Tax Fantasies of the Right and Left

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By Steven Pearlstein
Friday, April 17, 2009

I almost choked on my scrambled egg whites yesterday morning when I read The Post's story about the April 15 "tea party" protests promoted by Fox News and other conservative organizations.

There, in black and white, was Dick Armey -- the former Republican House leader and an archbishop of the anti-tax movement -- acknowledging that federal tax rates were now "at a good level."

Praise the Lord! A Republican leader has finally dared to utter that taxes had been cut enough and that the optimal tax rate is not zero. It's probably only a matter of time before Armey is declared a heretic by Rush Limbaugh and sentenced to 20 lashes with a Laffer curve.

Armey was right about something else this week: Unless we're prepared to make major cuts in spending on defense and entitlements -- and there is no evidence of a political will to do so -- there's no way to balance the budget and do everything the president wants without a modest increase in the share of national income that goes to taxes.

In thinking about taxes, let's start with a few hard realities:

About 20 percent of household income is paid in federal taxes -- income taxes, payroll taxes, excise taxes, corporate taxes. There's no reason that number cannot rise to 23 or 24 percent once the current recession has passed without hurting long-term economic growth. Indeed, we've had that level of taxation before in the United States, as recently as 2000, and many other prosperous and growing economies do, as well.

At the same time, it's not a good idea to try to raise all that extra money just from households with annual incomes of more than $250,000. That may have been a winning campaign promise for candidate Obama, but it makes for lousy economic policy.

A quick back-of-the-envelope calculation suggests that balancing the budget solely on the backs of those making more than $250,000 a year would almost surely require pushing marginal income tax rates well above 50 percent. That's a level at which taxes begin to discourage people from working and investing. Almost certainly, it is a level that would prompt them to invest significant time and money to find new ways to evade taxes.

A lot of liberals make the argument that its okay to soak the rich because the rich have captured nearly all the income growth in the past couple of decades. There's no disputing that income inequality has increased. But it's also important to remember that there is only so much a progressive tax code can do to counteract the market. With the top 10 percent of households already paying 55 percent of the total federal tax bill, we're hitting against that limit.

Rather, it's probably time to consider ways of tinkering with the market so that it doesn't produce such unequal outcomes. That might include boosting workers' skills and bargaining power, or breaking up the oligopolies that allow lawyers and investment bankers and hedge-fund managers to earn so much more than everyone else.

So what's the "right" level of taxation?

President Obama wants to raise the top income tax rate to 40 percent from 35 percent, which is probably as high as it ought to go. Once you add in state income taxes, the marginal income tax rate would get pretty close to 50 percent in many states.

The marginal rate, of course, is not the same as the overall tax burden -- the percentage of all household income that goes to paying all forms of federal taxes. According to the Congressional Budget Office, the richest 10 percent of households had a federal tax burden of just under 28 percent in 2006, the last year for which data are available. Even if Obama succeeds in pushing through his tax increases for those households, the federal tax burden would rise only to where it was in 1996, a pretty good year for the economy.

At the same time, it's worth noting that the effective federal tax burden also declined for every other income category during that same decade. Given the stagnation of incomes for working-class families in recent decades, those households are probably not in much of a position to absorb a tax increase. But for those with incomes from $100,00 to $250,000, it's hard to argue that returning the federal tax burden to Clinton-era levels would lead to serious economic hardship.

The old Republican fantasy was that tax cuts were the magic elixir that would solve every problem. Now that the public has finally rejected it, it's disappointing to see Democrats offering up the equally fantastic notion that Americans can have all the government they want while getting someone else to pay for it.

Steven Pearlstein can be reached at pearlsteins@washpost.com.


© 2009 The Washington Post Company

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