David R. Henderson  

Thoughts on the Latest Tax Bill

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Pssst: Someone tell the Republicans they won.

Now that I've had time to reflect, I do have some thoughts on the tax bill that differ a lot from thoughts of others who are usually my political allies. Most of the criticisms that Scott Sumner and Steven Landsburg make are ones I share. So I'm not judging the tax bill to be good. Viewed in a political vacuum, it sucks. Viewed in the world we're in, it's actually a pretty good bill.

I put aside here my huge disappointment about the delay of the sequester. I think we could have gotten just a clean bill on taxes with no delay of the sequester. The problem on the sequester was, I think, more with Republicans than with Democrats because many of the Republicans, probably most, did not want to cut a seriously bloated Department of Defense. But the fact that all sides were willing to delay spending cuts is a serious statement about future efforts to rein in federal spending.

Back to the tax side. Think about the context. Republicans, who, since 1981 have been the anti-tax-increase party, hold only the House of Representatives. The President, who is very hostile to high-income people and very strongly in favor of double-taxing savings, was just re-elected. The Democrats hold the Senate.

Had the Republicans held out for anything like the reforms that Sumner and Landsburg wanted, the bill would have been Dead on Arrival in Harry Reid's Senate. You don't even need to bring Obama into the picture. End of story. So then taxes would have gone up dramatically for people at every income level. So what could Speaker John Boehner and Minority Leader Mitch McConnell do?

What they could do is try to raise as high as possible the threshold beyond which marginal tax rates rose. Boehner first tried that with a $1 million annual income threshold before Christmas but couldn't pass that through the House with just Republican votes. If Republicans regret that, they probably shouldn't. Harry Reid would have killed that bill also. But, with the New Year's eve agreement between Vice-President Biden and Mitch McConnell, those large increases in tax rates apply only to singles with income of over $400K and married couples with income over $450,000. That's bad, but look at what the Republicans got in return.

After years in which Democrats attacked "the Bush tax cuts," which were temporary (they were originally were set to expire in 2011) many of the Democrats, plus many Republicans, voted to make most of the tax cuts permanent. After a president who wants stiff taxes on capital just got re-elected, the top tax rate on long-term capital gains and dividends rises from 15 percent to 23.6 percent. Had the bill not passed, the top tax rate on dividends would have risen to the 43.4 percent that Obama wanted. After doing a fix almost annually on the Alternative Minimum Tax (AMT) to prevent it from catching about 25 more million households than it typically applies to, Congress and the President have now made the AMT fix permanent.

(I do have one hedge about the AMT. I wrote in a 2007 Wall Street Journal piece that the AMT had the makings of a modified flat-rate tax and that, rather than repeal it, Congress should reform it to make it closer to a flat-rate tax. Now that the fix is permanent, that's unlikely to happen. But let's face it: it was always unlikely to happen. Now it's just become a little unlikelier.)

Oh, and finally, because the Congress and President agreed, we now have a death tax (it really is a death tax: people aren't taxed on their estates until they die) that takes 40 percent of everything after a basic exemption of $5 million. Does that sound bad? Had the bill not passed, the estate tax would have taken 55 percent of everything past a basic exemption of $1 million.

One other piece of context: At a Hoover event I attended some years ago, after the Democrats had won both the House and the Senate but Bush was in his last two years as president, former Reagan Secretary of State George Shultz said that one of Bush's biggest mistakes was in not using his political capital, after his 2004 re-election while the Republicans still had both houses, to make the tax cut permanent. With some exceptions, Obama just did.

So here's the big news: the anti-tax side won. Sure, Obama would love to raise taxes even more, especially on people making between $200K and $450K. But now he has almost zero leverage to do that.

I turned on Rush Limbaugh's show this morning to see what he was saying and he was denouncing Boehner and company as people who caved. Someone ought to tell the Republicans that they won.


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COMMENTS (24 to date)
Ken B writes:

If I were wicked I'd suggest you and Steve Landsburg should fashion a bet ...

I find David's take a little more convincing. Talking about this last week with my very anti-tax right wing friend who lives in Europe, he was ready to blame the GOP for all the woes of the world if they didn't agree to some deal. The GOP was definitely the party in the cross hairs here. Unfairly I think but politics is not about fair.

Peter writes:

So why did the GOP agree to the initial deal that would raise taxes that much?

Eelco Hoogendoorn writes:

Sure, Obama would love to raise taxes even more, especially on people making between $200K and $450K. But now he has almost zero leverage to do that.

