Wednesday, April 21, 2010

In Which I Fix the Budget Deficit

In an earlier post I debunked the idea that the rich didn't collectively represent enough income to make much difference in raising revenue, and that therefore only taxing the middle class could really pay for anything big. As you may recall, I concluded that while this may have been true in 1981, it certainly was not today: today the rich have a lot of income, a lot more than they had in 1981.

Nonetheless, the idea that the middle class will have to pay for deficit reduction is broadly accepted, even by the middle class (sort of). A recent poll finds 84 percent think the middle class will have to make sacrifices to reduce the deficit, although almost equal numbers oppose cutting Social Security or Medicare.

"Moreover," notes the assistant director of the polling institute, "although majorities favor increasing taxes on those who earn $250,000 or more, they are opposed to hiking them on the middle class, which would raise much, much more money since there are so many more people who are middle class." A Reuters article on the same poll commented, "In tackling the deficit, most economists agree taxing the rich only won't raise the revenue necessary to make a dent."

Well, yes, you could raise more money by taxing the middle class, if you define "middle class" pretty broadly. But much, much more? Let's see if we can give Most Economists a hand in making a dent in the deficit by taxing the rich only. 

To start with, the Congressional Budget Office projections of the Obama budget show an annual deficit of 5.3% of GDP over the period 2010-2019. I think cutting the deficit by 3% of GDP would be a pretty good dent, don't you? That would reduce the deficit to 2.3% of GDP, a level at which the ratio of debt to GDP is falling, and a lower level than was seen at any time during the administrations of Ronald Reagan and George H.W. Bush. 

As we saw in my earlier post, the top 1% of the population (which starts at about $400,000, by the way) gets about 23% of income. So 3% of GDP would be 3/23 = 13% of their income. They currently pay about 22% of their income in income taxes (source). So they would now be paying about 35%. So much for the deficit problem. 

What Most Economists will be wondering is what marginal tax rate this represents, since the marginal rate is what determines the economic costs of a tax-- the degree to which people change their behavior just to avoid the tax. The top marginal rate now is scheduled to return to just under 40%, but an increase to 53% wouldn't be quite enough, because not all income is taxed at the top rate. Maybe 55%? 

Is that too high? For several decades now I've been a believer in the standard microeconomist's story about too-high marginal tax rates: that they create economic costs, and that the higher they are, the more costly additional increases are. Therefore it's better to raise everyone's rates a little than to raise a few people's rates a lot. I still believe the basic story, but I'm starting to think that its theoretical appeal leads many economists to exaggerate its practical importance. 

Consider: In every decade from the 70s through the 90s the economy grew at an average rate of 3% per year, and in the 00s at only 1.5% per year. But in the 60s, the growth rate averaged 4% per year. During that decade, the top marginal rate never went below 70%. In fact, the economy managed to eke out a 3% growth rate in the 50s, when the top rate never went below 91%. 

I'm not saying that higher top tax rates increase economic growth (though I'm not ruling it out, either). I just think it's hard to argue that the economic costs are all that large, when the economy kept humming along even at dramatically higher tax rates than we have now.

And I'm a little puzzled by how this idea that we can't bring down the deficit by taxing the rich got so entrenched. Is it that people who think that way get better funded? Or that people haven't noticed that it's not 1981 any longer? Or is it just some puritanical idea that medicine won't work if it doesn't taste bad? 

Historical note: The acknowledgments in the CBO report linked above say, in part, "Lenny Skutnik printed the initial copies..." Lenny Skutnik! Remember him? In fairness to Ronald Reagan, he did refer in his speech to "the heroism of one of our young Government employees," but the Zeitgeist in 1982 was such that I don't recall any of the discussion of his heroics mentioning that he was, in fact, a bureaucrat.

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