It’s Time to Let the Bush-Era Tax Rates Expire

The Bush-era income tax rates will expire at the end of the year. That is only one of a number of financially significant–some say cataclysmic–deadlines that occur around year end: the payroll tax holiday ends, the alternative minimum tax patch will expire, $36 billion in Obamacare taxes will take effect, tax extenders will expire, the (minimal) 2009 “stimulus” tax cuts will run out, the inheritance tax will increase, and 100% expensing for business investment will expire.

At the same time, $109 billion in sequestration begins, affecting both non-defense and, disproportionately, defense spending. But other spending reductions will go into effect as well: extended unemployment insurance benefits will expire, and, unless action is taken, Medicare reimbursement rates for physicians will decline.

And on top of all of that, the U.S. will hit its debt ceiling of $16.4 trillion in the coming weeks.

All of the above issues, and more, will be in play in negotiations between the Obama administration and Congressional Republicans over the so-called “fiscal cliff.” Because Republicans control the House and have an effective veto in the Senate, they should be able to bargain on equal terms with the administration. There is, however, a serious problem: Republicans do not speak with a single voice. There are differences between the House and the Senate, and various groups of Republicans have differing priorities. As for President Obama, he has laid down a single marker: taxes on upper-income Americans must increase. That is, in his eyes, the one absolute.

So I think the Republicans should call Obama’s bluff, and accept his offer by agreeing to let all of the Bush-era tax rates expire. Taxes on the “rich” will go back to what they were during the Clinton administration. But so, under this proposal, will taxes on everyone else. What would this mean? The 35% bracket would go to 39.6%; the 33 percent bracket would go to 36 percent; the 28 percent bracket would increase to 31%; the 25% bracket would go up to 28 percent; and the 10% bracket would be eliminated, with 15% being the lowest rate.

But wait! you say. Obama doesn’t want everyone’s taxes to go up, only rich people’s. But really, how vigorously can the Democrats object? For a decade they have been telling voters that the Bush tax cuts only benefited the wealthy–“tax cuts for the rich!”–and that Republicans don’t want to rescind the Bush tax cuts because they are holding out for billionaires. Fine; if the Bush tax cuts only benefited the wealthy, then Democrats can have no objection to doing away with all of them, and returning marginal income tax rates to what they were during the administration of the most revered Democrat of them all, Bill Clinton. It is a little late in the day for Democrats to admit that the large majority of the Bush tax cuts went to people who are not, by any definition, wealthy.

This approach has major advantages. Currently, upper-income taxpayers are pretty much pulling the whole sled, as the U.S. relies on its upper-income citizens to a greater extent than any other developed country. This is an unhealthy situation. When it comes to income taxes, most Americans have little or no skin in the game, so why not vote for more government largesse? Raising everyone’s income taxes will give more voters a stake in federal spending. America desperately needs to get its spending under control, and that won’t happen as long as most voters think spending is not their concern since they don’t, to any significant extent, pay for it. The most important consequence of increasing marginal rates on all taxpayers is that it will cause federal spending to be scrutinized more critically.

Raising everyone’s income taxes will make a meaningful contribution to cutting the federal deficit; the changes in income tax rates described above are estimated to raise $66 billion. That is, to be sure, a small number compared to other issues that will be subject to negotiation. Ending the payroll tax holiday, for example, will raise an estimated $125 billion, while the expiration of the alternative minimum tax patch will raise an estimated $130 billion. Expiration of the provision for 100% expensing of business investment, something that is completely off the media radar screen, would raise an estimated $45 billion, not a great deal less than allowing the much-debated Bush-era marginal income tax rates to expire. But because the Democrats have focused so heavily, for so long, on marginal income tax rates, Republicans should be able to bargain for meaningful consideration if they agree to restore all of those rates to Clinton administration levels. That consideration should begin with substantial spending cuts–now, not in the mythical “out years”–along with preserving current rates on capital gains and dividends.

Some will object that increasing marginal income tax rates will hurt the economy. That would be true in a vacuum, but the overall impact of a deal along the lines suggested here would probably be positive. Cutting inefficient, wasteful federal spending will help the economy, as will preserving current capital gains and dividend rates. And there are other measures for which Republicans can bargain. The single dumbest thing the Democrats have done over the last few years has been their refusal to eliminate double taxation on profits that are earned overseas and repatriated to the United States. We are, I believe, the only country foolish enough to tax such profits twice. As a result, an enormous amount of money–you could Google a bit and get an estimate of the amount, but it is vast–is prevented from coming back to the United States to be invested here. As part of a deal that includes expiration of the Bush-era income tax rates, Republicans likely could convince Democrats to go along with a rational international corporate tax policy. The result would be a huge boon to the economy.

For a decade, the Democrats have been demagoguing the Bush administration’s “tax cuts for the wealthy,” even as they themselves voted to extend those tax rates to the end of 2012. The time has come to call the Democrats’ bluff. In exchange for agreeing to raise taxes and finally putting the demonized Bush tax cuts to rest, Republicans should be able to negotiate spending cuts and other reforms that will represent a significant step toward getting the country’s fiscal house in order.

UPDATE: Steve made similar points in his post, Is There a Conservative Case For Higher Taxes?.

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