Barack Obama has a potentially strong hand on the tax issue, but is misplaying it. An enormous opportunity was missed when he ignored the issue of tax reform in his State of the Union address on Jan. 24. But it’s not too late for him to get control of an issue that is certain to be widely discussed during the presidential campaign. If Obama fails to act, Democrats in Congress should seize it for themselves.
For Republicans, every problem in society is caused by government doing too much; never too little. And most of the time, it can be reduced to excessive taxation. Therefore, tax cuts are often the solution to any problem. And if tax cuts are good, bigger tax cuts are better. Thus, every Republican running for president has a big tax cut at the core of his economic policy, with much of the debate revolving around who has the biggest one.
In the real world, however, federal taxes are at their lowest level in several generations and there is no evidence that taxes are a major factor, let alone the key factor, restraining economic growth at this time.
According to the Congressional Budget Office, federal revenues are expected to equal 16.3 percent of the gross domestic product this year. The postwar average is 18.5 percent. In 2011, revenues were 15.4 percent of GDP and were just 14.9 percent of GDP in both 2009 and 2010. We haven’t had four consecutive years in which revenues have been so low since the 1940s.
Of course, it’s not unreasonable to say that taxes ought to be low just now due to a sluggish economy. Indeed, one reason taxes as a share of GDP are low is precisely because growth is slow. When people don’t have jobs and businesses aren’t making money their income tax payments fall to zero. When the unemployed find jobs and businesses start making money again, the government’s revenues will naturally rise. In fact, the improvement in the economy is the principal reason why revenues are expected to rise in CBO’s forecast; not because of any legislated tax increase.
There is, of course, a legislated tax increase looming. The tax cuts enacted during the George W. Bush administration, as well as the temporary cut in the payroll tax, which will likely be extended enacted, expire at the end of the year. CBO estimates that expiration of these tax cuts will cause revenues to rise to 18.8 percent of GDP next year and about 20 percent of GDP thereafter.
Here comes the tricky part. Both Obama and all of the Republican candidates are very concerned about the budget deficit and growth of the federal debt. But they all talk about this problem as if it has only one cause: higher spending. In fact, spending is expected to fall substantially in coming years as temporary stimulus spending expires, the war in Afghanistan winds down, and other factors already in law.
After peaking at 25 percent of GDP in 2009, spending fell to 24.9 percent in 2010 and 24.1 percent in 2011. It is expected to fall to 23.2 percent this year. Under CBO projections, it will continue to fall to 22.5 percent next year and about 22 percent thereafter. Thus we see that the nation’s long-term fiscal problem is actually quite manageable, with a projected deficit of just 2 percent of GDP – provided that we leave policy on automatic pilot, allow taxes to rise and spending to fall on schedule, and avoid enacting any major new programs or start any new wars.
The problem is that neither Congress nor the White House, neither Republicans nor Democrats, are inclined to leave things alone. Republicans, especially, are keen to not only extend the Bush tax cuts forever, but to enact new ones. They blithely assume that preventing an increase in the deficit simply means cutting spending by whatever amount is necessary. But history tells us this is never going to happen even if we elect a Republican president and give the GOP control of both the House and Senate next year. The last time Republicans controlled all three institutions, from 2001 to 2006, spending rose from 18.2 percent of GDP to 20.1 percent.
Thus, realistically, the Republicans’ tax cuts are fiscally unrealistic. Allowing the Bush tax cuts to expire on schedule is the single best thing that could be done to get the deficit under control. And it doesn’t require enacting any laws that could be stymied by a Republican filibuster in the Senate. The tax cuts automatically expire under existing law.
Here’s where it gets even trickier. Neither Obama nor the Republicans want to do that. Obama’s policy has long been to continue the tax cuts for those making less than $250,000 per year, but allow those for the wealthy to expire. He would also like to raise taxes on the ultra-wealthy by ensuring that those with an income of $1 million or more pay at least 30 percent of their income in federal taxes.
However, this will require legislation that Republicans will never allow through the Senate. But it’s equally unlikely that Senate Democrats will ever permit Republicans to cut taxes as they would like. Keep in mind that even if Democrats lose the Senate in November, they will undoubtedly have enough seats to sustain a filibuster. Therefore, some sort of compromise will be necessary to avoid a fairly large de facto tax increase on January 1 if no action is taken.
One possible compromise would be to substitute an alternative package of tax cuts to replace the Bush tax cuts. Obama should have used this option as an action-forcing event to spur Congress into action on tax reform. While there might not be enough time to replicate the Tax Reform Act of 1986, it certainly would be possible to fix some of the big problems in the tax code, such as the ever-rising Alternative Minimum Tax and continually expiring, but always extended, provisions such as the research and development tax credit. That would at least be progress.
The problem is that Obama would have to play hardball. He would have to be willing to take a pretty strong stand against just extending the Bush tax cuts, as well as opposing any new budget-busting tax cuts, in order to compel the Republicans to compromise. But he appears very unwilling to take such a stand lest he be branded a tax increaser.
The irony is that the only way to prevent a significant increase in taxes next year is if Obama is re-elected. There is no possibility, given the electoral situation, that the 2013 tax situation is going to be resolved before the election. Whether it’s resolved afterwards depends on the election results.
As I noted, even if Democrats lose the Senate as well as the White House they will easily be able to filibuster extension of the Bush tax cuts. Therefore, Obama actually holds the winning hand; only he can ensure that taxes don’t rise next year for most taxpayers by negotiating a compromise acceptable to Senate Democrats. Whether he has the skill to play it may determine whether he is re-elected or not.
Bruce Bartlett’s new book, The Benefit and The Burden: Tax Reform--Why We Need It and What It Will Take, published by Simon & Schuster, is available at Amazon.