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Tuesday, December 11, 2012

A dynamic tax rate solution to the fiscal cliff

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.