Why the Deficit Commission and Senator Warner are Wrong on Tax Policy and Our Tax Plan is Right

By Tom Pallow of ThirdWayProgressives.org; contact: 202-902-1133

It is time that we, in regards to tax and fiscal policy, rid ourselves of our ridicules catch 22.

What is this catch 22? If we raise personal income taxes on the wealthy in order to acquire the federal tax revenue we need, we will be taking money away from private sector job creators at a time when private sector jobs are what we most need. But, if we dont’t raise taxes on the wealthy, we will go further in debt which could raise interest rates, and we will not have the federal revenue we need to keep consumer demand up either through the tax code or through government spending just at a time when a lack of consumer demand is the biggest factor that is keeping our economy weak.

Of course, if there were any Fed funds rate left to lower, the Fed could lower rates to stimulate the economy, and we would not have to worry about this catch 22. But the Fed rate is essentially O, and even if the rate were quite high, breaking our catch 22 would create a much more economically efficient tax system.

So how should this catch 22 be broken? Raise personal income tax rates on the wealthiest 2% of income earners up to where President Obama wants to raise them or above that. Then, award a tax credit worth $.15 on the dollar for all W2’d US employee expenses up to the payroll tax cap. Also, set a flour cap on how low a private business can exercise these credits to the point as though the personal income tax bracket rates were 5%, 10%, 20%, 28%, 33%, and 35%. Remember, only about 18% of all the income that is generated by the top 2% of US income earners is the profits of any business that is taxed as personal income that has one or more employees in the US (1,2,3).

Such a tax plan would raise more federal revenues than President Obama’s personal income tax plan while cutting the effective tax rates to below where they are today for the employers of 98% of Americans who work for a business that is taxed as personal income. You can look on the website, ThirdWayProgressives.org, for details on how this is done, along with similar C Corporation, Capital Gains, and FICA tax plans. Each plan achieves the same basic goal of raising more federal revenues while incentivizing and creating more private sector jobs in the US.

But this paper is about why the Deficit Commission and Senator Mark Warner are wrong on tax policy, and why our policy would work much better. So why is this all so?

The primary feature of successful tax policy that the Deficit Commission’s tax reform plan is very sub-par in is regarding the promotion of economic growth. Successful tax policy needs to achieve three primary goals. Firstly, of course it needs to raise needed government revenues. But secondly and thirdly, it should increase consumer demand, and it should lower the cost of capital for employers in the US. Achieving goals two and three will increase economic growth. The higher the economic growth of the country, the more government revenues will be raised without having to raise tax rates.

Further, even though government tax revenues can be used to increase consumer demand by increasing government spending and/or lowering tax rates for the poor and middle class, it is only profits and increases in wages in the private sector that can provide growth to the economy as a whole over the long run. Increases in wages and salaries will increase government revenues, and private sector profits can be reinvented in the economy. These are the only ways to grow the economy over the long run.

If a government is very inefficient and very small relative to GDP, an economy will increase its growth rate over the medium run due to increases in efficient government spending. However, our advanced economy now has total government spending (federal, state and local), at about 44% of GDP. Today in the US, increases in government spending would not be likely to increase overall economic efficiency, productivity, long term employment, or long term economic growth. We need the private sector to do that now.

So how do the Deficit Commission’s tax proposals stack up when compared to our tax plan in regards to raising new federal revenues, increasing consumer demand, and lowering the cost of capital for businesses that want to expand in the US?

The truth is that their plan compares very poorly. Their plan appears to raise about $925 billion over 10 years, while our plan would raise about $1.25 trillion over 10 years, yet dynamically scored our plan would raise about four to five times the federal revenues! However, their plan compares most poorly when it comes to promoting economic growth. Also, it compares poorly when it comes to increasing consumer demand and lowering the cost of capital for businesses in the US.

For example, the commission’s first and most favored option is to lower all personal income tax rates in exchange for all tax deductions being eliminated. Today’s 33% and 35% rates or next year’s 36% and 39.6% rates would go to 23%. Today’s 25% and 28% rates would go to 14%, and today’s 10% and 15% rates would go to 8%. However, in order to get to these lower rates everyone would have to get rid of all current tax deductions: the Child Tax Credit, the Earned Income Tax Credit, the Home Mortgage Interest Deduction, and all deductions for retirement savings, among other deductions.

The problem here is that this type of trade off would greatly decrease consumer demand, and therefore slow economic growth. It would decrease consumer demand because those in the top 5% of US income earners would be getting a much better deal as a percentage of their total income than would the bottom 95%. That is, the top 5% of income earners pay about 60% of all federal personal income taxes, however, they are only responsible for about 22% of all tax deductions, and this number is much lower when including the EITC. So this would create a direct shift in income to the top 5% from the bottom 95%. Moreover, since the top 5% has an average savings rate of about 30%, while the bottom 95% only saves about an average of 3% of their income, this would mean that the overall economy would suddenly have a large chunk of consumer demand pulled from it, as well as a shift in income from the poor and middle class to the rich.

