Where Will New Revenues for Deficit Reduction Come From?

 If Washington is going to need new tax revenues to bring the deficit under control—which it inevitably will– I increasingly wonder where the cash is going to come from. If you listen to what President Obama has been saying in recent days, it appears that while corporations and nearly all individuals and families would avoid any tax hit at all, a handful of high-income households would get socked with major increases.

These tax hikes would be so big, in fact, that top-bracket taxpayers might end up paying a rate of 67 percent on ordinary income and nearly 50 percent on capital gains.    

Since proposing his 2012 budget, the president has laid out three goals: He wants to reform the corporate income tax, but in a way that raises no more money than the current code.  He’s repeated his long-standing vow to never raise taxes on individuals making $200,000 or less (or couples up to $250,000). Thus, he’d exempt 96.5 percent of households from any tax hikes. And despite those self-imposed constraints, he also wants to dramatically reduce the long-term deficit.

As a result, a relative handful of individuals and families (fewer than 6 million) would foot the entire revenue bill for deficit reduction. The pain of spending cuts would be distributed very differently, of course.   

How big would these tax hikes have to be? To find out, my Tax Policy Center colleague Rachel Johnson crunched some rough numbers.  Although Obama has never quite set a specific deficit reduction target, let’s assume his goal is fiscal balance. And let’s say Obama would get there with the same formula as his fiscal commission—two-thirds of deficit reduction from spending cuts and one-third from taxes.

To reach balance in 2020, Obama would have to reduce the deficit by $735 billion in that year alone. Using the two-thirds/one-third formula, the tax hike would be about $245 billion.  

Also, keep in mind that to get the deficit down to $735 billion, Obama is already assuming the Bush era  tax cuts expire after next year for high earners and new taxes in the health law kick in. That means those folks will already be paying a top tax rate of 39.6 percent on ordinary income as well as higher rates on capital gains and dividends.  Even after that, the top 3.5 percent of earners would be hit with an additional average annual tax hike of more than $42,000.

These folks are doing quite well, thank you, making an average of well over a half a million dollars a year after taxes. And they’ve been big beneficiaries of tax cuts over the past decade. Still, their incomes would fall by 7 percent, on top of the cut in incomes of 2.5 percent to 4 percent they’d face with the expiration of the 2001 and 2003 tax cuts.  

If they had to pay just through higher rates, the top bracket on ordinary income would rise to more than 67 percent and the rate on gains would approach 50 percent. Note to president: This isn’t going to happen.

Among the oddities of this policy: While corporations would, on average, pay no more in tax than they do today, nearly one million successful businesses  that report their income on individual tax returns would get clobbered.  But rather than writing a bigger check to the IRS, many firms would simply reorganize themselves as corporations, especially if Congress also slashed the corporate rate below today’s 35 percent.     

Perhaps budget balance isn’t really the goal for Obama and Congress. Maybe they’ll  be happy with a long-term deficit of 3 percent of Gross Domestic Product–a level many economists believe is sustainable since the debt would be growing no faster than the economy. Or perhaps some future budget deal will rely even more heavily on spending cuts (though that seems pretty unlikely as long as Democrats have some say in the matter).  In those cases, the burden on high-earners may be eased.

But if Obama and Congress are serious about balancing the budget, they are not going to get there by squeezing tax revenues from just a small sliver of households.