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The Economy Grows When Everyone Pays Their Fair Share

Tax Fairness Is No Obstacle to Economic Growth

SOURCE: AP/Nati Harnik

In the president's deficit plan, he calls for broader individual and corporate tax reform based on the principles that the tax code should be simpler and fairer, that it should incentivize job creation in the United States, and that millionaires should never pay lower taxes than middle-class families. This last proposal is the so-called “Buffett rule,” named after investor Warren Buffett, pictured above, whose effective tax rate is lower than his secretary’s.

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President Barack Obama today proposed to close tax loopholes and roll back some of the tax cuts that the wealthy have enjoyed over the last decade as part of his overall jobs and deficit reduction plan. Conservatives wedded to the supply-side mantra that cutting taxes on the wealthy is the cure to any economic ill claim his plan would be bad for the economy, but the reverse is true.

Under his plan, the U.S. tax code would be more fair, better for the middle class, and less strewn with loopholes that distort business and consumer decision making. We’ll illustrate some of the reasons why this is the case in a moment, but first let’s review the outlines of the president’s plan. President Obama’s plan:

  • Extends middle-class tax cuts, including the tax cuts enacted under President George W. Bush and expanded in 2009 under President Obama, and also extends and expands the payroll tax holiday in effect since January 2011.
  • Allows the Bush “bonus” tax cuts to expire on schedule at the end of 2012 so that the top two rates revert to their 1990s’ levels of 36 percent and 39.6 percent.
  • Limits the benefit that top-bracket taxpayers receive from itemized deductions and other preferences to 28 percent instead of up to 35 percent under current law. That means that wealthy taxpayers can still claim these deductions and benefit from exclusions but they won’t receive any additional benefit on top of what taxpayers in the 28 percent bracket receive.
  • Closes a number of additional loopholes and special subsidies in the tax code, including those for oil-and-gas companies, hedge fund managers, corporate jet users, and companies that use accounting techniques to report income in low-tax foreign countries.
  • Calls for broader individual and corporate tax reform based on the principles that the tax code should be simpler and fairer, that it should incentivize job creation in the United States, and that millionaires should never pay lower taxes than middle-class families.

This last proposal from the president is the so-called “Buffett rule,” named after the legendary investor Warren Buffett, who laments the fact that his effective tax rate is lower than his secretary’s.

There are several reasons why the president’s plan is good economic policy. The first is that top marginal tax rates at the levels that President Obama proposes are perfectly consistent with strong economic growth. If history is a guide, modestly higher top marginal rates are more likely to improve our economy by contributing to lower deficits than to hurt it. While there may not be a cause-and-effect relationship here, it’s clear that lower top marginal tax rates on the wealthy have not been associated with better growth.

For most of the past several decades, top marginal tax rates were much higher than the current 35 percent or the 1990s’ level of 39.6 percent. During those periods, both jobs and economic growth were much stronger than they have been in periods with lower rates, especially since George W. Bush’s tax code went into effect in 2001, as CAP’s Michael Linden has found. (see Figure 1)

Chart 1-1

Chart 1-2

Conservatives have no good explanation for why the economy grew so rapidly in the 1990s despite what they describe as growth-crushing tax rates. The top rates were raised from 28 percent to 31 percent in 1990, and then again to 39.6 percent in 1993—a much steeper rate hike than simply allowing the current 35 percent top rate to revert to 39.6 percent, as President Obama has proposed.

What followed the early 1990s rate increases was an unprecedented economic expansion and a balanced budget. With higher tax rates on both ordinary income and capital gains in effect, business investment was stronger in the 1990s than in the period since the 2001-03 tax cuts. Millions of jobs were created and real incomes grew across the income spectrum. About 18.2 million private-sector jobs were created in the six years after the top tax rate was raised to 39.6 percent in 1993, compared to only 4.7 million private-sector jobs created in the corresponding period after the 2001 Bush tax cuts.

In fact, there are fewer private-sector jobs in America today than there were when President Bush signed his tax cuts into law. The bottom line is that there is simply no evidence that allowing top tax rates to revert to the fair and fiscally responsible 1990s’ rates will harm economic growth.

The second reason President Obama’s plan is good for the economy is that it’s good for small business. When defending tax cuts for the richest people in America, supply-side conservatives reflexively invoke small business owners. But a closer look at the tax burdens shows that extending the Bush tax cuts for the top two brackets isn’t about small businesses. A very small percentage of taxpayers with business income of any kind—estimated at less than 3 percent—are affected at all by the expiration of the high-end Bush tax cuts because their incomes are less than $250,000.

