Why Tax Hikes For the Wealthy Are Inevitable

It violates conventional wisdom, but raising some taxes in a weak economy may be okay.

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Thanks to Herbert Hoover, it's considered insanity to raise taxes during an economic downturn. Three years into the Great Depression, Hoover sought to close a mushrooming federal deficit by passing the Revenue Act of 1932, which boosted income taxes on most earners and pushed the top rate from 25 to 63 percent. If economists agree on anything, it's that cutting people's disposable income in the midst of the depression made things dramatically worse, not better. Franklin Roosevelt committed the same sin a few years later, hiking a slew of taxes to pay for Social Security and other things—triggering a fresh downturn in 1937, just as the economy seemed poised to recover.

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So with today's economy teetering at the edge of a second recession, why is President Obama so determined to let the Bush tax cuts expire on top earners at the end of the year, effectively raising their taxes? And why do Republicans seem willing to go along with the idea? Here are five reasons:

The proposed tax hikes would affect relatively few people. Obama wants to extend the Bush tax cuts for most workers, which means that for individuals earning less than $200,000 and couples earning less than $250,000, nothing would change. That accounts for nearly 97 percent of all taxpayers. For the other 3 percent, Obama would let tax cuts expire, which means the top tax bracket would rise from 35 percent to 39.5 percent, and the one below that would rise from 33 percent to 36 percent. Dividend and estate taxes would also rise, but those mostly affect the wealthy. So for all the hype about raising taxes, it would only happen for a small minority of Americans.

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The bite on top earners won't be that painful. Some families will feel squeezed if the tax hikes go through, like those whose incomes are just over the threshold—especially if they live in expensive coastal cities and have kids in college. But most high-income taxpayers would fork over a relatively small portion of their incomes in additional taxes. A two-earner family with two kids at home and $500,000 in annual income, for example, would pay about $13,000 more in taxes under Obama's plan. (Use this tax calculator to run your own before-and-after scenarios.) That's an extra 2.6 percent of their income, not counting financial-planning changes that could lower the family's tax burden.

That extra tax isn't a trivial amount. But since the wealthy save a much higher portion of their income, it's not likely to affect the family's standard of living that much, or translate into deep cuts in overall consumer spending that would threaten an economic recovery. The wealthy obviously spend much more per person than everybody else, but compared with the huge middle class, there aren't that many rich shoppers. Spending by middle- and low-income earners is what drives the economy. By leaving their taxes alone, the Obama proposals would at least ring-fence the incomes of those who do most of the nation's spending.

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Tax hikes on the wealthy have popular support. The majority of Americans feel it's just fine if the Bush tax cuts expire and Obama does not extend them for the wealthy. In a recent USA Today/Gallup poll, 15 percent of people said the tax cuts should expire for everybody and 44 percent said they should expire just for the wealthy. Only 37 percent felt the tax cuts should be extended for everybody. Since practically everyone wants lower taxes, the relatively high portion of people in favor of some kind of tax hike indicates growing awareness of the national debt and the need to raise more government revenue. That's probably why Republicans, eager to ding Democrats for wanting to raise taxes, have signaled that they'll grudgingly go along with an extension of the tax cuts for everybody but the wealthy: They're siding with public opinion.

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Today's tax burden is unusually low. As a percentage of GDP, income-tax revenues are at the lowest point in 60 years, according to Donald Marron, director of the nonpartisan Tax Policy Center. Since 1970, income-tax revenue as a percentage of GDP has ranged from a high of 10.2 percent in 2000 to a low of 6.5 percent today. The Bush tax cuts essentially ushered in a tax holiday of sorts, and now the recession has cut the government's tax revenues even more. So a rise in tax rates would be nothing more than a reversion to the mean, and it only makes sense to start with those who earn the most.

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America is going broke. And everybody in Washington knows that taxes are going up for most Americans sooner or later. The $14 trillion national debt hasn't caused a crisis yet, but it will if government spending continues to outpace revenue. Spending cuts alone won't solve the problem. Nor will higher taxes on the wealthy alone, since there aren't enough of them to dig the nation out of its hole. That means a big hike in middle-class taxes is coming. It might take the form of a new consumption tax, known as a value-added tax, which could be partly offset by reforms that would thin out a mind-boggling thicket of income-tax deductions and exemptions and make taxes fairer and simpler. However it happens, higher taxes on the wealthy are the first step. There will be many more.