The Coming Tax Bomb

By JOHN F. COGAN and R. GLENN HUBBARD
April 8, 2008; WSJ Page A21

As the presidential campaign enters its final stages, there will be increased debate over budget priorities and how they will be paid for. Many commentators and political leaders, including Sens. Hillary Clinton and Barack Obama, believe that tax increases are needed to restore near-term budget balance and finance longer-term entitlement growth.

These claims fail budget arithmetic and economics. Worse, they raise serious questions about the nation's broad fiscal policies and its commitment to economic growth.

By historical standards, federal revenues relative to GDP, at 18.8% last year, are high. In the past 25 years, this level was only exceeded during the five years from 1996 to 2000. Still, we stand on the verge of a very large tax increase, one that will occur unless the next Congress and president agree to rescind it. Letting the Bush tax cuts expire will drive the personal income tax burden up by 25% – to its highest point relative to GDP in history.

This would be the largest increase in personal income taxes since World War II. It would be more than twice as large as President Lyndon Johnson's surcharge to finance the war in Vietnam and the war on poverty. It would be more than twice the combined personal income tax increases under Presidents George H. W. Bush and Bill Clinton. The increase would push total federal government revenues relative to GDP to 20%.

Why this large tax increase? The tax code changes enacted in 2001 and 2003 are scheduled to expire at the end of 2010. If they do, statutory marginal tax rates will rise across the board; ranging from a 13% increase for the highest income households to a 50% increase in tax rates faced by lower-income households. The marriage penalty will be reimposed and the child credit cut by $500 per child. The long-term capital gains tax rate will rise by one-third (to 20% from 15%) and the top tax rate on dividends will nearly triple (to 39.6% from 15%). The estate tax will roar back from extinction at the same time, with a top rate of 55% and an exempt amount of only $600,000. Finally, the Alternative Minimum Tax will reach far deeper into the middle class, ensnaring 25 million tax filers in its web.

Proponents of bigger government invariably argue that allowing all or some of President Bush's tax cuts to expire is necessary in the near term to balance the federal budget, and necessary in the longer term to finance the retirement and health-care promises made to the baby-boom generation. But a tax increase is neither wise nor necessary.

As has so often been true in the past, the economic damage caused by the tax increases and tax avoidance behavior will prevent the promised revenues from being realized. At the same time, the promise of higher revenues will encourage Congress to continue its profligate spending. As a result, a tax increase won't lower the budget deficit.

Moreover, current tax rates can be maintained and even reduced and still allow for necessary increases in national security appropriations and the balancing of the federal budget. Although budget balance may not be achieved overnight, a firm commitment by the next president to spending control will enable balance by the end of his or her first term.

Balancing the federal budget without a tax increase will require strong fiscal restraint. To achieve balance by the end of the next president's term in office, federal nondefense spending growth needs to be restrained to 2% per year instead of the currently projected 4.5%. This will be tough, but the federal government has been on a bipartisan spending binge for a decade. How large is this binge? Compared to the 1997 level adjusted for inflation and new homeland security spending, in 2007 actual nondefense appropriations were $125 billion higher, or cumulatively, a nearly $900 billion excess for the decade. If the next two congresses were to remove this excess gradually and shave 1% per year from projected entitlement growth, the budget could be balanced.

But what about national security? Certainly, balancing the budget without raising taxes requires that the wars in Iraq and Afghanistan be brought to a successful conclusion over the next five years. However, it does not require that the U.S. troop presence in either country be eliminated. Nor does balancing the budget preclude overdue and necessary increases in the defense budget.

The costs of needed improvements in our national security, though seemingly large, are small when measured in the context of the federal budget. According to the Congressional Budget Office, adding 100,000 active duty soldiers and 60,000 Army or National Guard members costs about $25 billion per year. Increasing the size of the Defense Department's procurement budget by 25% costs a similar amount. Each of these adds just 0.1% to annual federal spending – a small difference in the federal budget, but a powerful addition to our nation's security.

