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Let’s Raise Taxes on the Middle Class

Friday, November 16, 2012

Serious base-broadening will require a net increase in the tax burden on the middle class, which benefits hugely from the biggest tax breaks.

Throughout the recent presidential election campaign, we heard President Obama and Republican candidate Mitt Romney blast one another for allegedly wanting to raise taxes on the middle class, which they defined as households making less than $200,000 per year. And we heard each candidate repeatedly promise not to do so. One of the only things the two candidates appeared to agree on was that raising taxes on the middle class is a bad idea.

That might be true if you’re trying to be elected president. But from a tax policy perspective, raising taxes on the middle class is a terrific idea.

Raising taxes on the middle class is a necessity given the enormous fiscal gap facing our country. While that gap will have to be closed primarily by cutting entitlement spending, increased revenue will also need to be part of the solution. And it won’t be possible to get all of the money necessary from those making more than $200,000 per year. As Alan Viard, my colleague at the American Enterprise Institute, has documented, observers across the political spectrum have recognized that tax increases on the top 2 or 3 percent won’t be enough to close the fiscal gap.

It seems that presidential campaigns are not a good time for difficult conversations about fiscal consolidation. But the campaign is over now. So, to kick off that difficult conversation, let’s start by examining some basic principles of tax reform. What changes can and should we make to bring in more revenue?

One way to boost revenue is to increase tax rates. But high tax rates can impose large costs on the economy by discouraging not just work, but also entrepreneurship, education, and saving. Fortunately, there’s a better way to increase revenue: broaden the tax base.

Perhaps the biggest problem with the current tax code is that the base — that is, the kinds of activities that are taxed — is too narrow, requiring higher marginal tax rates than would otherwise be needed. What is excluded from the base? Many things — but among the largest items are interest payments on mortgages and premiums on employer-provided health insurance. Of course, there’s nothing wrong with people buying houses or employers offering health insurance coverage. But since these activities are taxed preferentially, there is more owner-occupied housing and employer-provided health insurance than there would be otherwise. In other words, these tax breaks — which are effectively government subsidies in disguise — distort people’s decisions. Curbing them would not only raise revenue, it would also encourage Americans to make decisions based on actual economic costs and benefits, rather than tax considerations.

Observers across the political spectrum have recognized that tax increases on the top 2 or 3 percent won’t be enough to close the fiscal gap.

Furthermore, many economists emphasize that taxing consumption is preferable to taxing income. Taxing income punishes saving, while taxing consumption does not. As an income tax is imposed on both wages and investment returns, those who save their paychecks end up owing more in taxes than those who spend them immediately. Discouraging saving in this manner can be particularly harmful to economic growth.

Thus, broadening the base and shifting the burden of taxation toward consumption can help to minimize the negative economic impact of increasing revenue.

But serious base-broadening will require a net increase in the tax burden on the middle class, which benefits hugely from the biggest tax breaks. To avoid this outcome, some observers have suggested curbing tax breaks only for the rich. But that would excessively limit both the amount of revenue that can be raised and the potential improvement in economic incentives. Roughly 95 percent of American households make $200,000 or less. It is ridiculous to protect 95 percent of households from ever paying higher taxes, even as part of much-needed tax reform combined with fiscal belt-tightening.

It’s also worth noting that many American middle-class households are among the richest people in the world. In his book The Haves and the Have-Nots, Branko Milanovic of the World Bank estimates that an income of $18,500 ($74,000 for a family of four) puts a person in the top 5 percent of the world income distribution. Thus, from a global perspective, much of the debate over the distribution of taxes in the United States focuses on the relative burdens of the super rich and the merely rich.

The best solution to our fiscal gap does not include shielding everyone except possibly the very rich from higher taxes. Increasing revenue through sensible, growth-friendly tax reform will require scaling back middle-class tax breaks and raising the tax burden on the middle class. As President Obama enters his second term — free from having to worry about reelection — he should exercise leadership and put this option on the table.

Sita Nataraj Slavov is a resident scholar at the American Enterprise Institute.

FURTHER READING: Slavov also writes “Social Security's War on Working Wives,” “Surviving Academe’s Liberal Bias,” and “Beware of Predatory Lenders? No, Fear Predatory Borrowers.” Stan Veuger discusses “Obama’s Big Tax Increases on Small Business.” Steve Conover explains “The Myth of Middle-Class Stagnation.” Aparna Mathur breaks down “How Taxing the Rich Harms the Middle Class.”

Image by Dianna Ingram / Bergman Group

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