Looking at the deficit commission’s tax plans

November 12, 2010
silly headline attempting to sum up the effects of the deficit commissions tax proposals.

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The WSJ does none of its readers any favors with its silly headline attempting to sum up the effects of the deficit commissions tax proposals. “Top Earners May Face Big Hit”, it says—which would surely be more accurate if the “May” was replaced with “Won’t”.

The piece begins:

A presidential panel’s draft overhaul of the tax system could hit higher earners hard, largely by wiping out deductions and investment breaks that tend to especially benefit those who make enough money to itemize their taxes.

For one thing, the draft is coming from the panel chairmen, not from the panel itself. And more generally, while it’s true that most people who itemize their taxes are high earners, it doesn’t follow that most high earners itemize their taxes, or get a huge benefit from doing so. Some are better off with the standard deduction, especially if they don’t have a mortgage; others are subject to the phaseout rule, and others still get hit by the alternative minimum tax.

On top of that, the chairmen aren’t really suggesting that all these “tax expenditures,” as they’re known, actually be wiped out. They’re actually suggesting something quite reasonable: that you start with a very simple tax rate, and then, if you find a tax expenditure you really believe in—the earned income tax credit, say—you pay for it by raising some or all of those basic tax rates.

That’s a great way of making the cost of these deductions explicit: you want generous mortgage-interest tax relief? OK, but your income tax is going up a penny.

But putting that to one side, the big question is whether the higher tax burden from the loss of deductions would wipe out the tax savings from lower income tax. The WSJ seems sure that it would:

Deductions and investment breaks… increase after-tax income for the top 20% of earners… by more than 10%…

Higher earners could stand to recoup some of that loss through several other proposed changes, notably lower marginal income-tax rates. The plan… would cap the top tax rate as low as 23%, down from the current top rates of 33% and 35%.

Really? High earners would only recoup some of that loss? If you’re currently paying income tax of 35%, that means your after-tax income before deductions is 65 cents on the dollar. If that’s raised by 10%, it becomes 71.5 cents on the dollar. On the other hand, if you simply pay income tax of 23%, your after-tax income is significantly higher, at 77 cents on the dollar.

Paul Krugman, for one, is convinced that the rich are going to be winners, not losers, here:

What the co-chairmen are proposing is a mixture of tax cuts and tax increases — tax cuts for the wealthy, tax increases for the middle class. They suggest eliminating tax breaks that, whatever you think of them, matter a lot to middle-class Americans — the deductibility of health benefits and mortgage interest — and using much of the revenue gained thereby, not to reduce the deficit, but to allow sharp reductions in both the top marginal tax rate and in the corporate tax rate.

It will take time to crunch the numbers here, but this proposal clearly represents a major transfer of income upward, from the middle class to a small minority of wealthy Americans.

In fact the two aren’t completely contradictory; it’s just that what the WSJ considers “Top Earners” have a large overlap with what Krugman considers “the middle class.” (Think people earning between about $120,000 and $350,000 per year.)

And Krugman isn’t giving the whole picture either. One of the best parts of the chairmen’s plan is the way in which it raises the tax rate on capital gains and dividends so that they’re simply treated as ordinary income. The very wealthy, who often live off capital rather than labor, would definitely be hit hard by that move.

The WSJ does have one fact on its side when it sees taxes going up rather than down on the rich: “the draft proposal recommends overall that taxes go up by $751 billion by 2020,” it says. But that’s a cumulative figure, not an annual figure. Overall, taxes would be unchanged in 2012, go up on a net basis by a mere $20 billion in 2013, and rise as far as $160 billion in 2020. That’s substantially less than the $241 billion the chairmen want to cut in discretionary spending this year: their plan concentrates much more on spending cuts than it does on higher taxes to achieve deficit reduction.

The fact is that a net increase of $160 billion in 2020 is so small, compared to the overall tax base, and so far away in time, that it’s impossible to tell with any certainty at all who would be the winners and who would be the losers. Some taxes will go down, some deductions will go away, and other taxes will go up: it’s a complicated plan and the effect on various income strata is likely to depend enormously on how much any given taxpayer currently itemizes, and how much tax they currently pay on capital gains and dividends.

And the big picture is that the chairmen do not propose to reduce the deficit by raising taxes: indeed, they propose a hard cap on how much the government can get in tax revenue. This is a cost-cutting proposal, rather than a tax-hiking one. It also has zero chance of ever making it into law. But as an idea of where some kind of hypothetical bipartisan consensus might exist, the message is clear: no one’s interested in innovative new taxes, least of all a carbon tax. If the deficit’s going to come down, the technocratic elite wants to see that happen from spending cuts instead.


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