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A Better Fiscal-Cliff Deal
Trade a millionaires’ surtax for a 28 percent corporate tax and watch business investment grow.


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When the Treasury Department scored the president’s ill-fated 2013 budget last February, it estimated that raising the top two personal-income-tax rates — to 36 from 33 percent and to 39.6 from 35 percent on incomes above $250,000 and $377,000, respectively — would raise just $23.1 billion in 2013, barely enough to finance federal spending for two days. In the fiscal-cliff negotiations, House speaker John Boehner capitulated on the higher 39.6 percent tax rate but hoped to confine it to incomes above $1 million. That idea — his Plan B — failed to get the votes of a majority of the House Republican caucus; but what will replace it?

The Tax Policy Center (TPC) estimates that Boehner’s proposal to raise the bar from $250,000 to $1 million would result in about a billion less in revenue each year than would Obama’s plan, which would still raise $22 billion.

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The threshold matters, but the revenue clearly does not. Estimates of $22 to $23 billion of added revenue from raising the highest tax rates are obviously dwarfed by $536 billion of looming tax increases from the “fiscal cliff,” and by budget deficits that routinely top $1 trillion. In fact, $24 billion of the fiscal cliff consists of Obamacare’s 3.8 percent surtax — on interest, dividends, capital gains, and rent — for couples earning more than $250,000.

Mr. Boehner has been curiously eager to embrace “closing loopholes” on these same high-income taxpayers, a leftist dream that dates back to the 1972 McGovern campaign. Yet phasing out and capping deductions and exemptions was always the form of the largest of Obama’s tax increases on higher-income households, amounting to $33 billion next year. For Republicans to accept these backdoor tax increases would preclude any future tax reform that involved trading a cap on deductions for lower marginal rates.

Suppose the Obama-Boehner scheme to couple fewer deductions with a higher tax rate might actually raise about $55 billion next year, without (as the Treasury estimates assume) being undone by a consequent reduction in economic growth. The most that could possibly accomplish would be to briefly postpone the next in a series of fiscal cliffs as we repeatedly bump up against the debt ceiling. This is why Obama insists on putting off the debt ceiling for at least two years. He knows perfectly well that budget deficits will never drop below $1 trillion under his plan.

Obama and Senate Democrats pretend they could hand out hundreds of billions in middle-class tax breaks and refundable tax credits forever if only the House would raise tax rates on the top 2 percent. In reality, the July Senate bill extends some of these tax cuts for only one year while properly ending the untenable payroll-tax holiday — which accounts for $115 billion of the fiscal cliff.

What about economic growth? The economy normally grows by 3 percent a year, even when recessions are included, but has now grown by 0 percent for five years. We need quite a few years of economic growth in the range of 5 to 6 percent to merely get back to the 3 percent trendline. Decent economic growth would slash spending on unemployment benefits, food stamps, Medicaid, SSI, and dubious disability claims, while boosting revenues from greater payrolls and profits. Democrats and Republicans may disagree on how much economic damage their tax-increase proposals would cause, but nobody could argue that they would cause faster economic growth.

Before the election, by contrast, both Romney and Obama proposed reducing the corporate tax rate from 35 percent to 25–28 percent. This would give a lot of bang for no bucks. Nearly every other advanced country has a corporate tax rate no higher than 28 percent, and most of them raise more revenue than we do because they have greater domestic profits to tax (and less corporate debt to deduct). In “The Dynamic Effects of Personal and Corporate Income Tax Changes in the United States,” an ambitious historical survey, Karel Mertens of Cornell University and Morten O. Ravn of University College in London found that “cuts in corporate taxes have no significant impact on revenues because of a very elastic response of the tax base.”

Republicans’ favorite argument against high individual tax rates is that they hurt small businesses that choose to file under the individual tax code as pass-through entities, such as partnerships or Subchapter S corporations. Such businesses grow by reinvesting their earnings, so taxing away 39.6 percent of the income generated by the business shrinks both the incentive and the funding needed to expand. A corporate tax rate of 25 to 28 percent, however, could be a vital safety valve. The wider gap between a presumably higher individual tax rate and a lower corporate tax rate would quickly induce thousands of pass-through firms to set up Subchapter C corporations to shelter retained earnings from the possibly increased individual tax rate. The retained earnings would then be available for expanding the business. Business earnings would be double-taxed at the individual level only if and when owners paid themselves higher salaries or dividends, or taxed as capital gains if the expanded business is later sold. 

House Republicans have been capitulating to most of Obama’s tax plans without getting anything tangible in return except the president’s blatantly impossible promise to make middle-class tax breaks “permanent.” It is time for the GOP to ask the president to make good on his half-hearted campaign rhetoric about cutting the corporate tax rate. This would greatly invigorate the tax climate for all businesses, big and small. The positive impact on business investment, and on multinational decisions to locate new businesses in the U.S. rather than abroad, would be swift and powerful. There is nothing to lose from cutting the corporate tax rate, not even revenue, and the economic gains are likely to be quite astonishing.

— Alan Reynolds, a senior fellow with the Cato Institute, was director of economic research with Jack Kemp’s Tax Reform Commission.



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