What exactly makes you believe the advance auction of stolen goods will not continue as usual?

The long term trend of increasing government expenditure is once again unbroken. Politicians of all colors rejoice (unless they are not in power, in which case they will pay lip service to the contrary).

David R. Henderson writes:

@Peter,
So why did the GOP agree to the initial deal that would raise taxes that much?
In order to get a 10-year tax cut in 2001. They didn't have the votes to get a permanent tax cut bill through the Senate.

David R. Henderson writes:

@Steve Y,
Wow! Thanks for this. And would all of the above have gone away if the tax bill hadn't been passed?

David R. Henderson writes:

@Eelco Hoogendoorn,
What exactly makes you believe the advance auction of stolen goods will not continue as usual?
I don't believe that.

Duncan Earley writes:

Can someone explain what David and others mean by the double tax on savings (or investments)?

I understand that income is taxed first and then if you save that income the interest on those savings is taxed, but isn't interest on savings just another type of income? The savings themselves (the principal or accumulated capital) is not taxed?

What am I missing?

Evan writes:

@Duncan Earley: If I earn $100 in year 1, save it all, and earn 10% interest, then in the absence of any taxes I'll have $110 in year 2.

If a 20% tax is applied only to ordinary income, I am able to save only $80 in year 1 and, after earning interest, in year 2 I have $88, or exactly 80% of what I had before the tax was enacted. Note my interest income is $8 instead of $10; it has already been taxed at 20% because I had less principal to invest.

Finally, consider a 20% tax on ordinary income and interest income. In this scenario I invest $80, earn $8, lose $1.60 to the interest tax and have $86.40 after taxes, for an effective rate of over 20%.

That's what most people are referring to when they say taxes on interest income amount to double taxation. (Sometimes they are referring to taxes on dividend income and the fact that corporate profits are taxed before dividends are distributed.)

Note that taxing interest income penalizes savers more than spenders (i.e., leaves them with lower present value after tax income) and therefore tends to discourage savings.

Methinks writes:

Steve Y,

And that's not nearly a complete list of holes in the swiss cheese Some of my very favourites aren't on it. And I think we all understand that the list will grow as tax rates rise.

David Henderson,

I don't care if Team Republican won this little battle. They lost it long ago when they didn't make the cuts permanent because some of their own (I'm looking at you, McCain) refused to vote for permanent reductions.

All I see is the clowns in the Potomac Swamp winning and everyone else losing. Besides Obama's personal vendetta against people who are far more productive than he is, what is the purpose of providing huge disincentives for people who have the ability to produce enormous amounts of wealth? The additional revenue they will receive, if it is positive (I have my doubts - at least it won't be from me), won't even be a rounding error on the annual deficit.

We're not moving toward financial apocalypse any more slowly because of these tax hikes. We're very likely moving faster because our welfare state is growing at an accelerated pace. Politicians are winning. Parasites are winning and America is slipping away. I fail to see a reason for optimism even if the Republicans won this.

Essen writes:

@Evan
Thanks for the explanation. That helped me understand.
I am a little confused on the discouragement of savings bit.
I want the money one year hence. (principal+interest). Why would I spend all my money (only the principal) now? However much I am taking a hit due to double taxation?

Tim writes:

I was under the impression that the reason the tax cuts were only 10 years was because they were passed under Budget Reconciliation rules which only require 51 votes and are not subject to a filibuster. In 2001, the GOP only had 50 Senators (plus Dick Cheney to break ties) and thus couldn't overcome any Democrat attempts to block passage.

Using the budget rules trick allowed the bill to pass, but because of the way those rules operate they are only good for the 10 year forward budget window.

W. Peden writes:

Essen,

You presumably want to spend the principal now, but you're willing to give it up in return for your earnings from interest. So there's a tradeoff: spend the money today or have the possibility of earning interest?

(If you really want the money tomorrow, then interest is the incentive to risk via investment rather than hoard the money.)

Reducing earnings from investment via double-taxing shifts the tradeoff in favour of spending the money today and so discourages saving.

David R. Henderson writes:

@Tim,
Correct.

Methinks writes:

@Tim & David,

My mistake. Thanks for the correction. I still don't feel better off.

Mr. Econotarian writes:

Wake me up when someone cuts spending...

Chris Koresko writes:

My guess is that the Republicans haven't really won. Yes, the tax rates are now fixed indefinitely for most people. But rates aren't everything.

Recall that Boehner initially proposed to keep all rates fixed but raise taxes preferentially on high-income earners by capping tax deductions. The intent was to increase revenue while adding less distortion to incentives. Obama rejected that approach -- he was dead-set on a rate increase.

