By Josh Barro
It's important to remember the fight over extending the Bush tax cuts is not the endgame in the fight over tax policy. We can expect three significant tax increases within the next few years. The first is a partial expiration of the Bush tax cuts. The second is the package of tax increases, mostly aimed at high earners, that Obamacare will bring in 2014. And the third is the tax increase that will be part of whatever deal is eventually struck to reduce the long-term budget gap to a reasonable level.
If the top bracket Bush tax cuts expire, the top tax rate on dividends and capital gains will go from 15 percent to 20 percent, and the top rate on earned income will go from 37.4 percent to 43.1 percent. The Obamacare tax increases will add more, taking the top capital income rate to 23.8 percent and the top earned income rate to 43.9 percent. (Note, these figures are higher than the nominal top rates usually discussed -- 35 percent now, 39.6 percent if the Bush tax cuts expire -- because they include Medicare tax and the effect of provisions that phase out itemized deductions.)
The real problem is what happens when the third shoe drops. There will be strong political pressure for the third tax increase to be distributionally neutral or even progressive, increasing the share of the tax burden that is borne by taxpayers at the top of the distribution. That means we could be looking at effective top federal tax rates nearing 50 percent -- and exceeding 55 percent in states with high income taxes of their own.
Advocates of letting the top-bracket Bush tax cuts expire often argue that it's "a return to Clinton-era" rates and that economic performance was strong during the Clinton administration. The Clinton-era tax code also raised enough revenue to finance the government, and I would be fine with returning to similar rates as part of a deal that closes the long-term budget gap.
What I am not OK with -- and what Republicans are right to resist -- is a tax code that adopts rates slightly higher than we saw during the Clinton administration and yet still leaves huge out-year budget gaps, and therefore contains the threat of additional tax rate increases in the future.
That's why it's important that all the Bush tax cuts be allowed to expire at once. Full expiration would only make the federal tax code modestly more progressive, and it would massively shrink the long-term fiscal gap, reducing the threat of future tax increases. Coupled with entitlement reforms, it could be a one-and-done approach to making the long-term federal budget sustainable. After expiration, a revenue-neutral tax reform could reduce economic distortions and ease the economic pain from collecting more taxes.
But since the economy isn't ready for full expiration, that's going to have to wait. In the meantime, Congress should do what it did last year and extend the entire tax cut package for another year. Low interest rates make it cheap for the government to run deficits, so it's not urgent that the fiscal adjustment start now.
Maybe I give Republicans too much credit for having thought this through. Certainly, they appear to believe that a tax increase can be avoided altogether, which is delusional. But they also rightly perceive that Democrats' desire to raise the top marginal tax rate will not end with the expiration of the Bush tax cuts. Republicans are eventually going to have to hand the Democrats a tax increase, and when they do, they should make sure we won't need another soon after.