As our government attempts to find a revenue and spending
compromise to prevent the U.S. from going over the so-called fiscal cliff, let
us consider three issues that must be addressed: the economic, the political,
and the moral. The economic issue requires a solution that supports a growing
economy. The political issue requires a solution that allows conservatives to
understand the compromise as being consistent with no increase to top tax
rates, and supports private sector solutions to our economic issues, while
liberals would like to higher top rates now. The moral requires a solution that
does not pass on more debt, or less opportunity, for future generations.
In the debate over whether increased taxes will dampen
economic growth, the focus tends to be on their potential disincentive to
working and making profits. The
argument is that higher taxes means less net income, and hence less incentive
to work and take risks. Now, if all we were concerned about was economic
activity now, and ignored the future, this might make sense (then again, if we
were ignoring the future, then debts and deficits would be meaningless as
well). However, we are concerned
about the future. There is also a concern for the size of government, and
finding private sector solutions through investment and charity. So what supports the private sector to
invest and donate more?
Increased tax rates now, with decreasing rates as the recovery
expands. Here’s how:
An investment is an expense now, to
generate more income in the future. When tax rates increase, the marginal cost
of that investment decreases. For
example, a one million dollar investment at a 20% tax rate has a net cost of $800,000, whereas the same investment
at a 40% tax rate has a net cost
of $600,000. Similarly a one million dollar
tax-deductible charitable donation at a 20% tax rate costs the donor only
$800,000 (assuming their income is larger than one million), while a 40% rate
reduces the net cost to $600,000. Charity becomes less expensive.
A second concept important for a solution is that of average
top tax rate. If the top tax rate was 35% this year, and
40% the next year, the average top
tax rate would be 37.5%.
With this in mind, we can construct a tax policy that
encourages private investment and charitable contributions when the economy
needs stimulus. For example, we
can increase tax rates temporarily, maybe 2 years, followed by a longer length
of time (e.g. 4 years) when tax rates are lower. Repeat this pattern as necessary. The increased tax rates
now, combined with the expectation of lower rates in the future, incentivizes
businesses to increase investment now, with an expectation of greater net
returns during the times of lower tax rates. Similarly, it incentivizes
charitable contributions now, at a
time when it would help the economy the most.
The political beauty of this is the possibility of a tax
plan where both parties can be satisfied. If we look at the average top tax
rate over a cycle of six years, then it is possible to have a higher rate now
while keeping the average the same as it is now. For example, increasing the
top rate to 45% for two years, and then decreasing it to 30% for four years,
maintains an average of 35% over the
six years. Because the rate is
higher now, there is a tax benefit for investing now so as to be positioned to
have greater income when the rate is low.
This does not preclude reducing or eliminating deductions and other
loopholes (although changes to these will impact the effectiveness of this
policy), it just makes a tax rate increase now more palatable while encouraging
the private sector to increase supply (through more investment) and demand
(through charitable spending), thereby stimulating growth. The numbers above
are merely illustrative, although they could be a starting point for
negotiation.
More than this, such a tax plan is consistent with the
morality of avoiding passing on a debt to the future. First, a debt problem is a REVENUE problem, not a sending
problem. Why? Because even if all spending is eliminated (including the
military), we still have a debt, and interest, to be paid. Revenue will be
required. Second, whatever one believes to be the long-term optimal tax rate,
tax morality would imply paying more in taxes now, relative to those who pay
them in the future. Third, the issue is not just financial debt, it is also the
quality of the country, and economic capacity, we pass on. The greater sin is not the money the
future must pay off; it is reducing their ability to pay it off.
Consider this question: is it better to leave a $15 trillion
debt with an economy that produces $10 trillion a year, or to leave a $20
trillion debt with an economy that produces $20 trillion a year? It is the debt as measured in the
number of years of economic production that is the issue. Failing to invest in the future
is not a responsible option. To leave future generations with crumbling
infrastructure, and without a productive education, because we wanted to pay
less taxes now, is the height of selfish myopia. Anyone claiming that we must
reduce these types of spending now, so as not to burden the future with debt,
is disingenuous at best.
This last point raises another element for a long-run solution:
we could add a debt reduction portion to the tax rate. The U.S. currently has a federal debt
of about $16 trillion. Let’s say
we commit to paying this off in 50 years, which implies that those who are too
young to work now will have a country with no federal debt when they retire. It
would tax additional revenue of about $320 billion each year (assuming a budget
that is deficit neutral). With a GDP of roughly $15 trillion a year, this would
require an extra tax of about 2%.
Of course, another possibility would be a mix of higher
taxes and printing money to pay off the debt. While the latter could cause some
inflation, any serious attempt at
reducing the debt will have some inconvenience. Again, leaving the future with higher prices, but with an
otherwise healthy economy, is morally preferable to leaving them with a weak
economy. Including a debt tax implies that our example above would become a 47%
tax rate reducing to 32%. At some
point in the near future, the increase of 2% would have to extend to lower tax
brackets, preferably after the economy has created more jobs.
The reason for the biggest increase in taxes being in the
upper income brackets is simple. Only those with sizable disposable incomes
(above what they need to pay for their current lifestyle) are in a position to
make significant investments and charitable donations. Presumably this is why some refer to
them as “job creators.” Increasing
the tax rate at lower incomes will do little to generate more investment or
charity, since there is little to no disposable income.
The use of a short-term increase in the top tax rate, with
an assurance that it will decrease thereafter, combined with a small tax to
start paying off the debt, should be palatable to both democrats and
republicans, liberals and conservative.
It includes the conservative argument for a private sector solution of
private investment and increased charity, which they see as necessary to grow
the economy and deal with issues of poverty, while liberals would get a higher top
tax rate now that can support the type of public investments they see as
necessary to grow the economy and balance the budget.
