Rumors abound that the Bush administration might be open to accepting tax increases as part of a budget or entitlement-reform compromise with the Democrats. According to Fred Barnes of The Weekly Standard, Treasury Secretary Henry Paulson “is believed to be receptive to a deficit-reduction deal, for instance, that would raise the top rate (now 35 percent) on individual income and/or the payroll tax cap, in return for spending restraint and entitlement reforms.”
Having worked as a White House economic-policy staffer during President Bush’s first term, it is very hard for me to believe that the president would ever support such a tax hike. In fact, his record indicates that he would stand by lower tax rates through both thick and thin.
During his first term, the president championed three major tax-reduction packages: The 2001 and 2002 tax cuts supported an economy that was recovering from a recession, a dot-com bubble gone “pop,” the corporate accounting scandals, and the 9/11 terrorist attacks. The 2003 tax cuts accelerated the scheduled reduction in the top marginal rate from the 2001 tax package and, more importantly, sharply cut tax rates on dividends and capital gains to 15 percent. By increasing after-tax rewards for work effort, saving, and investing, the 2003 rate cuts worked precisely as advertised. Since the third quarter of 2003, the U.S. economy has expanded by a quarterly average of 3.6 percent (annualized) and has added over 6 million new jobs. At the same time, the unemployment rate has declined from 6.3 percent to 4.4 percent.
If anything, it is the Democrats who are openly discussing the possibility of raising taxes. Just two days after the November election, former Clinton Treasury Secretary Robert Rubin declared, “You cannot solve the nation’s fiscal problems without increased revenues,” and by increased revenues he means higher taxes.
The most popular option being discussed in Democratic policy circles is a hike in the highest marginal tax rates to reduce the burden of the alternative minimum tax and/or redistribute income away from the so-called rich to the middle-class and poor. Additionally, most Democrats have traditionally supported raising the payroll-tax wage cap ($94,200) to address the entitlement budget crisis, instead of creating personal retirement accounts and slowing expenditure growth through price-indexing Social Security benefit payments. In the end, congressional Democrats may not need to propose new taxes since massive tax hikes are already baked in the cake: The Bush tax cuts are slated to expire on January 1, 2011.
From an economic standpoint, raising the top tax rate and the payroll-tax wage cap would hurt the economy and ultimately raise far less tax revenue than static-revenue estimating models would predict. The combination of these two proposals would place dramatically higher tax rates on economic success. As shown in the chart below, assuming that these tax hikes became effective in 2008, the maximum federal tax rate would rise from the current 38.44 percent (35 percent income tax rate plus the Medicare payroll tax) to 52.89 percent. Such an increase would severely reduce after-tax incentives for productive efforts while encouraging tax avoidance.
These tax-rate hikes would be especially damaging to entrepreneurial ventures, which are the wellspring of innovation and growth in our economy. On the other hand, according to a study by the Small Business Administration (SBA), reducing marginal income-tax rates increases entrepreneurial start-ups, decreases exits from entrepreneurship, and lengthens the duration of entrepreneurial ventures. Specifically, for married tax filers, the SBA found that a marginal-rate reduction of 1 percentage point on entrepreneurial income increases the probability of entrepreneurial entry by 2 percentage points and lengthens the duration of entrepreneurial activity by 44.8 percent. Conversely, raising marginal rates by 14.5 percentage points — by lifting the wage cap and raising the top tax rate — will reduce the probability of entrepreneurial starts by 29 percentage points and significantly shorten the duration of entrepreneurial activity.
For the overall economy, allowing the tax on capital to rise from 15 percent to 40 percent would depress the U.S.’s economic-growth potential by 0.6 percentage points, according to estimates by economist Michael Darda. Further, over a decade, this tax increase would result in a reduction in cumulative nominal gross domestic product by nearly $6 trillion while stripping away more than $1 trillion in tax receipts. That’s hardly a recipe for raising worker wages or for cutting the budget deficit.
In the unlikely event that the president agrees to hike the top income-tax rate and the wage cap on payroll taxes, the result would be a significantly larger increase in the top rate than occurred during the George H.W. Bush and William J. Clinton administrations. But President George W. Bush has been the staunchest supply-sider since President Ronald Reagan, and he has no incentive to change course now.
Indeed, President Bush’s most significant domestic-policy legacy will be his tax-rate reductions and their positive impact on the economy. In my view, the president will almost certainly veto any attempt by congressional Democrats to prematurely unwind this legacy. Meanwhile, Republicans should provide an alternative to the Democrats high-tax agenda by continuing the fight to make the Bush tax cuts permanent and advancing a pro-growth, pro-family, pro-capital-formation reform of the tax code — one that lowers and flattens marginal tax rates, ends special-interest tax loopholes, creates tax relief for families with children, and ends the double taxation of savings and investment.