Latest tax legislation produces more of the same

After much anticipation of a Grand Bargain and big changes to US tax and spending policies, the US public finally got a deal just a couple days after going off the “fiscal cliff”. And for the most part it’s more of the same.

Tax rates and most deductions and credits remain in place. A very small portion of taxpayers — those making more than $250k if filing joint, or $200k if single — will see a slight reduction in the amount of deductions they can take. An even smaller portion — those making more than $450k if joint, $400k if single — will see a small increase in tax rates from 35% to 39.6%. The most common credits and deductions remain in place — for example, the energy credits, the American Opportunity Tax Credit for education costs, and (very important to those who are foreclosed on or go through a short sale) the exclusion of canceled debt income. In general, any credit or deduction you used in 2011 is probably still available for 2012 (and 2013). The 0% tax rate for capital gains by individuals in the 10% and 15% tax brackets remains the same, while the top rate goes up from 15% to 20% for taxpayers at the very top end of the income brackets. The “carried interest” loophole that allows hedge fund managers and certain other privileged members of the financial community to treat their income as capital gains subject to a maximum rate of 20% (instead of ordinary income at 39.6%) remains in place.

Overall, there’s good news and bad news. The good news is that virtually all taxpayers were saved from significant tax hikes (at least in the short term, more on that in a moment). One piece of particularly good news is that the Alternative Minimum Tax has finally been permanently fixed, with inflation adjustments built into the law, so that taxpayers in middle and upper-middle income levels won’t have to worry about how AMT might affect their taxes since the adjustments will no longer be made at the very end of almost every year. Overall, total federal tax revenues in the US will remain near post-WWII lows at about 16% of GDP, with estimates that they may reach 18-19% of GDP in a best-case economic recovery scenario. (Overall tax revenues will generally be a little less than under Reagan, just by way of comparison.) Unfortunately, this is also bad news for a variety of reasons.

First of all, the fact that it takes this much posturing and debate to make such insignificant legislative action does not bode well for the future of our nation. It’s clear that about 1/3 of the nation, and by extension about 1/3 of Congress, will irrationally refuse to support absolutely anything proposed by the current President. (It’s quite possible that if a Republican is elected President, about 1/3 of Congress would act the same way after seeing that irrational opposition can be a winning strategy electorally in much of the nation.) This means that any legislation at this point now needs to be supported by almost 80% of the remaining members of Congress. Getting 80% support for pretty much any idea is nearly impossible, meaning we’re stuck with an almost completely paralyzed legislature for the foreseeable future. (On the bright side of things, the Texas secession movement seems to be picking up steam; so maybe the die-hard obstructionists will join them in leaving and we can dissolve into a couple of peaceful neighbors with different philosophies of democratic governance…or at least a rational person can dream irrational dreams…)

Second, the deal does almost nothing to reduce the deficit. As my favorite quote on the deal put it, “President Obama sought $1.6 trillion [in additional tax revenue] over 10 years. House Speaker John Boehner offered $800 billion. So they compromised … on $620 billion.” (Nicely put, Ruth Marcus.) At less than $100 billion per year in additional revenue, this deal goes less than 10% of the way toward closing the deficit. Now, as Andrew Jackson demonstrated by paying off the national debt just before we entered one of the worst depressions of the 19th century, paying off the national debt is no panacea. In fact, it’s not particularly desirable. (Complicated discussion, skipping it for now.) But a “sustainable” deficit is one that causes the debt to grow no faster than the rate of overall economic growth, keeping the overall debt stable as a percent of GDP. That means a sustainable deficit to shoot for is somewhere in the range of $250 billion. But the increased revenue of this deal does almost nothing toward getting us to even that goal. And the only spending cuts that can make any significant progress toward this goal are MASSIVE cuts to both the military and Medicare/Medicaid, which is a political impossibility. (Although if we simply kept our military spending in line with the global average — ~1.5% of GDP — this would still leave us with far and away the most well-equipped military in the world and save $500 billion in the process…so that’s certainly a rational possibility, just not a political possibility, unfortunately.)

The last bit of bad news, and this one will come as quite a surprise, is that based on the historical evidence, the top tax rate didn’t go high enough to maximize overall economic growth. Now of course, a lot of things go into increasing growth, and it’s impossible to say with absolute certainty how any change will affect the economy. But, the empirical evidence based on history shows that when tax rates on the top earners are quite high, they tend to reinvest more money in their business (which generally means to their employees) in order to avoid those high rates. One good statistical analysis I’ve seen puts the optimal top tax rate for maximizing economic growth at about 65%, and there are a number of other studies (many that are far more wonkish…for example work by Pikkety and Saez) that reach very similar conclusions.

So in the short run, good news for tax filings this year and next. The credits and historically low tax rates remain pretty much in place. In the long run, we’re continuing to run unsustainable deficits and set top tax rates at levels that have historically been associated with slower growth. So enjoy the breaks for 2012 and 2013 while they last.

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