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The Tax That Spells Trouble for the Economy

Tuesday, March 9, 2010

The savers hit by Obama’s proposed healthcare tax provide the largest volume of funds to finance investment in our economy.

President Obama has announced that he will push forward with his healthcare plan. Commendably, the president has pledged to avoid adding to the deficit, promising that tax increases and spending cuts will cover the full cost of the overhaul. But one tax increase in the president’s plan spells trouble for the economy. For households with incomes above $200,000 ($250,000 for married couples), the 2.9 percent Medicare payroll tax on labor income would be extended to interest, dividends, capital gains, and profits from passive investments in partnerships and S corporations.

The White House claims that its proposal would “improve the fairness of the tax system” by treating different forms of income in the same way. Unfortunately, the proposed extension of the Medicare tax would impede economic growth.

The savers hit by the tax are precisely the ones who provide the largest volume of funds to finance investment in our economy.

The proposal would increase one of the most economically harmful types of taxes—a tax on saving. Saved money was already taxed when earned; taxing the return to saving simply penalizes saving for the future rather than spending today. Worse still, this new tax burden would be piled on top of the existing penalties on saving imposed by individual and corporate income taxes and the estate tax. Savings are crucial to economic growth because they finance business investment in plant, equipment, and innovation. Declines in business investment lead to lower worker productivity, driving down wages throughout the economy.

A lot of political rhetoric focuses on how higher tax rates would affect small businesses. And it’s certainly true that this tax would hamper investment by small firms that are organized as partnerships and S corporations. But let’s be clear. The new tax would also boost investment costs for big firms organized as corporations. Big firms, no less than small ones, create jobs, provide goods and services to consumers, and contribute to American prosperity. Whether a corporation finances business investment by issuing new stock, reinvesting its profits, or borrowing, the investment generates some kind of income—dividends, capital gains, or interest—that would be in the crosshairs of the new tax.

Linking healthcare overhaul to taxes on a small group of wealthy people distracts from the long-term fiscal reality posed by unsustainable entitlement spending.

Of course, the high-income cutoffs mean that the new Medicare tax wouldn’t apply to most American savers. But the savers hit by the tax are precisely the ones who provide the largest volume of funds to finance investment in our economy. In 2007, tax returns from households with incomes greater than $200,000 reported 47 percent of all interest income, 60 percent of all dividends, and a staggering 84 percent of all net capital gains. We can’t afford to discourage this group from investing in America’s future.

Furthermore, linking healthcare overhaul to taxes on a small group of wealthy people distracts from the long-term fiscal reality posed by unsustainable entitlement spending. Commentators across the political spectrum have recognized that our long-run fiscal imbalance cannot be addressed without imposing sacrifices on a broad segment of the population, including the middle class. Adding a costly new program while taxing only 3 percent of the population merely kicks the harder choices further down the road.

It is always tempting to pay for benefits to the many by taxing the savings of the few. But resisting that temptation is essential for economic growth.

Alan D. Viard is a resident scholar at the American Enterprise Institute, and Amy Roden is AEI's program manager for economic studies.

FURTHER READING: Viard recently answered the question “What Should We Expect from Fiscal Stimulus?” while Roden argued that our current tax structure is “No Way to Help the Poor.” The two collaborated on a report outlining “Big Business: The Other Engine of Economic Growth.” Viard further explores “Should Millionaires Pay for Healthcare Reform?” and “The Case Against the Millionaire Surtax.”

Image by Darren Wamboldt/Bergman Group.

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