Not by Income Tax Alone
Can we fix our budget problem by raising income taxes alone? With deficits as far as the eye can see, Rosanne Altshuler, Katie Lim, and I presented a paper at last week’s TPC/USC budget conference that came up with a fairly straight-forward answer: No.
We set a low bar for ourselves. Instead of trying to balance the budget, we aimed to cut the deficit to a sustainable 2 percent of GDP. And we wouldn’t even start to do the heavy lifting until 2015—to give the country time to regain its economic footing.
The Congressional Budget Office projects an average deficit over the 2015-2019 period of 3.2 percent of GDP under current law—that is, if the Bush tax cuts expire next year as scheduled and Congress stops patching the AMT. The average deficit jumps to 6 percent of GDP in the more likely event that Congress follows current policy and makes both the Bush tax cuts and AMT patches permanent as the president has proposed.
Katie used TPC’s tax model to simulate three income tax increases scaled to meet our deficit goals under both current law and current policy: raise all tax rates proportionally, raise just the top three income tax rates, or raise rates for taxpayers targeted by President Obama—couples with income over $250,000 and singles with income over $200,000. We also tried eliminating or limiting itemized deductions.
The results were discouraging, to say the least. Under the higher tax baseline of current law, we’d have to raise all individual rates by 15 percent to meet our 2 percent deficit goal. But under the lower-revenue scenario of current policy, rates would have to jump nearly 50 percent. In other words, the 10 percent bracket would become nearly 15 percent and the 35 percent top rate would go to 52 percent.
What if Congress just raised taxes for high-income taxpayers? Their rates would go up more than 40 percent under current law and more than 150 percent under current policy. In other words, the top tax rate would return to the bad old days of 90 percent. Even if we go for the Administration’s more modest goals—start with current policy and aim for deficits averaging 3 percent of GDP—those top tax rates would have to more than double, taking the top rate over 75 percent.
And our estimates ignore behavioral response. Research has shown that tax increases lead people, particularly at the top of the income distribution, to cut back their taxable income. While analysts disagree on the magnitude of that income shift, they’d all acknowledge that cranking the top rate up to 90 percent would lead to a massive reduction in taxable income and hence a lot less additional revenue than we found. People facing those high tax rates might work less or hire smart accountants. Either way, reaching our 2 percent deficit goal would require even higher tax rates and would quite likely prove impossible.
If we start with current law, we could also meet our goal by eliminating all itemized deductions, but that wouldn’t yield enough revenue under current policy. Besides, wiping out popular deductions for home mortgage interest, state and local taxes, charitable contributions, and other expenses would never fly. We even looked at capping the tax-reducing value of itemized deductions to 15 percent, but that wouldn’t raise nearly enough under either current law or current policy. (Last year, Obama proposed a more lenient 28 percent cap.)
Our simple exercise yields two important messages: We can’t balance the budget with income tax increases alone. We also have to cut spending and perhaps look for another revenue source as well. VAT, anyone?