However, it appears that the Democrats are now intent on keeping Federal spending at 'emergency' (stimulus) levels forever. Now that the 'moral' victory of a rate increase is won, they will turn to the real issue, which is raising enough revenue to fund the newly expanded government. And so they're likely to start trying to cap deductions and/or close 'loopholes'.

Note that some of those 'loopholes' are not the special favors and accounting tricks the name suggests. For example, I understand that according to IRS rules owning a home produces an imputed income (due to the fact that the homeowner isn't paying rent), and that imputed income can be taxed like real income. I think the effect is essentially a federal property tax. So far the IRS hasn't enforced this, presumably because half the country would be seriously annoyed if they did. But the rule is there, and I don't think there's any legal reason it can't be enforced.

To summarize, I wouldn't breathe a sigh of relief over this deal. It's almost certain that a strong and likely successful effort to raise taxes (though not rates) is coming soon.

Thomas Sewell writes:

In terms of tax rates, the Republicans did as well as they could get with this deal after recent election results.

In terms of curbing spending and in terms of long term financial health for the federal government, they didn't get anything. That's what GOPers are complaining about.

There is a glimmer that they might get something when the debt limit expires again and the sequestration deadline matches up with it, but my pessimistic view of previous "deals" leads me to believe that they'll likely settle there for something minor like 100B/year in reductions in the rate of increased spending and call it a major victory 'cause they "saved" a trillion dollars over ten years.

Chris Koresko writes:

Thomas Sewell: "...my pessimistic view of previous "deals" leads me to believe that they'll likely settle there for something minor like 100B/year in reductions in the rate of increased spending and call it a major victory..."

And the media will cheer the President's leadership and fiscal responsibility when he saves two trillion dollars by not building a dinosaur-themed amusement park on the planet Uranus.

Methinks writes:

Chris, if such an IRS rule exists, it's really going to mess up politicians' homeownership at any cost drive. It's clear Oblamebush doesn't care about angering anyone, but to deny politicians re-election would be juuuuuuust horrible. Low probability of that one being trotted out.

Jeffrey tucker writes:

David, what is your opinion of the payroll tax hike that has already cut into wages? this has many people extremely upset.

David R. Henderson writes:

@Jeffrey tucker,
David, what is your opinion of the payroll tax hike that has already cut into wages? this has many people extremely upset.
I'm against it. Notice, though, that without this bill, the payroll tax hike would have happened also. So this bill had zero effect on that.

Chris Koresko writes:

@Methinks: I'm not confident of the status of the IRS rule. I heard about it on a conservative talk radio program which is usually pretty reliable, but those guys do occasionally get fooled by third-hand info. I looked at the IRS website and wasn't able to find anything there in about 15 mins of searching.

I did, however, find a piece on this at the Huffington Post which includes this paragraph:

5. Exclusion of net imputed rental income. Homeowners don't pay themselves rent. If they didn't own their own homes, they would pay rent -- and whoever received that rent would have to declare it as income and pay taxes on it. But this "imputed rental income" goes untaxed -- another major subsidy to homeowners. The foregone rent is called "imputed rental income," and the White House Office of Management and Budget calculates the foregone tax that results from it at $50 billion a year.

The general tone of the HuffPo article seems to be in favor of closing this "loophole" (along with a bunch of others they list) to raise Federal revenue. HuffPo is generally aligned with the Progressive left, so I imagine it probably reflects their views on this subject.

[broken link fixed--Econlib Ed.]

Methinks writes:

Chris, if such an IRS rule exists, it's really going to mess up politicians' homeownership at any cost drive. It's clear Oblamebush doesn't care about angering anyone, but to deny politicians re-election would be juuuuuuust horrible. Low probability of that one being trotted out.

Chris Koresko writes:

Dems look for up to $1T in new revenues

From the article: Former Sen. Kent Conrad (D-N.D.), a longtime chairman of the Senate Budget Committee, argues the federal government loses $1.2 trillion a year because of various tax breaks, a large pool for lawmakers to draw from to reduce the deficit.

“Through the tax code, we spend more there than we spend through all the appropriated accounts,” he said in his Senate farewell speech.

Conrad displayed a chart on the Senate floor Wednesday showing that people in the top 1 percent of income earners collect over $250,000 in after-tax income from tax expenditures. These expenditures are defined as revenue losses due to special exclusions, exemptions or deductions from gross income.

That didn't take long, did it?

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