The Right Coast

Editor: Thomas A. Smith
University of San Diego
School of Law

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Saturday, December 8, 2012

The meaning of tax rate increases instead of deduction caps
Tom Smith

I feel a bit stupid for not having realized this before; others no doubt have. I have been puzzled by Obama's dogged insistence that new revenues be raised by tax rate increases instead of deduction caps. He has said, to the Business Roundtable for example, that this is because you can't raise revenues enough just by imposing deduction caps. But this seems not to be true. While "Obama said it, therefore it must not be true," may be a bit of a stretch, nevertheless, his having said it, to be fair, in no way adds to any warrant for believing it to be true. And anyway, I have read it ain't so. If you were willing to make the caps low enough, you could raise the desired revenues. Moreover, you could do so in the tax neutral way most of us were taught is preferable from the policy perspective. Generally, you don't want taxes (ha, ha) to influence investment and consumption decisions, or to do so as little as possible. So if having to raise enough revenues is not the reason, what is?

Some Republicans are saying, it is because Obama wants to be seen as triumphantly crushing the head of the GOP dragon under his heel, a la St. George or whoever his PC equivalent may be. This may be part of it, but not the main reason. The obvious explanation I think is to consider what tax deductions actually are.  They are the very catalog of political influence in this country. The real estate industry, the non-profits, the long list of other deductions you can take: The tax code is the fine print of the social contract on which the fat belly of Leviathan comfortably rests. Those of us squished by its slimy blubber may breathe only with difficulty, but for the beast itself, it's more like a soft mattress to which it has comfortably conformed, and vice versa. Any sort of tax reform, including deduction caps, which are incremental reform, partially wipes out part of these accumulated deals among State and special interest factions. So if you want to raise revenues for the State, and leave the tissue of these deals intact, it has to be by raising rates, not imposing caps, and the more funds you want to raise, the more important this is.

Raising rates in fact is good for tax expenditure dependent factions, if I may invoke that Madisonian notion.  The higher the marginal rate on income, the more relatively attractive a tax deductible donation becomes. If marginal rates were 100 percent (assuming you would bother to make income at all) you would be indifferent between paying the tax or making the donation. If you made an additional $1000, you could pay it all to the tax person, or give it to your favored charity.  Assuming you prefer your own charity to the general fisc, and how could you not, you would donate instead of pay the tax.  At 50 percent rates, you would get to keep 50 cents of every additional dollar you made. Giving a dollar to your charity would only cost you 50 cents therefore; but at 100 percent tax rates, it costs you nothing. So an increase in marginal rates actually improves the position of all the favored groups that benefit from tax deductions, and this group consists of precisely the politically favored, almost by definition. You can also see clearly why caps on deductions have just the opposite effect. To generalize, marginal rate increases are much the more statist way to raise money compared to caps, in the sense that it promotes the interests not just of the State, but also all those groups that have managed to get their interests written into the tax code. I'm sure the Obama adminstration understands this well.

It is probably also the case that Republicans are sincere when they say that marginal rate increases, especially on small business income, will discourage attempts to make more money, because marginal income will be taxed so highly, more than 50 percent in some states. This is turn will hurt economic growth on the margin. Democrats, to give them the benefit of the doubt, may think that the economy is so deeply depressed that would be investors are mired in a liquidity trap, and the income they should spend or invest, but instead will save, has to be taxed away, then spent by government, so that it can stimulate demand.  There may be stranded pools of liquidity in our financial system now; the notion that Basel III regulations are requiring banks to sit on capital more than they otherwise would is plausible to me. But I'm skeptical that the whole country and even whole world stuck is in some kind of giant liquidity trap.  My guess is, marginal rates will go up, the economy will get worse and at some point, much further in the future than one would hope, the American people, so called and such as it is, will have heard enough excuses and insist we move out of our government's basement and go to work.  Here's hoping.

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Nice turn of phrase - quoted here:

Posted by: JVDeLong | Dec 9, 2012 12:43:16 PM