The current economic slowdown will increase the federal budget deficit this year and, in all likelihood, next year as well. But as the economy enters its recovery phase, raising taxes would choke off the recovery. The right policy, for both the economy and the budget, would be to make current tax rates permanent well before the scheduled increase. Giving investors greater certainty that current tax rates will be maintained will spur investment and aid the economic recovery, as it did in 2003. Federal budget balance will be achieved once the economy is again operating on all its cylinders.

This near-term budget debate foreshadows the more significant long-term budget debate the next president must lead. The CBO tells us that after a generation, Social Security and Medicare spending, left unchecked, will rise by 10 percentage points of GDP. Continuing the current hands-off entitlement policy will have severe consequences. The strategy of ratifying spending with higher taxes would require that all federal taxes rise by nearly 60%, bringing them to a European-level tax burden.

We still have time to prepare for the looming entitlement problem. Although baby boomers soon begin their retirement, the real impact of their numbers on the federal budget will not be felt for a decade. According to official budget forecasts, Social-Security costs will claim 4.5% of GDP in 2013, no higher than its claim on GDP during the first half of the 1990s.

Having time is no excuse for inaction, but a near-term tax increase is the wrong way to prepare. Higher revenues will encourage Congress to raise spending, compounding the long-term budget problem. And, the long-term tax increase required to fund unchecked long-term spending would likely reduce annual GDP growth by a full percentage point.

The proper way to prepare to meet the entitlement challenge consists of three essential elements: Change entitlements to slow their cost growth; eliminate all nonessential spending in the remainder of the budget; and, most important but often overlooked, adopt policies that promote economic growth. The greater the economic growth, the larger the economic pie, and the greater the public and private resources available to finance entitlement obligations and other national priorities.

Last year's federal budget illustrates the importance of economic growth to the federal budget's overall health. The federal budget deficit was recorded as 1.2% of GDP, half its average level over the past four decades. This modest deficit occurred despite the fact that Congress has been on a decade-long spending binge; despite the fact that not a single entitlement program has been significantly reduced since the late 1990s and two entitlements, Medicare and farm support payments, have been significantly increased; and despite the fact that we are in the midst of costly but necessary wars in Iraq and Afghanistan.

The consensus that tax increases are needed for fiscal balance is wrong. The next president can fund our defense priorities, maintain tax cuts, and balance the budget. A tax-increase consensus blurs the basic debates over our budget priorities in 2008 – and severely limits our choices in 2028.

Mr. Cogan, a senior fellow at the Hoover Institution, was deputy director of the Office of Management and Budget under President Reagan. Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush.

Obama talks cap-gains rate with CNBC

n an interview in conjunction with his big economic speech in New York, Senator Obama tells CNBC’s Maria Bartiromo he favors increasing the capital-gains tax rate.

Bartiromo reported after her interview: “Right now, as you know, the cap gains tax is at 15 percent. He has yet to give us a specific number. How high he wants that number to go? He has said, and he told me today, that he won't go above 28 percent. So we are talking about the possibility of a doubling in the capital gains tax. He was averaging at about 25 percent.”

Here is her exchange with the senator:

BARTIROMO: "How do you plan to change the tax code when it comes to capital gains? How high will that 15 percent rate go?"

Sen. OBAMA: "Well, you know, I haven't given a firm number. Here's my belief, that we can't go back to some of the, you know, confiscatory rates that existed in the past that distorted sound economics. And I certainly would not go above what existed under Bill Clinton, which was the 28 percent. I would--and my guess would be it would be significantly lower than that. I think that we can have a capital gains rate that is higher than 15 percent. If it--and if it, you know--when I talk to people like Warren Buffet or others and I ask them, you know, what's--how much of a difference is it going to be if it's 20 or 25 percent, they say, look, if it's within that range then it's not going to distort, I think, economic decision making. On the other hand, what it will also do is first of all help out the federal treasury, which is running a credit card up with the bank of China and other countries. What it will also do, I think, is allow us to make investments in basic scientific research, in infrastructure, in broadband lines, in green energy and will allow us to give us--give some relief to middle class and working class families who have been driving this economy as consumers but have been doing it through credit cards and home equity loans. They're not going to be able to do that. And if we want the economy to continue to go strong, then we've got to make sure that they're getting a little relief as well."

