HomeCan Income Tax Rate Hikes Close the Deficit?

Can Income Tax Rate Hikes Close the Deficit?

AUTHOR: William Ahern, Director of Policy and Communications, The Tax Foundation
Apr 15, 2010

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When David Walker was head of the General Accounting Office, he changed the agency’s middle name from Accounting to Accountability, but the concept doesn’t seem to have caught on in Washington.

The federal deficit is projected by President Obama’s Budget to stay at previously intolerable levels for an entire decade: starting out above $1 trillion, dropping to the $700-to-$800 billion level, then rising back to $1 trillion.

Everyone has a different idea of what an “intolerable” budget deficit is, or to put it more positively, how high the deficit can be in an ordinary year and still be “sustainable.” In recent testimony to Congress, Federal Reserve Chairman Bernanke said that the structural deficit was sustainable at 2.5 to 3 percent of GDP. [1]

At current debt levels, the government really needs several years of completely balanced budgets, not just deficits that are barely sustainable. But at no point in the next ten years, according to the Obama Budget, will the deficit even shrink to as little as 3 percent of GDP. According to the CBO, it will never even get as low as 4 percent.[2] And the dire deficit projections of reliable nonprofit groups like the Pew Trust and Peterson Foundation are even more alarming: the deficit won’t even shrink to 5.5 percent of GDP in their analysis. [3]

‘Mind-boggling’ is the term Martin Sullivan of Tax Analysts uses to describe the tax and spending changes that would have to occur just to get the deficit down to 3 percent of GDP.

“Our gridlocked, dysfunctional Congress simply cannot bring itself to absorb these types of painful shocks,” says Sullivan. “Given these unprecedented pressures I believe that within the next decade there is more than a 50-50 chance there will be an upheaval either of the political system or the economy.” [1]

The trouble with political discourse about the deficit is that voters are often numb to the subject, and as a result, politicians are able to avoid the unpopular votes for cutting spending or raising taxes. Whether deficits are expressed in hundreds of billions of dollars or percentages of GDP, their importance is hard for leaders to convey or for the public to grasp. This public disinterest has been exacerbated by false, dire projections that high deficits would immediately wreak economic havoc. Usually in a partisan vein, commentators have predicted that high deficits would immediately jerk interest rates and inflation rates skyward. Neither of those things has happened, but that doesn’t mean deficits don’t matter.

If anyone doubts that deficits matter, they might consider the recent warning of Moody’s that the U.S. could lose its Aaa bond rating due to high debt service costs. According to Moody’s baseline scenario, Uncle Sam will spend almost 11 percent of federal revenue servicing debt in 2013. But if that rises above 14 percent, which it does under Moody’s adverse scenario, U.S. debt would be downgraded to Aa.

Amazingly, bonds sold by several corporations – Berkshire Hathaway, Johnson & Johnson, Lowe’s, and Proctor & Gamble – have sold recently at lower interest rates than Treasury bonds, an rare event that reflects investors’ nervousness about U.S. spending and debt.

But what should the nation do? Enact spending cuts? Enact tax hikes? Or do nothing and hope the economy surges so strongly that it brings in far more revenue than anyone is expecting?

The current Congress has shown no appetite for spending cuts, and many bills are simmering on the Hill that will put the budget in a deeper hole. So unless the U.S. is on the verge of a phenomenal growth surge, there could be more taxes in the offing. The so-called Bush tax hikes are all set to expire at the end of this year, but President Obama has promised to keep all the tax cuts that benefit people making less than $200,000 (single) or $250,000 (couples), and that is most of the tax cuts.

I wonder if President Obama regrets setting the threshold that high. By permanently raising the AMT exemption and preserving Bush’s 28- and 25-percent tax rates, he is protecting tax cuts that Democrats denounced in 2001. Congress might well snub the President’s assertion of who deserves to keep their tax cuts and let more of them expire.

But unless a growth surge brings down the deficit estimates substantially by mid-summer, even letting more of the Bush tax cuts expire won’t come close to erasing the deficits. Even in 2012 or 2015 when the effects of the housing bubble and the fiscal stimulus have dissipated, the tax rates hikes required to balance the budget are far higher that what they were in the Clinton era.

According to the Tax Foundation’s Microsimulation Model, to erase the 2010 deficit, Congress would have to multiply each tax rate by 2.4. So the 10-percent rate would be 24 percent; the 15-percent rate would be 36 percent, etc., on up to the top rate, currently 35 percent which would have to be 85 percent. These rates are simply untenable.

True, the federal deficit is larger in 2010 than in any future year, partly due to the anomalous TARP program and the fiscal stimulus legislation that spilled over into 2010. But even in later years, a simple ticking up of income tax rates to any practical level is incapable of erasing the deficit. Average tax payments would have to rise by almost $10,000 in 2010, and by smaller but still intolerably large amounts in subsequent years.

This analysis is “static,” meaning that it assumes individuals would not change their income-earning or tax-planning behavior in response to higher tax rates. Revenue estimators would dispute this assumption, knowing from experience that even small tax increases alter taxpayer behavior. With high-income people paying a federal tax rate in the 65-to-85 percent range, state and local taxes would bring the marginal tax rate on some people close to 100 percent.

There can be little doubt that the high tax rates necessary to balance the budget in any of the next several years would discourage all manner of income-producing endeavors. Consequently, even when the deficit is projected to be as “low” as it is in 2012 and 2013, it is probably not possible to close the deficit with personal income tax hikes.

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[1] Remark made during Q&A after submitting testimony to the House Committee on Financial Services on February 24, 2010.

[2] Congressional Budget Office, “Preliminary Analysis of the President’s Budget Request for 2011,” March 5, 2010.

[3] Peterson-Pew Commission on Budget Reform, “Red Ink Rising-A Call to Action to Stem the Mounting Federal Debt,” December 2009.

[4] Martin Sullivan, “Mind Boggling Tax Hikes on the Horizon,” Tax Analysts at http://www.tax.com/taxcom/taxblog.nsf/Permalink/MSUN-82ZGEJ?OpenDocument

William Ahern is director of policy and communications at the Tax Foundation. This commentary is based on Tax Foundation Fiscal Fact, No. 217, available at TaxFoundation.org.

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