The Unintended Consequences of Hillary's Soak-the-Rich Tax Policies

Tax policy is thought by many in Washington to be one of the more effective tools in the battle against inequality. Indeed, presidential candidates like Bernie Sanders have implied they would raise taxes on the rich to correct for rising inequality, and according to the Wall Street Journal, Hillary Clinton is set to announce her plans to increase taxes on capital gains this week.

Populist calls for higher taxes on the rich play very well on the stump, but the resulting policies always seem to produce unintended consequences. Two provisions of Bill Clinton's 1993 tax increase are good examples: The luxury tax on yachts nearly killed the domestic boat-building industry; and, the $1 million limitation on the deductibility of executive salaries encouraged companies to compensate CEOs with stock options rather than wages, which has likely made executives more focused on short-term share prices and less on long-term profitability.

The latest example of progressive tax policy gone wrong is the so-called Fiscal Cliff deal President Obama struck with House Speaker John Boehner at the end of 2012, which raised taxes on the rich through higher tax rates on wages, capital gains, and dividend income.

The final deal reverted the top income tax rate of 35 percent to the Clinton-era rate of 39.6 percent for couples earning over $450,000 (single filers earning over $400,000) while also limiting their itemized deductions and personal exemptions.

For investors, the deal boosted the tax rate on capital gains and dividends to 20 percent from 15 percent. Coinciding with this higher base rate, however, was the introduction of the Affordable Care Act's 3.8 percent tax on investment income for high-income taxpayers (singles with adjusted gross income above $200,000 and joint filers above $250,000), which lifted the combined top rate for capital gains and dividends to 23.8 percent as of January 1, 2013.

Time will tell whether these tax hikes will have any long-term effect on the inequality gap. However, one thing is now very evident from IRS data: the deal had the unintended consequence of exacerbating the appearance of increased inequality in 2012 because the rich sought to avoid the impending higher taxes by shifting a massive amount of income from future years into 2012. Indeed, 2012 saw so much income brought forward that the number of tax returns with $1 million or more in income rose 30 percent to a record 392,850, some 91,000 more "millionaires" than the previous year and topping the pre-recession high of 392,220 millionaire returns set in 2007.

To those who track inequality, it would appear that 2012 was a pretty bad year for working-class Americans. While IRS data shows that total Adjusted Gross Income (AGI) for the nation increased by 9 percent over 2011 levels, a one-year gain of $726 billion, nearly 60 percent of those gains accrued to millionaires. By contrast, the incomes of those earning under $75,000 fell by a collective -1 percent, thus adding fuel to concerns over rising inequality.

Arguably, what drove this "rise" in inequality in 2012 was tax policy, not the economy. After all, GDP grew by a meager 2.3 percent that year. However, no matter which category of income we look at-wages, capital gains, dividends, or business income-it is clear that the rich were taking advantage of the relatively lower Bush-era tax rates to recognize income before any of the new tax laws went into effect on January 1, 2013.

IRS data indicates that high-income business owners took the advice of their tax advisors and booked business income and bonuses early before the new rates took effect. While wages were either negative or essentially flat in 2012 for every income group below $100,000, wages for millionaire returns increased by a collective 27 percent, and by a remarkable 59 percent for returns with $10 million or more in AGI.

Wealthy taxpayers have even more discretion as to the timing of investment income and it is here we can really see the signs of tax planning. Investors and businesses, like the market, are forward looking. They knew that the top tax rate on capital gains and dividends would rise substantially in 2013. Indeed, there was even the possibility that the dividend rate would revert to the ordinary income tax rate as it had been during the Clinton years.

U.S. corporations certainly anticipated these changes as well and did their shareholders a favor by paying out more dividends. In 2012, taxpayers declared 34 percent more income from ordinary dividends and 44 percent more income from qualified dividends than the previous year, a combined increase in dividend income of nearly $130 billion. More than 78 percent of these gains accrued to millionaire taxpayers, and nearly half of the total gains were reported by taxpayers with incomes greater than $10 million.

Even more impressive was the jump in capital gains income, where we see a virtual stampede of taxpayers cashing in before a big tax hike. Taxable net gains jumped 65 percent in 2012 over 2011 levels, to $620 billion from $375 billion. Remarkably, 81 percent of this $245 billion increase in reported gains were claimed by taxpayers earning more than $1 million.

But this appearance of rising inequality is an illusion, a trick of timing because the Fiscal Cliff deal cannibalized income and tax revenues from future years. After all, income shifted forward to be taxed in 2012 cannot be taxed again in the future. While detailed IRS figures are not yet available for 2013, preliminary data on investment income is signaling a fall.

The preliminary figures for 2013 show that income from ordinary dividends fell by 19.6 percent and income from qualified dividends fell by 23.5 percent. Meanwhile, net capital gains income declined by 12.5 percent. While some of these declines could be attributed to the sluggish economy, the Fiscal Cliff deal has to shoulder some of the blame.

Rather than being an antidote for inequality, the Fiscal Cliff deal of 2012 likely increased the appearance of it for at least one year and robbed the government of future tax revenues. Demonstrating once again the unintended consequences of tax policies aimed at soaking the rich.