Obama's 'Patriot' Act

Wall Street Journal
February 27, 2008; Page A16

No, we're not talking about Barack Obama's opposition to the post-9/11 antiterror law. We're referring to the Senator's support for something called the Patriot Employer Act, which deserves more attention as an indicator of his economic agenda.

Along with Democratic co-sponsors Sherrod Brown and Dick Durbin, Mr. Obama introduced the bill in the Senate in August 2007. Recently in Janesville, Wis., he repeated his intention to make it a priority as President: "We will end the tax breaks for companies who ship our jobs overseas, and we will give those breaks to companies who create good jobs with decent wages right here in America."
[Barack Obama]

Mr. Obama's proposal would designate certain companies as "patriot employers" and favor them over other, presumably not so patriotic, businesses.

The legislation takes four pages to define "patriotic" companies as those that: "pay at least 60 percent of each employee's health care premiums"; have a position of "neutrality in employee [union] organizing drives"; "maintain or increase the number of full-time workers in the United States relative to the number of full-time workers outside of the United States"; pay a salary to each employee "not less than an amount equal to the federal poverty level"; and provide a pension plan.

In other words, a patriotic employer is one which fulfills the fondest Big Labor agenda, regardless of the competitive implications. The proposal ignores the marketplace reality that businesses hire a work force they can afford to pay and still make money. Coercing companies into raising wages and benefits above market rates may only lead to fewer workers getting hired in the first place.

Under Mr. Obama's plan, "patriot employers" qualify for a 1% tax credit on their profits. To finance this tax break, American companies with subsidiaries abroad would have to pay the U.S. corporate tax on profits earned abroad, rather than the corporate tax of the host country where they are earned. Since the U.S. corporate tax rate is 35%, while most of the world has a lower rate, this amounts to a big tax increase on earnings owned abroad.

Put another way, U.S. companies would suddenly have to pay a higher tax rate than their Chinese, Japanese and European competitors. According to research by Peter Merrill, an international tax expert at PriceWaterhouseCoopers, this change would "raise the cost of capital of U.S. multinationals and cause them to lose market share to foreign rivals." Apparently Mr. Obama believes that by making U.S. companies less profitable and less competitive world-wide, they will somehow be able to create more jobs in America.

He has it backwards: The offshore activities of U.S. companies tend to increase rather than reduce domestic business. A 2005 National Bureau of Economic Research study by economists from Harvard and the University of Michigan found that more foreign investment by U.S. companies leads to greater domestic investment, and that U.S. firms' hiring of more offshore workers is positively, not negatively, associated with the number of American workers they hire. That's in part because often what is produced overseas by subsidiaries are component parts to final, higher-value-added products manufactured here.

Mr. Obama is also proposing to raise tax rates on affluent individuals, as well as on capital gains and dividends. This would also lead to more capital and jobs leaving the U.S. The after-tax return on U.S. investment would fall appreciably if these tax hikes were adopted, and no amount of tax-credit subsidy will keep capital from fleeing to lower tax jurisdictions.

If the U.S. didn't impose the second highest corporate income tax rate in the world, companies would have less incentive to move jobs overseas. Rather than giving politically correct companies a 1% tax credit, it makes more sense to reduce the U.S. corporate tax rate for everyone -- by at least 10 percentage points to the global average.

Economists have long understood that companies don't really pay taxes; they merely collect them. A study by the American Enterprise Institute has shown that U.S. workers bear the cost of the corporate income tax in lower wages and salaries. To borrow Mr. Obama's language, what's really unpatriotic is the 35% U.S. corporate tax rate.

Inflation and the Tax Man

By RICHARD W. RAHN
January 17, 2008; WSJ Page A17

Rudy Giuliani's tax-reform proposal includes indexing capital-gains taxes for inflation -- that is, putting the original price of the asset in today's dollars. All of the Republican candidates have called for low or lower taxes on capital gains, while the Democrats favor higher capital-gains taxes. But inflation-indexing of capital gains should be part of every candidate's "economic stimulus" package, regardless of party affiliation.

