Politics & Policy

Obama’s Tax-Plan Disaster

The candidate's "soak the rich" tax rates will do widespread economic harm.

Here’s an unusual campaign promise: I pledge to take action as president to drive down stock prices, discourage investment, and deepen the recession. Who has promised this? Democratic presidential candidate Barack Obama, albeit not in so many words.

With the stock market in crisis mode and the economy in a pronounced slump, would any economist — even the most extreme liberal Keynesian — advocate increasing taxes? Of course not. But contrary to economic commonsense, Obama is proposing to do exactly that by raising tax rates on America’s small businesses and investors.

#ad#Specifically, Obama wants to raise taxes on income, capital gains, and dividends for families earning more than $250,000 annually.  Under his plan, the top two marginal tax rates will increase from 33 to 36 percent and from 35 to 39.6 percent, while both the capital-gains tax and dividend tax will rise from 15 to 20 percent. According to the plan, the extra revenues generated by these tax increases will be redistributed to lower- and middle-income people through a hodge-podge of refundable tax credits. In the meantime, these “soak the rich” tax rates will do widespread economic harm.

First, Obama’s tax-rate increases on income will fall heavily on small businesses, which create the majority of net new jobs. Here’s why:  According to Internal Revenue Service data, half of all business income is taxed at individual rather than corporate tax rates, and about two-thirds of all flow-through business income is earned by small-business owners with annual incomes exceeding $200,000.   The bottom line: Up to one-third of all business income is taxed at the two marginal rates Obama wants to raise.

Second, history demonstrates the economic folly of raising capital-gains taxes at any time, and the economic benefit of keeping them permanently low. By influencing the incentives for people to invest, the capital-gains tax directly impacts the demand for — and value of — equities. Similarly, it influences the rate of investment, particularly in new, high-risk ventures.

Between 1969 and 1978 capital-gains tax rates rose from 25 percent to 35 percent. Across the same period stock prices and venture-capital investment declined. A 1978 economic study by economist Michael Evans of Chase Econometrics Associates found that “the sharp declines in the stock market in 1969-1970, and 1977-1978 are due in large part to the Tax Reform Acts of 1968 and 1976.” Initial public stock offerings (IPOs) — an important measure of new venture-capital investment — also declined in this period, from an annual average rate of nearly $2 billion between 1969 and 1972 to an average of $225 million between 1975 and 1978.

When capital-gains tax rates were cut in 1979 and 1982, the results were just as predictable: Equity values rose along with investment commitments to new ventures. Conversely, when capital-gains tax rates were increased from 20 to 28 percent in 1986, the rate of IPOs stagnated.

About a decade later President Bill Clinton signed legislation that chopped the capital-gains tax rate back down to 20 percent. And once again economic growth, investment, jobs, and federal tax receipts all increased. (David Wyss of Standard & Poor’s DRI, an economic consulting firm, has produced a study documenting these incentive effects.)

Yet despite this progress, the current capital-gains tax rate — 15 percent for individuals — is still too high. Many foreign countries tax capital gains at much lower rates, putting the U.S. at a competitive disadvantage. According to the American Council of Capital Formation, the U.S. is currently in the middle of the 30-member OECD pack in terms of taxing capital gains. Fourteen OECD countries do not tax capital gains at all.

Third, Obama’s plan to raise taxes on dividends will negatively impact business investment, the retirement income of seniors, and finally economic growth.

When a corporation issues common stock to finance new job-creating investment, the returns on that investment are taxed twice, once at the corporate level and then again at the individual level when dividends are received by shareholders. This double tax on dividends encourages businesses to rely on debt rather than equity to finance new investment, a strategy that can weaken their financial condition.

The 2003 dividend tax cut from 35 to 15 percent reduced these economic distortions and provided incentives for companies to pay out dividends rather than retain their earnings. As a result, dividend payments were estimated to have increased by 20 percent.

But Obama’s proposed increase in the dividend tax would reverse this healthy trend. It also would disproportionately impact America’s seniors by taking a bigger bite out of their taxable dividends while reducing both the quality of dividend payments and the value of the stocks that produce them.

According to the American Association of Retired Persons, “Of the nearly $150 billion in dividends that were reported on tax returns in 2000, people aged 65 and older received a highly disproportionate share (48 percent).” Near-retirees also received a big share of dividend income (29 percent), as did those so-called “rich” families that make more than $250,000 a year. According to the AARP study, more than one-third (37.3 percent) of dividend income went to retirees with incomes in excess of $200,000.

Simply put, raising taxes on investment is never a good idea. A 2008 study by the Center for Data Analysis found that fully repealing the 2003 capital-gain and dividend tax-rate reductions would reduce employment by 270,000 jobs, cut real GDP by $44 billion, and decrease after-tax personal income by $113 billion in a single year.

On the other hand, by maintaining low tax rates and cutting certain tax rates that remain too high, as John McCain proposes to do, the economy will remain poised for growth. Looking long-term, McCain proposes to lock in the Bush tax rates of 2003 and slash corporate tax rates. For the short-term, he proposes to cut the capital-gains tax in half for a two-year period, from 15 to 7.5 percent, a stimulus measure that would spark an immediate boost in equity values.

To be fair, Obama is not calling for a full repeal of the 2003 tax cuts on income and investment, but the tax hikes he has in mind are toxic enough. His tax plan has even drawn a rebuke from the editors of the New York Times, who wrote that with “the economy tanking … it’s hard to imagine how [Obama] could prudently [raise taxes on the wealthy].” And while Obama has hinted that he would consider delaying his proposed tax increases if the economy is in recession, who really thinks a President Obama and a Democratic Congress will prioritize lower taxes over new spending?

The Times is right and Barack Obama is wrong. Now is precisely the wrong time to hike taxes — especially on entrepreneurs and investors.

– Cesar Conda, a former economic and domestic policy advisor to Vice President Dick Cheney and former Gov. Mitt Romney, is a principal of Navigators LLC, a Washington-based issues management firm.

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