And only a small percentage of the benefit from extending the high-end Bush tax cuts would accrue to the slim percentage of small business owners who are in the top two brackets. New data from the Treasury Department show that 92 percent of the benefit of the high-end Bush tax cuts goes to wealthy individuals who are not small business employers.[1]

Again, the claim that 1990s-era marginal income tax rates on incomes of more than $250,000 will stifle small businesses is disproved by recent history. Small businesses created jobs at a much faster rate when the Clinton tax code was in effect. Between 1993 and 2000 small businesses (those with fewer than 500 employees) added nearly a million jobs per year on average (973,000). But in the period after the Bush tax cuts were enacted in 2001 until the onset of the recession in 2007, small business job growth was less than twice as rapid (414,000 per year).[2]

Rather than extending these wasteful, budget-busting Bush tax cuts, President Obama is proposing more effective ways to spur small business hiring and investment, including payroll tax cuts that would incentivize hiring directly. That’s good for small businesses and the broader economy, too.

The third reason why President Obama’s plan is good for our economy is this: Given how the incomes of the wealthy have grown, a modest tax increase on millionaires and the top 2 percent of Americans is something they can easily afford. President Obama is simply proposing to allow the top two tax brackets to revert to their 1990s levels of 36 percent and 39.6 percent, which would only affect the approximately 2 percent of households with incomes of more than $250,000 ($200,000 for singles).

His proposal would also limit the benefit that top earners derive from itemized deductions and other tax preferences. They would still be able to claim and benefit from these preferences under the proposal but only to the same extent as a family in the 28 percent tax bracket (currently $139,350 to $212,300 for couples).

The president’s more comprehensive tax reform should adhere to what he terms the “Buffett rule,” the principle that millionaires should not pay overall tax rates lower than middle class. Despite claims of “class warfare,” President Obama is simply suggesting shared sacrifice, balanced between revenues and spending cuts, at a time when Congress has already made significant cuts to the federal services that middle-class families rely on and is contemplating more. And the sacrifice required of the highest-income earners is actually quite modest compared to their good fortunes and the magnitude of the tax cuts they have received in recent years.

A quick look at the data proves the point. Income data from the Congressional Budget Office show that from 1982 to 2007 (the most recent year for which reliable data are available) the before-tax, real incomes of the richest 1 percent more than tripled. Their after-tax income went up even faster—as should be expected with the tax cuts they have benefited from. Meanwhile, income growth for almost everyone else has grown slowly or stagnated. (see Figure 2)

Chart 2

Meanwhile, after successive rounds of tax cuts, the overall tax burden on rich Americans is also significantly lower than it was only a short time ago. Millionaires are paying one-quarter less in federal income taxes than they were as recently as the mid-1990s, largely because of capital gains tax cuts. The top 1 percent is paying about 20 percent less. (see Figure 3)

Chart 3

Allowing the top marginal rates to revert to where they were during the 1990s boom is not a large burden. If the top 1 percent continues to experience income growth at the same rate as they have over the last quarter-century, allowing the high-end Bush tax cuts to expire would be the equivalent of a 10-month pay freeze. They can afford it.

The upshot: Predictable attacks from conservatives on President Obama’s plan don’t hold up to the facts. Supply-side policies have failed over and over again. President Obama’s plan rightly shifts the focus toward policies that will create jobs and boost consumer spending power among the broad middle class.

Seth Hanlon is Director of Fiscal Reform at the Center for American Progress. Thanks to Hannah Brion for research assistance.

Endnotes

[1]. Martin Sullivan, “Economic Analysis: The Myth of Mom-and-Pop Businesses,” Tax Notes, September 12, 2011. Sullivan’s analysis is based on data from the recent Treasury Department report: Matthew Knittel and others, Methodology to Identify Small Businesses and Their Owners (Department of the Treasury, 2011). The definition of small businesses includes entities taxed on a pass-through basis with under $10 million in annual gross receipts. It excludes passive investment entities and entities that are not employers.

[2]. U.S. Small Business Administration, Office of Advocacy, based on data provided by the U.S. Census Bureau, Statistics of U.S. Business and Nonemployer Statistics, available at http://www.sba.gov/sites/default/files/files/us_timeseries.pdf.

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