The Great Debate

Fear and loathing of income inequality is both totally understandable and ultimately misplaced.

It’s understandable because everywhere around us it seems as if top income earners ‑ those latter-day kulaks vilified as the “1 Percent” by the Occupy crowd and populist politicians ‑ are gaining while the rest of us seem barely able to hang on to a lower-middle-class standard of living.

It’s misplaced because it glosses over strong evidence that the ability to rise above your starting place ‑ the American Dream, by most accounts ‑ is better than it was 40 years ago.

There is no doubt that the spread between top earners and those below them has grown over time. The share of income earned by the top 1 percent in the United States has doubled since the early 1970s. The top 20 percent’s share  has risen, too, though the increase is much smaller and has leveled off since the 1990s.

Yet it is far from clear that inequality is a bad thing when it’s the result of market forces. Think about it: Do Bill Gates’ billions take bread from your mouth, or have Microsoft products allowed you to put bread in your wallet by making you more productive and the goods and services you buy cheaper?

The focus in Washington has now shifted to the fiscal cliff, with the White House and Congress, particularly the House Republicans, staking out negotiating positions on the expiring Bush tax cuts and the looming budget sequester.

The White House’s firm opening salvo—and House Speaker John Boehner’s grudging admission that he is “open” to a budget deal that contains new revenue—have been much discussed. With six in 10 Americans expressing support for higher taxes in exit polls on Nov. 6, President Barack Obama’s position is a strong one.

It’s important to remember, however, that the public came out on Election Day in support of more than Obama’s tax stance. Exit polls and public-opinion surveys show that the president’s mandate goes far beyond taxes and the fiscal cliff.

Republican leaders such as Grover Norquist and Senate Minority Leader Mitch McConnell (R-Ky.) continue to strike a hard line on taxes and revenues, “warning” President Barack Obama that the GOP will not negotiate or compromise when it comes to tax policy and deficit reduction.

From an electoral politics standpoint, the Democrats should “have at it.”

As the election made clear, this policy is out of step with voters. Obama made raising taxes on people making more than $250,000 a year a centerpiece of his economic message – something he emphasized in his recent press conference – and he was rewarded with a resounding victory. Voters also handed Democrats an increased Senate majority, where the tax debate played out front-and-center in many campaigns.

This theme echoed through state politics as well. Voters in California, for example, passed Governor Jerry Brown’s plan to fund K-12 public schools through a revenue increase that comes from the highest earners.

The election left us with a status quo political lineup, one that failed to make any meaningful fiscal progress over the past two years. So is it realistic to expect that we can avoid the fiscal cliff and achieve some sort of “grand bargain”? Yes, it is possible, and here is how to do it:

First, President Barack Obama should form a “unity Cabinet” to demonstrate to the public and Congress that he wants to bring the nation together and accelerate progress on key challenges. It should include Democrats, Republicans and independents. All should be respected in both parties, have meaningful private-sector experience and credibility within and outside the Washington Beltway.

These criteria are especially critical when it comes to the president’s top economic team. Obama will almost certainly change the leadership at the Treasury Department, since Treasury Secretary Timothy Geithner has talked about leaving after the first term, and the Office of Management and Budget. Smart appointments could help reboot Obama’s relationships with Congress and increase the chance of success.

It won’t be easy for President Obama to do big things in his second term, with Congress still divided. Yet one legacy-caliber goal is easily within reach: Obama can restore fiscal balance without deep spending cuts by doing, well, nothing. By simply letting the Bush tax cuts expire at the end of this year, for everyone, and vetoing all future tax cuts, the president would leave office in four years with America’s fiscal house largely in order while ensuring a strong federal government for years to come.

Economists predict that allowing the U.S. to go over the “fiscal cliff” would produce a mild recession, and they are probably right. But with signs pointing to a slow yet steady recovery, that downturn would likely be short-lived and worth the longer term gain of achieving fiscal stability without taking a meat clever to key government programs.

Obama promised on the campaign trail that he wouldn’t raise taxes on the middle class and implied that repealing the Bush tax cuts for the wealthy would yield enough revenue. In fact, more than three-quarters of all revenue lost by the U.S. Treasury because of the Bush tax cuts is due to cuts that benefit households making under $250,000, according to the Congressional Budget Office. Simple math suggests that as long as the vast majority of earners are paying the lowest tax rates in half a century, it will be hard to tame the deficit without deep spending cuts.

President Barack Obama’s lackluster, let’s-work-together performance in Wednesday night’s presidential debate stoked the fears of his liberal backers that Democrats simply won’t fight for them the way Republicans relentlessly battle for their wealthier, aging, corporate constituents.

After four years of Republican intransigence – even when Democrats have championed Republican ideas – the Democratic left insists that the White House hasn’t grasped that the 2012 campaign is not about policy. So far, Republicans are proving more adept at speaking, in both coded and direct terms, to Americans’ stark demographic and psychological divisions.

