In the coming months, we face an important and difficult debate on federal income taxes. It is more than simply a matter of revenue and economic growth; it is also a debate about the politics of taxation.
I begin with some facts. Higher taxes slow the economy and reduce employment. The only question is “how big” is the tradeoff between a tax increase and a smaller economy? Second, the U.S. federal income tax has long been a progressive income tax, meaning high-income taxpayers pay a higher proportion of their income than low-income taxpayers.
However, to the surprise of many, the so-called Bush tax cuts of 2001 and 2002 actually made the system more progressive than what we experienced in the Clinton years. While the Bush tax cuts reduced taxes on the very rich by 5 percent, they also resulted in a 100-percent tax cut for about one quarter of households. Finally, a big chunk of income-tax payers aren’t actually households, but small businesses representing half of all “high income” taxpayers. These facts cry out for a bit of interpretation.
While tax cuts tend to make the economy grow—sometimes briskly—the effect can be entirely offset if it is accompanied by a large budget deficit or if the government spends its money on unproductive things. Unless you’ve recently awakened from a Rip Van Winkle-like slumber, it hardly bears noting that the last decade has seen more than its share of deficits and unproductive spending.
So what does this mean for the tax debate?
The economy is growing with agonizing slowness, so a tax increase that will accompany the expiration of the Bush tax cuts this January will further slow the economy, perhaps deeply. More to the point, it will overwhelmingly affect small businesses on which everyone pins their hopes for new jobs. But that isn’t really why it is shaping up to be a huge political fight.
Repealing the Bush tax cuts and their big cuts for the “rich” composed an important part of a winning election campaign in 2008. Abandoning that mantra will be painful, but sticking to it might well be political suicide. Note again that many of the “rich” are really small businesses owned by middle-class folks. An even more delicate truth is that the Bush tax cuts entirely eliminated income taxes for the poorest 25 percent of taxpayers (the poorest 25 percent of households have never paid income taxes). So, today, about half of all American households pay no income taxes. Starting this January, that changes, but it won’t become starkly obvious until April 15, 2012—months before the next presidential election.
Supporters of the Bush tax cuts are also in a bind. Many now view the complete elimination of income taxes on half of households a bad lesson in civic responsibility. For them, any compromise short of a long extension of the tax cuts is bad policy and politics. This debate will soon rage. Meanwhile, the deficit grows, the economy lags, confidence wanes and an election looms.•
Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at email@example.com.