Accounting for inflation in this way has the advantages of producing more short-term revenue to the Treasury as long-term gains are "unlocked." Furthermore, lowering the cost of capital would stimulate investment and the stock markets, and would increase the fairness of the tax system by not taxing phantom gains for people at all income levels. It would also square capital-gains taxation with the U.S. Constitution.

Assume you purchased a common stock in a company in 1984 for $100 a share and sold it in 2007 for $200 a share. Have you received any "income" from the sale of the shares of stock? The IRS would say "yes," but this is clearly wrong. The IRS will claim that you had a $100 per share capital gain on the stock in the above example, yet actually the increase was solely a result of inflation. Because you cannot buy more goods and services with $200 now than you could have with $100 in 1984, you have had no "income" or wealth accretion.

Over the years numerous economists, lawyers and others have tried to fix this problem and have gotten nowhere with Congress. But now, due to increased concerns about inflation, economic growth and judicial salaries, the time may be right to move forward.

Chief Justice John Roberts has just renewed his call for an increase in pay for federal judges. He, his predecessor William Rehnquist and other judges have complained about the "steady erosion" of judicial salaries over the past 20 years. According to Article III, Section I of the U.S. Constitution, compensation of federal judges "shall not be diminished during their Continuance in Office."

As inflation has outstripped the increase in judicial salaries, the judges have clearly had "diminished compensation" in real terms. Chief Justice Roberts currently makes $212,000 per year, yet all but five of his predecessors in the past 200 years made more in inflation-adjusted dollars (Warren Burger's 1969-1986 income averaged about $250,000 per year in 2006 dollars).

The debate centers on the definition of income. The 16th Amendment to the Constitution states, "The Congress shall have the power to lay and collect taxes on incomes," and the Fifth Amendment clearly states, "No person shall . . . be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use without just compensation."

If the portion of a capital gain due solely to inflation is not income, then taxation without inflation-indexing is an unconstitutional taking of property. Income is commonly defined as, "the amount of money or its equivalent received during a period of time in exchange for labor or services from the sale of goods or property, or as profit from financial investments."

To be money or its equivalent, the payment must have the power to command goods or services produced in the economy. Thus, if the money received from the sale of an asset cannot command more goods and services than the original capital invested, there clearly has been no income.

Too few judges and members of Congress have a basic understanding of economics. As a result, they do not readily see how small but steady losses in value over long periods (except when it comes to their own salaries) is damaging. Inflation of 2%, 3% or 4% per year may seem trivial, but over time it causes great distortions -- the U.S. dollar is now worth less than 1/20th of what it was worth in 1913 when the Fed was established. If the 12% inflation the U.S. experienced in 1979 had continued, the price level would have doubled every six years.

Congress, in order to prevent unlegislated tax-rate increases, has indexed the tax brackets and some other parts of the income-tax code for inflation, which recognizes that a dollar of income in 1998 is not the same as one in 2008. Yet they have failed to do this for capital gains or the AMT, which is now creating great heartache for them as well as for taxpayers. For the code to be logically consistent and to avoid an unconstitutional taking of property -- and for the word "income" to have the same meaning throughout the code -- any capital gain necessarily needs to be indexed for inflation.

The reasons capital gains have not been indexed for inflation (in addition to some members of Congress and judges who do not understand the proper definition of income) are that some argue it would be too complex, and that, since capital gains are taxed at a lower rate than regular income, the problem has already been addressed. Some claim it would result in a big revenue loss. But in the age of advanced tax software, indexing of capital gains is no more complex than many other provisions of the tax code. (The whole code needs to be simplified, but that is another issue.)

Taxing capital gains at a lower rate is done for a number of good economic reasons, and only offsets inflation for assets that have appreciated rapidly in a short time period. Adjusting capital gains for inflation would clearly increase revenues in the short run because of the "unlocking" effect, and probably over the long run because of the higher levels of investment it would stimulate. Over the past 30 years, the Joint Tax Committee, using largely static models, has consistently erred grossly -- at times even getting the direction of the plus or minus sign wrong -- in forecasting capital-gains tax revenues as a result of tax-rate changes.