That Republican nominee Mitt Romney stood before the nation and all but disowned the tax-cut, Medicare, health policy and other GOP doctrines he had campaigned on for months is likely to matter little to his backers. The last three Republican presidents, as MSNBC commentator Chris Hayes pointed out, also campaigned on promises of economic growth, deficit reduction and tax relief – and all left behind a faltering economy and ballooned deficits. What they reliably delivered was tax cuts benefiting the wealthy.

One of the few thin­gs that President Obama and Mitt Romney are likely to agree on when they debate next week is the need for tax reform. Both candidates have backed streamlining America’s crazy-quilt tax code, and both have said that reforms could boost economic growth. Meanwhile, two key congressional committees held a rare bipartisan hearing last week – with lawmakers from both parties saying that tax reform is needed to rev up the economy.

Yet exactly how and why tax reform would spur growth is far from clear. Many proponents of reform, including Romney, want to lower tax rates while retaining the same level of revenue. But doing that means reducing major individual tax breaks that subsidize key sectors of the economy – including housing and healthcare. Long term, there are good arguments for whacking such subsidies, which tilt heavily in favor of affluent households and distort our economy. But curbing these freebies doesn’t offer a short-term economic fix and, in fact, could hurt growth.

Let’s start with the best-known big tax break – the mortgage interest deduction, which will cost the U.S. Treasury about $100 billion next year, according to the Congressional Research Service. Shrinking this loophole is a good idea in principle, since it primarily benefits more affluent households who have big mortgages and itemize their taxes, but it would be a blow to a housing sector that is still struggling. Smaller subsidies for home buyers would mean weaker sales and less new construction and would keep home values depressed – not an outcome that anyone wants to see right now. Among other things, such reform could be another severe blow to construction workers, who now have the highest unemployment rate of any group.

When Fox News worries out loud that Mitt Romney’s failure to account for his time at Bain and his personal tax affairs may represent his Swiftboat moment, it is plain the Republican presidential bid has careened offtrack. The Bain attacks are “part of a strategy by Team Obama to turn Romney’s biggest perceived strength – his business experience – into his biggest weakness,” writes Fox’s Juan Williams. “Romney needs to come clean or his hopes of being president will end long before Election Day.”

How has Romney come so close to bungling his big chance, even before he has been nominated by his party? He appeared to be in an ideal position to turn his experience as a businessman into a winning political narrative. During these jobless economic doldrums, Romney might have become a champion of capitalism, explaining how private enterprise works and how it creates jobs.

His problem is that his time at Bain is not a classic story of heroic capitalism at work. Instead of an old-school entrepreneur with a good idea who raises funds to employ Americans to make a product that sells successfully around the world, Romney took distraught companies, charged them hefty fees, fired workers, and set the stumbling enterprise off in a new direction, laden with debt. Some companies prospered, some failed. Some gave Americans new jobs, some sent jobs overseas.

The United States is used to being a world leader, but this time, it’s bad news for American jobs and growth: As of Apr. 1, we now have the highest corporate tax rate of all the industrialized nations in the world.

Japan has officially reduced its combined corporate tax rate from 39.5 percent to 38.01 percent, leaving the U.S. in the dubious position of being number one in anti-competitiveness with a current combined rate of 39.2 percent. That’s right: Our combined corporate tax rate, and federal rate at 35 percent, leaves us in a weaker position relative to other leading economies. That’s the bad news. The good news is that there is a sensible solution to lowering it and many signs that, in a surprising turn of events, the political will to achieve it exists in both parties.

In February, Treasury Secretary Timothy Geithner announced the outlines of a plan to reduce the U.S. corporate tax rate from 35 percent to 28 percent. Meanwhile, House Republican leaders have united around an even lower rate of 25 percent – the worldwide average tax rate among Organization for Economic Cooperation and Development (OECD) countries.

Headlines over the past couple of weeks have been dominated by reactions to President Obama’s new proposal for corporate tax reform. The optimism stems from the realization that practically all the major plans by Democrats and Republicans would move the U.S. tax code in the direction of a territorial-based system (in which a corporation is taxed on domestic, not foreign, income). Moreover, these plans all accept the premise that to make the U.S. code more competitive globally, the tax base must be broadened, and that means cutting deductions and preferences in exchange for lowering the top-line rate (i.e., down to between 25 percent and 28 percent from today’s 35 percent rate).

Even with this apparent consensus, however, it seems inevitable that actual reform will not occur until 2013. Perhaps more important, the way these issues play out in the coming months could very well shift the reform discussion from how to tax income to how to tax consumption for both individuals and corporations. Here are three developments to watch.

The politics require more “tax winners.” To get the corporate tax rate down to the new target range, Congress might have to cut both accelerated depreciation and the expensing of research and development. The difficult truth is that any revenue-neutral tax reform proposal would likely create as many (and maybe even more) losers than winners. In essence, a rate reduction to 28 percent might help a few industries, but slashing the deductions for capital spending or investment could end up raising the effective tax rate for even more companies.  The net effect could be a slightly smaller economy relative to its full potential, as new investment and the growth of the available capital stock could be restrained. In an effort to broaden the coalition and create more winners, Congress will probably have to consider cutting the top rate even further, then redefining what’s actually counted as corporate income.