Snookered on the Fiscal Cliff

On January 1, the rates for the federal individual income tax are scheduled to go back to their Clinton-era levels.  According to Tax Foundation, the higher tax rates would bring in an extra $156 billion to the federal treasury in 2013.  But because of the anemic economy, no one wants to see income tax rates go up for the middle class.

President Obama, however, does want the tax rates on the top 2 percent to revert back to what they were under Clinton.  But Speaker Boehner and the Republicans prefer to get more revenue by putting a cap on "loopholes" in the tax code (that is, exemptions, deductions, write-offs, etc.).  In other words, Democrats want to raise statutory tax rates, while Republicans prefer to zero in on effective tax rates -- the "real" rates taxpayers actually pay.

The top statutory rate for individual income taxes under Clinton was 39.6 percent.  But according to the Congressional Budget Office, the highest effective tax rate for the top 1 percent under Clinton was 24.2 percent (Table 1A).  So during the celebrated Clinton era, high earners were lowering their tax bill through at least 38.8 percent!

In his November 14 press conference, Pres. Obama said: "But what I will not do is to have a process that is vague, that says we're going to sort of, kind of, raise revenue through dynamic scoring or closing loopholes that have not been identified." But loopholes wouldn't need to be identified if a cap were put on the dollar amount that can be claimed using them.

Boehner's idea of putting caps on loopholes is a much better idea than merely raising statutory tax rates.  After all, the whole idea of loopholes is to lower one's real rate of taxation.  But here's another idea: rather than caps on loopholes, get rid of loopholes altogether for taxpayers at the very top.

If Congress disallowed any and all loopholes for the top 1 percent, they could set the top 1 percent's statutory rate to their current effective rate and still bring in the same amount of revenue.  In 2010, the effective rate for the top 1 percent was 20.7 percent.  (That figure comes from Average Effective Federal Tax Rates, a table at Tax Policy Center.)

You'll notice that for the top 1 percent, the 2010 effective rate is just 3.5 points lower than the highest effective rate under Clinton, the aforementioned 24.2 percent.  So if the feds simply must raise the tax rates on the evil top 1 percent, they could set them to somewhere between 20.7 and 24.2 -- if they take away all their loopholes.

If one knows the effective rates for all the groups in Obama's top 2 percent, one can apply the above method to them, too.  For instance, the Tax Policy Center's table shows that the top 0.1 percent has an effective tax rate that is a tad lower than the top 1 percent. (Incidentally, according to that table, it takes revenue of just $508,677 to get into the top 1 percent, and $1,973,943 to get into the top 0.1 percent.)

Even if only for Obama's top 2 percent, the radical simplification described above might be difficult for Congress to swallow.  They may prefer to raise statutory rates and leave the complexity in the tax code.  That's because the tax code with its many loopholes is one of the main ways Congress asserts its power.  But consider this: it's possible that a taxpayer could have a statutory tax rate of 100 percent and end up owing nothing if there are enough loopholes.  So it's not too bright to dwell on statutory tax rates when they can be easily subverted.  (Congress would do well to consider the French.)

If radical simplification for the top 1 or 2 percent is a bridge too far for Congress, then Speaker Boehner's idea for capping loopholes should be embraced -- it's a much better way to guarantee increased revenue than a statutory tax rate hike that can easily be gotten around with loopholes.

Speaker Boehner and the GOP House would be foolish to accede to raising statutory tax rates in the way that the Democrats are insisting, because soon after the higher rates are enacted, the Dems will call for limiting loopholes as well.  If Republicans don't play the fiscal cliff correctly, they'll get snookered, and the folks may never get true tax reform.

Jon N. Hall is a programmer/analyst from Kansas City.

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