The Bush administration ought to make inflation indexing part of its "stimulus package." If properly explained, considerable bipartisan congressional and judicial support should be obtained. A number of legal scholars have argued that the executive branch could unilaterally make the change by requiring the IRS to correctly define the words "cost" and "income," given that it was the IRS that originally incorrectly defined them.

It is not likely that many judges or members of Congress would find it in their personal, political, or the national interest to argue that phantom gains are "income." After all, most Americans do understand the meaning of income, even if some in Washington do not.

Mr. Rahn is the chairman of the Institute for Global Economic Growth and an adjunct scholar at the Cato Institute.

URL for this article: http://online.wsj.com/article/SB120053175732296095.html

Another Bush Tax Cut

Wall Street Journal December 20, 2007; Page A16

Nancy Pelosi and her fellow House Democrats surrendered to reality yesterday, grudgingly handing President Bush and taxpayers another victory. They finally passed a one-year "patch" that will prevent the Alternative Minimum Tax from hitting some 22 million middle-class Americans when they file their 2007 tax returns next year.

Congress passed the AMT in 1969 to hit a handful of millionaires who were said to be exploiting too many loopholes also passed by Congress. But because it isn't indexed for inflation, and because Democrats raised AMT rates in 1993 to 26% and 28% from a single rate of 24%, the AMT has turned into a blob that sucks in ever more taxpayers earning between $75,000 and $200,000 a year.

Now back in the majority, Democrats have found themselves hoist on their own 2006 campaign pledge for "pay as you go budgeting," which meant offsetting any AMT tax "cut" with $50 billion in other tax increases or spending cuts. Mr. Bush and Republicans sensibly argued that, because it was never intended to hit so many people, the AMT shouldn't be used as an excuse to raise taxes on other Americans. And with an election year coming, Senate Democrats didn't want to raise taxes on their rich hedge-fund donors. So House Democrats had little choice but to abandon "paygo" as well and pass AMT relief without any offsetting tax increases.

This is good news for the economy, which is struggling enough without a new tax on private equity or other risk takers. Even better for the longer term, this Democratic decision to abandon paygo may foretell less damaging economic policy in 2009. The main goal of paygo is to make cutting taxes all but impossible, and in particular to prevent any extension of the lower Bush tax rates that expire after 2010. This year's AMT fight has exposed paygo for the political fraud it is, and sets a precedent for abandoning it in 2009 in order to avoid walloping the economy with an even bigger, and more damaging, tax increase.

Democrats will of course have to come up with another one-year "patch" in 2008 before the election, and already they're promising that this time they really will stick to paygo. Right. Our own advice is that Democrats could avoid these annual acts of political masochism if they'd merely repeal their own 1993 AMT tax-rate increases, which would stop the tax from snaring so many voters in their own "blue" states. Meantime, who would have guessed that a Democratic Congress would continue Mr. Bush's streak of cutting taxes in some form in every year of his Presidency. Congratulations, Madam Speaker.

Dems Call for Taxes on Wealthy at Debate

What else is new? Tax the wealthy-tax big corporations. Tax relief for the middle class and the poor. . The rhetoric to the uninitiated is high-minded and seems to make sense. But change it a bit and you get the the reality.

Tax the successful, tax the winners, reward the mediocrity...reward the losers. If you think this is the future success story for America, than by all means vote for your favorite Democrat. I pray Americans are smarter than that, but when they get a chance to vote for a 'free lunch'..all bets are off.

New Iowa Pumpkin Tax Puts Damper on Growers' Halloween Spirit

Renee Mulvey

The Iowa Department of Revenue is taxing jack-o'-lanterns this Halloween.

The new department policy was implemented after officials decided that pumpkins are used primarily for Halloween decorations, not food, and should be taxed, said Renee Mulvey, the department's spokeswoman

"We made the change because we wanted the sales tax law to match what we thought the predominant use was," Mulvey said. "We thought the predominant use was for decorations or jack-o'-lanterns."

Methinks, Renee must be a Democrat...

Read it all.....