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A Stark Tax Contrast

by Keith Hennessey

Romney believes in incentives; Obama doesn’t

President Obama is correct when he says that the 2012 election represents a stark choice between two conflicting visions of economic policy. Comparing Mitt Romney’s approach to tax policy with President Obama’s, let us begin with the most obvious difference: President Obama proposes higher taxes, beginning four months from now, than Governor Romney does. If current law is not changed, all income-tax rates will increase on January 1 of next year. Governor Romney proposes to prevent all these rate increases from taking effect, while President Obama would allow the scheduled higher tax rates to bite rich taxpayers and successful small-business owners.

The candidates differ as well on whether tax reform should be used to pay for increased spending. Too many Republicans assume that everyone agrees that tax reform must be revenue-neutral. From this firm but false assumption, they dive immediately into endless debates about the ideal tax reform. To their opponents, however, revenue neutrality isn’t so important: President Obama wants to use tax reform to increase the amount of revenue the federal government takes in taxes.

Historically federal taxes have taken slightly more than 18 cents on every dollar earned in the United States. Governor Romney proposes to maintain that level. President Obama proposes to increase it to 20 cents on the dollar. Two percentage points higher may not sound like much, but in a $16 trillion economy it means government would take an additional $300 billion–plus per year from those who earn it. Federal taxes would be nearly 10 percent higher than they are today.

This difference on tax levels stems from the difference in the two candidates’ proposed paths for government spending. Every dollar of government spending must be paid for by either current or future taxes. So if candidate A proposes higher government spending than does candidate B, then A is implicitly proposing that future taxes also be higher, even if he won’t admit it during a campaign.

With Obamacare, the president and his congressional allies exacerbated an already unsustainable entitlement-spending trend that had developed over several decades. While he has enacted tax increases and proposes even more of them, President Obama proposes that spending grow even faster than taxes would rise. Even if all of his proposed tax increases were enacted in full, they would fall far short of being able to pay for the long-term government-spending path he promotes.

President Obama proposes only modest changes to the major entitlements, and he emphasizes that we should increase rather than cut discretionary spending. Massive and ever-increasing tax hikes are the only large fiscal-policy change he has not ruled out, and, given his other stated policy constraints, they would be the only way to prevent long-term deficits from triggering the next financial crisis.

Utah senator Orrin Hatch, the senior Republican on the Finance Committee, has explained the consequences of this spending trend:

We know their income-tax proposals do not add up to much in terms of revenue. Even if they let the entirety of the current tax relief expire . . .  there probably is not enough money to be found in the income tax to pay for the coming explosion in entitlement spending. . . . But no serious person believes that the Obama administration’s government can be financed simply by going after the wealthy. The only way to do it is by going after all Americans and raising taxes on all citizens. That is the silent plan that the president will not discuss on the campaign trail. That is the Democrats’ phantom budget. . . . Without significant reductions in spending or reforms to our entitlement system — neither of which we can expect from this president or the Democrats currently in Congress — there is just not enough money to be found in traditional revenue streams to cover the president’s spending bill. A [value-added tax] — or some other euphemized form of a VAT — appears to be the only option left to our friends on the other side of the aisle if they want to continue spending at current projections.

This same dynamic drives the candidates’ business-tax proposals. President Obama proposes higher business taxes to pay for additional government spending, while Governor Romney proposes corporate-tax reform to make American workers and capital more productive.

Both candidates propose to both broaden the corporate income-tax base and lower corporate rates: If we reduce the economic distortions in corporate-income-tax policies, market forces will allocate capital and labor to better uses. Over time this will increase productivity and wages. Corporate-tax reform done right can expand the U.S. economy.

But President Obama is using corporate-tax reform in pursuit of a second goal: to raise revenue to finance future increases in government spending. This key difference means that most of the economic benefits of a less distorting corporate-income-tax code will be outweighed by the drag from higher total corporate taxation.

Worse, he wants to impose a higher tax rate on the small-business owners who are the linchpin of economic growth. Most small-business owners pay taxes the same way that individual taxpayers do, so if tax increases on the rich are allowed to take effect on January 1, those increases will also apply to successful small-business owners. If a reelected President Obama can use his veto pen to force increases in the top income-tax rates, he won’t be hiking taxes only on Wall Street bankers and billionaire investors — he’ll also be punishing your favorite successful restaurant, florist shop, hardware store, and dry cleaner.

President Obama’s team points out that only a small fraction of small-business owners now pay taxes at the top marginal rates. They neglect to mention that this small fraction is also responsible for most small-business hiring. Successful small businesses are crucial to their communities.

A recent study by economists Robert Carroll and Gerald Prante concluded that President Obama’s tax increases would raise the marginal effective tax rate on small-business investment by more than 15 percent. The long-term effects of his tax policies would be even worse: Annually, American economic output would fall by about $200 billion, and real after-tax wages would fall by almost 2 percent.

Ignored by the Obama approach is that tax increases create a disincentive to economic growth. The Romney approach, in contrast, is based on the belief that incentives affect behavior.

President Obama struck a nerve when he told small-business owners, “You didn’t build that.” In other contexts he has stressed the importance of luck to success in the marketplace. The rich, he says, are successful because they are “blessed” and “fortunate” (that is, lucky), not because they worked harder or smarter than their competition. In the Obama approach, success is given to you, not earned by you. And if one believes that economic success is not the result of effort, then it is a small step to conclude that raising taxes on work and investment will not significantly reduce the size of the economic pie.

Governor Romney’s approach — lowering marginal tax rates and preventing rate increases on work and investment — is grounded in a belief that incentives matter, that they affect behavior, and that economic growth and success derive largely from effort, ingenuity, and risk-taking. If you tax something, you will get less of it, and if you raise taxes, you’ll get less yet. President Obama’s tax policy doesn’t acknowledge this; Governor Romney’s does.

– Mr. Hennessey served as assistant to the president for economic policy and as director of the National Economic Council under President George W. Bush. He is a research fellow at the Hoover Institution.

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