Senators Chuck Schumer, Bob Menendez, and Claire McCaskill want to extend the 2001 and 2003 tax cuts to encompass households earning up to $1 million rather than $250,000, and this has been described as a compromise. It’s worth recalling that Senators Schumer and Menendez represent states that contain a high concentration of high-earners, and that Senator Schumer in particular has been an avid defender of the carried-interest provision of the tax code. While Senator Schumer just secured reelection, Senators Menendez and McCaskill are up for reelection in 2012. Given the changing political climate in New Jersey, it is easy to see why Senator Menendez might be concerned about angering tax-sensitive upper-middle-income and affluent New Jersey voters. And Missouri, of course, is a “purple” state that has seen a Republican revival since President Obama’s election in 2008. The 2001 tax cuts were backed by a number of Democratic senators, including Bob Torricelli of New Jersey.
I have a few compromise proposals for Senators Schumer and Menendez: why don’t we slowly phase out the mortgage interest deduction and the state and local tax deduction, both of which benefit high earners, particularly those residing in high-tax states? This would be unambiguously progressive and both proposals would generate more than enough revenue to pay for the high-income rate reductions — eliminating the mortgage interest deduction would be more than enough on its own. This plan would be fiscally responsible without damaging work incentives. So … what do you say?
There is nothing remotely surprising about the fact that these three senators would seek to extend the 2001 and 2003 tax cuts up the chain. What is deeply unwise, in my view, is that they propose making the vast majority of the tax cuts — an extraordinary $3.6 trillion out of $4 trillion — permanent rather than extend all of the 2001 and 2003 tax cuts for a 2 or 3 year period, as recommended by Josh Barro of the Manhattan Institute in this column and elsewhere.
As I understand it, rolling back the high-income rate reductions for millionaires is essentially a political gimmick designed to mask the fact that Senate Democrats are quite comfortable with blowing a hole in the budget. As Peter Orszag has made clear, the uncontroversial “middle-class tax cuts” — they benefit high-earners as well, particularly those who itemize — are budget-busters. Because the economy is depressed, a two- or three-year extension would not cost 20 or 30 percent of the 10-year cost, but rather a fair bit less.
The Schumer-Menendez-McCaskill proposal is unambiguously less responsible than Barro-Orszag. It is a joke designed to protect the political interests of Menendez and McCaskill, not to address the long-term fiscal imbalance.
Many of my left-of-center friends ask me what I make of the fact that many fabulously wealthy people like Warren Buffett favor rolling back the high-rate reductions. I am completely indifferent. Marginal tax rates are more important than average tax rates, and high-rate reductions are more effective at improving work incentives than other tax cuts. That is one of the many reasons I appreciated the Bowles-Simpson approach. As Howard Gleckman observes:
Nearly every economist believes that, all else equal, low marginal rates are better than high rates. That’s because while all taxes throw some sand in the economic gears, low rates throw in somewhat less and thus are more economically efficient. With low rates, people are more likely to make decisions based on economic fundamentals. When rates are high, they make choices just to save taxes and can make some really stupid decisions. …
But if you want to talk fairness, it is pointless to look at marginal rates. Instead, you want to look at average tax rates. In other words, what share of their total income do people pay in taxes and how does that compare to what others pay?
Let me underscore this: higher average tax rates for high-earners aren’t necessarily a problem. But higher marginal tax rates will prove costly for the overall economy.