that tax breaks for the rich have been a root cause of our current mess, while others claim that the real problem has been high, uncompetitive rates for America’s business sector. They’re both wrong. Tax rates didn’t get us here.
We’ve had the same rates since 2003. From 2003 to 2007, gross domestic product (“GDP”) growth was solid, and federal revenues increased 38.5 percent at a robust annual pace of nearly 7.7 percent. During 2007, federal revenues totaled 18.5 percent of GDP against expenditures of 19.7 percent of GDP, producing a meager deficit of $161 billion, only 1.2 percent of GDP. Oh, how we miss those days.
Fast forward to 2011 with no rate changes. GDP growth ground to a halt during the period. Federal revenues dropped 10.7 percent from 2007, with expenses spiking 31.8 percent. The gap between revenues and expenses grew to an unimaginable nine percent of GDP. The annual deficit topped $1.2 trillion in each of the years 2009 through 2011, seven times larger than the 2007 deficit.
Tax rates didn’t cause this ugly reversal. The pro-business Bush tax cuts have now been around for a long time (some 11 years, the rest nine years). Looking back, no one can responsibly claim that higher or lower tax rates would have eliminated a protracted recession and a pitifully anemic recovery.
For more than two decades, the world markets were fueled by consumers in developed countries progressively spending at a faster pace. It was done with leverage – debt backed by assets that were supposed to continually grow in value and support perpetual borrowing and spending increases. We magnified the problem many times with government mandates and destructive securitization gimmicks that encouraged (forced?) banks to make mortgage loans to unqualified home buyers.
When the momentum shifted, asset values turned and headed in the wrong direction, spiraling down as demand shrank and fire sales escalated the descent. The resulting massive drop in demand forced employers to slash payrolls, which accelerated a huge drop in global demand for just about everything. It all confirmed that unrestrained asset-based leverage has the capacity to either fuel wonderful growth or quickly put large financial institutions and millions of businesses and families on their backs. But it was never about tax rates.
Myth 2: The Mess Can Be Fixed with Bold Tax Rate Changes
Many work to create the illusion that bold tax rate changes are the key to a real fix. We should not fool ourselves into thinking that the Code is the solution. Those who think that the ultimate cure is to take a bigger bite from the rich are just as wrong as those who claim that the supreme fix is dropping rates for everyone.
Obama advocates tax hikes on the rich, defined as families with incomes in excess of $250,000. When the new Obamacare tax is factored in, his proposals could drive marginal high-end tax rates up to the 44 percent range. Best case numbers suggest that the increased yield from the higher rates would fund government spending for about eight to ten days. The rich may be paying a “fairer share” in the eyes of many, but it cures nothing. Indeed, it likely will lead to slower growth and weaker government revenues because the bulk of the increased taxes will come from earnings that business owners would have otherwise used to fuel growth and create jobs.
Romney’s rate cures are just as tough to follow. He now advocates an across-the-board 20 percent cut in rates for everyone, which would put the top rate at 28 percent. This idea surfaced during his race for the nomination as his opponents scored huge gains with aggressive tax cut proposals and continually fed a misguided tax rate cut mentality that took center stage in the race. Concluding that his prior proposals weren’t bold enough to show his stuff as a true conservative, Romney stepped up his game to confirm to everyone that he, too, has what it takes to take a hatchet to personal tax rates.
It’s difficult to understand why the key to curing our ills must include personal tax rates that are substantially lower and less progressive than those delivered by George W. Bush. Lower rates might help business owners fuel growth, but I can’t connect the dots for the rest of America. We have enjoyed super low rates for a long time, nothing remotely comparable to the high rate structure of the Carter era. That simple fact moots all the comparisons to Reagan’s tax boldness. It’s easy to point a finger and claim that someone else doesn’t pay enough in federal income taxes, but, when it comes to personal income taxes, I have yet to find a knowledgeable soul who can credibly claim that he or she has been paying too much under the Bush tax cuts.
Romney’s other rate proposal would eliminate taxes on dividends, capital gains, and investment income for the middle and lower classes. It sure isn’t going to cure anything, and it may backfire politically in the end. How many middle-class Americans are sweating capital gain and dividend rates, which are already at historic lows? How many even have dividends and capital gains that aren’t tax protected by an IRA or 401k? For most, Romney might as well be offering them free wax for their yachts. It’s a gesture proposal that won’t register and could end up offending.
A key question about a Romney presidency has been whether Romney might follow the lead of Bush by using his first term to push hard for tax rate reform and to soft pedal much tougher issues, such as spending and senior entitlement reforms, in order to avoid the inherent reelection risks. Romney effectively mooted this risk with his VP pick. If Romney had any intention of soft pedaling any issue related to our fiscal mess during a first term, he wouldn’t have chosen Paul Ryan, a gutsy leader who lives and breathes a sense of urgency, knows the big picture, and doesn’t get caught up in rate myths
The rate gap between Obama’s and Romney’s respective plans is huge – 44 percent versus 28 percent. The fear with either of these extremes is that if one side does garner enough political muscle to shove through its extreme with no bipartisan support, it won’t last. The tax uncertainty and instability that has stymied effective business development and planning will continue. What we badly need is a permanent rate structure that has bipartisan support and offers a promise of real stability and predictability. Which leads to the third myth.
Myth 3: Tax Rate Stability is Impossible
It’s tough, but not impossible. There are plenty of smart middle ground solutions that could serve the interests of both sides and promote tax stability. As an example, in a recent article (“Tax Hostage Rerun: Small Businesses Deserve Better”) I offered a proposal that would decouple small businesses from the Buffett-Wall Street crowd for tax purposes, provide powerful business growth incentives, greatly simplify the code for all closely held businesses, and allow rates on the Buffett-Wall Street crowd to be hiked. This is one idea. There are others. There’s no lack of middle ground options. There’s just a huge lack of political will. When it comes to tax rates, the safe play is to go with the extreme and do nothing that might imply weakness by suggesting compromise or concern for the other side.
What we need are more voters who appreciate the power of compromise and smart middle ground solutions and more leaders who are willing to risk the wrath of their base and move to the middle on permanent rate solutions.
The conventions are firing up, with the Republicans taking the lead this week. It will be interesting to see how well the three rate myths fair in these spectacles. I suspect and fear that they will flourish. I hope that I am wrong.