President Obama is surrounded by plenty of smart economists. And plenty more are just a phone call away. Is no one telling him that he is trying to raise taxes in the worst possible way? I have frequently written why raising capital gains taxes by 60% and dividend taxes by 200% is bad for growth. But raising marginal tax rates on labor income should also be a last resort. E21:
The economic literature is quite clear that increases in marginal tax rates cause households to reduce their supply of investment and labor and result in a smaller economy. The adjustment to higher marginal rates is generally borne through three channels: (1) second earners drop out of the workforce or reduce hours, often due to the increase in the relative cost of child care services; (2) a reduction in the market production of services that could be performed at home, which depresses the demand for the services of housekeepers, mechanics, contractors, painters, and other service providers; and (3) an increase in tax-preferred investments, like municipal debt, rather than more economically productive investments.
More perplexing is the suggestion from some quarters that revenue gained from a limitation on deductions would somehow be less certain than an increase in tax rates. The idea is that if a household is motivated by taxes to take out a bigger mortgage, or opt for more expensive employer-sponsored health insurance (a tax exclusion), then reducing those tax benefits would result in less tax-favored activity, which would mean less revenue than previously supposed. The President has even argued that limitations on deductions could cause charitable organizations to collapse. So the President believes that taxes have no effect on hours worked or dollars invested but charitable contributions are perfectly elastic with respect to marginal tax rates?
This argument has it exactly backwards. Marginal tax rate increases are “riskier” from a revenue perspective because they encourage taxpayers to make greater use of these same deductions to reduce taxable income
If a policy choice has been made to increase the tax revenue collected from high income households, Congress should implement this choice in the least costly way possible. Limitations on deductions offer a mechanism to raise a given amount of revenue in a way that does not discourage an additional hour of work or increase the relative cost of consumption expenditures.
But apparently raising tax rates has talismanic properties for the current administration. Of course, they would argue that paring back or eliminating deductions would not raise enough tax revenue. All the more reason to break out of this tax trap and pursue deep, fundamental reform that would raise revenue and boost economic growth.