As for the ability of the Deficit Commission’s tax plan to lower the cost of capital for businesses, it would do the opposite of that. Keep in mind that the Deficit Commission’s tax plan would raise about $80 billion a year by 2015 and about $925 billion over 10 years, so it is also a net increase in taxes on the top 5% of income earners as well as all others. Most importantly, it is a tax increase in a way that would slow economic growth. This is, unlike our tax plan, it would increase taxes equally on those who run businesses that hire employees in the US with those who do not. Therefore, the Deficit Commission’s plan would raise the cost of capital for American businesses that employ in the US, thus slowing down the economy. Our plan of course would do the opposite of both these things. This is another reason why, when dynamically scored, our tax plan would raise as much as 4 to 5 times the tax revenues as the Deficit Commission’s and President Obama’s tax plans.

As for the Senator Mark Warner tax plan, it is a great pleasure to see that the Democratic Party is finally moving tax policy closer towards where it needs to be in the global economy of the 21 century. However, there are several ways in which the Warner plan needs to move closer to our plan and in one important way the plan fails miserably.

First of all, the tax cuts in Warner’s plan lay primarily in “targeted” capital expenses, and in our plan they rest primarily in W2’d US employee expenses. If, outside of raising government revenues, the primary goal of American tax policy is to help create American private sector jobs, especially good paying US private sector jobs, than nothing does this more directly and efficiently than a tax credit for US employee expenses. Whereas Capital Expenses for a tax credit for creating jobs in the US is a much more amorphous concept to nail down from a tax avoidance perspective. Capital expenses are much more difficult to be traced as to where they are actually being used, whether they are being used in the US or in a foreign country. Yet W2’d US employee expenses are about as definable and enforceable a tax concept as could exist when it comes to determining whether a business expense is being spent in the US or not. This is not to say that tax cuts or credits for “targeted” capital expenses would be a bad thing. They are great, especially for a few years during a recession, and especially when needing to rebuild an industrial base.

Secondly, when statically scored, our tax credits for US employee expenses would only cost about 22% of the federal revenue that would be raised under President Obama’s personal income tax plan. The Warner plan proposes using 100% of these possible new federal revenues towards tax credits for US capital expenses, R&D expenses, and payroll tax cuts. It is unclear what the percentage brake down for these tax credits and cuts would be. Yet it is easy to argue that US Employee Tax Credits as explained in our personal income and C Corporation portions of our plan would be a great addition to the three Warner tax cuts. In fact, because of the reasons mentioned above, that they are more direct and enforceable, it is easy to argue that they should be the largest single component. It would also be best to increase the payroll or FICA tax cut contribution to the Warner plan, but our FICA tax plan would create more jobs given that it is larger in size and structure. Also, the best way to merge the Warner plan with the C Corporation portion of our plan would be to install the tax cuts in our C Corporation plan for three years before instituting the tax increases in that portion of our plan.

This brings us to the perhaps the most important component of our plan and the Warner plan, and that is, how are these plans going to raise any new federal tax revenues? Obviously, neither our plan nor Senator Warner’s plan would raise any new federal revenues until 2013. Warner’s plan would raise taxes immediately to the personal income tax levels that Obama has proposed, but it would spend 100% of these revenues on tax credits for capital, R&D, and payroll expenses, most of which look to be permanent tax credits. Therefore, Warner’s plan would raise little if any new federal revenues. However, our plan features immediate tax cuts for businesses, with increasing tax rates in 2013 that would more than pay for our tax cuts. Our plan would collect in 2013 as much as 80% more federal revenues than President Obama’s plans, 35% more than the Deficit Commission’s plan, and apparently about $1.25 trillion over 10 years more than Senator Warner’s plan, and much more than the other three if these plans were dynamically scored!

Moreover, in order to improve our economy it is important not to raise taxes on anyone while our economy is still weak. The Warner plan would raise taxes on the top 2% of income earners immediately. While the top 2% of US income earners save about 35% of their income on average, this still means that they spend 65% of it. Such an immediate tax increase would pull consumer spending out of the economy, and therefore slow down the economy. However, our plan would work best in that it would not increase any taxes until three years out. It would give the economy three years to grow, and therefore three years to shift the spending in the economy from the top 2% to the poor, middle class, and businesses that are hiring in the US.

Also, because our plan would raise 80% more federal revenues than President Obama’s plan, 35% more than the Deficit Commission’s plan, and apparently about $1.25 trillion over 10 years more than Senator Warner’s plan, our plan would immediately signal to the bond market that we are serious about our national debt. This alone would probably be enough to keep interest rates low enough to no longer need any more QE2, and certainly in three years there would be no need.

So how do our’s, the Deficit Commission’s, and Senator Warner’s tax plans grade when it comes to the three primary goals of tax policy, raising government revenues, increasing consumer demand, and lowering the cost of capital for businesses in America?

The Deficit Commission’s tax plan does raise revenue, but it fails by lowering consumer demand and raising the cost of capital for American businesses. Warner’s plan certainly lowers the cost of capital for businesses in the US. But it is a mixed picture on increasing consumer demand, and if fails miserably when it comes to raising government revenues. Only our plan accomplishes all three primary goals, and it surpasses the other two plans in all three areas!

1. Emmanual Saez and Thomas Piketty, “The Evolution of the Top Incomes: A Historical and International Perspective,” National Bureau of Economic Research, working paper no. 11955, January 2006.
2. The World Top Incomes Database, Facudo Alvaredo, Tony Atkinson, Thomas Piketty, January 2011.
3. US Census Bureau, Statistics of US Businesses: 2008 : All industries US.