Despite the whopping 33.1 percent increase in third-quarter GDP, the economy is on extremely thin ice. GDP is currently about 3.5 percent below where it started in January, a drop that, if it happened all of a sudden, would signal the terrifying start of a deep recession. To be sure, policymakers should be praised for dramatically reducing the pain of the COVID-related shutdowns, but things are still perilously close to free fall. Against that backdrop, candidates should be rushing forth with stimulus proposals, and perhaps arguing about the relative merit of tax reductions versus spending increases. In fairness, President Trump has advocated both. But former Vice President Biden has chosen a surprising alternative path.
Despite the pandemic contraction, it might come as a surprise to hear that Joe Biden and his economic team are sticking to their guns and promising a giant tax increase next year. They’re even asserting that the Biden plan will be good for growth.
Before we dig into the bloody entrails of the plan, it’s useful to look at the “logic” that is being employed to pitch the Biden plan as an economic positive next year. Biden will, the story goes, work with Democrats to pass a $3 trillion stimulus. While his tax hike may score as high as $4 trillion over ten years, in the first year that is only $400 billion so we are looking at $3 trillion – $400 billion = $2.6 trillion in stimulus next year, a hefty number. Convinced? Perhaps you will see the flaw if you try it this way. Suppose we impose 100 percent tax on corporate earnings, which are about $2 trillion a year. The stimulus from the Biden plan ($3 trillion) would be higher than that next year, so the sky is the limit! In the real world, the 100 percent tax would induce most everyone to just shut down, regardless of how much money we borrow from the Chinese to spend on clunkers. As we shall see (sorry, I warned about the bloody entrails), that 100 percent tax rate is not so far from the truth.
On the corporate tax side, Biden increases the top rate to 28 percent (from the 21 percent achieved by the Tax Cuts and Jobs Act), but also allows expensing of capital purchases to expire, and imposes steep new taxes on multinational income. On the individual side, the top individual rate will rise to 39.6 percent. Biden advocates other increases in the top marginal rate through some additional measures. First, he phases out itemized deductions, which lifts the rate by about 1.2 percent (taking us to 40.9 percent). Then he removes the cap on the 12.4 percent Social Security tax (lifting the rate to 53.3 percent), with the capital-gains rate rising to equal the ordinary tax rate. This Social Security tax trick was already used before when Democrats removed the cap on the Medicare tax, so add the 3.8 percent from that to our rate to get up to 57.1 percent.
Think the 100 percent tax example was too extreme? Well, if you now consider that most Americans live in places with an income tax (with combined state and local rates climbing to above 15 percent in some locales), and factor in that you might have to pay 8.5 percent of income to pay for health insurance, then you can see how similar these proposed hikes are to my absurd example.
The plan does not end there, of course. The capital-gains rate for wealthy individuals is lifted to 39.6 percent (so get ready to sell everything in December if Biden wins). Biden even hacks away at retirement savings, ending the deductibility of IRA contributions and replacing that with a fixed credit.
In the paper we have mentioned throughout the week that I co-authored with Casey Mulligan, Tim Fitzgerald, and Cody Kallen, we sifted through all of these tax changes and used economic modeling to net out the total effect of the Biden plan. Perhaps the best summary measure is the “Marginal Effective Total Tax Rate,” something that tells you the gap between what capital investments earn before and after taxes. If you make 20 percent before tax and 10 percent after tax, then the rate would be 50 percent. Under current law, we found that the rate is currently 6.8 percent for small businesses, but would climb to about triple that under Biden. The idea that the effective rate on capital might be tripled precisely as America’s small businesses are struggling to avoid bankruptcy because of the pandemic is worthy of Halloween.
In the paper, we go on to show that these huge marginal tax-rate increases do not only affect a few rich people because small businesses tend to file as individuals and pay the top marginal tax rate. There are about 50 million workers in the U.S. working in these so-called pass-through businesses. Short-term cyclical factors are difficult to quantify, but perhaps as many as 10 percent of those workers could be expected to lose their jobs next year if these tax hikes are passed.
During the pre-pandemic Trump presidency, capital taxes were cut, leading to higher investment, productivity, and wage growth. Blue-collar wages grew the most, because blue-collar workers benefit the most when factories come home. Income inequality declined sharply. Biden promises to reverse those policies at precisely the wrong time.
Free fall anyone?