Why Middle Class Tax Hikes Are Coming

During the 2008 campaign, Barack Obama famously pledged not to raise taxes on individuals making less than $200,000 or families making less than $250,000. With this pledge, he offered over 95% of the electorate something for nothing: you'll get expanded government services, and somebody else will pay for it. The pitch worked, and he became the first winning presidential candidate in a generation whose platform explicitly contained tax hikes. Unfortunately for those who bought in, massive federal deficits will make it impossible for Obama to keep his promise.

The Office of Management and Budget projects a $1.5 trillion federal budget deficit for 2010, with deficits greater than $700 billion in each of the next 10 years. From 2010 to 2019, estimated deficits will total $9 trillion. That will increase the public debt from 41% of GDP in 2008 to 75% in 2019, a level not seen since the early 1950s. Even once the economy returns to normal (in OMB's view, that means 2012), deficits are expected to remain in the range of 3.7% to 5% of GDP.

It is possible for a government to run deficits continuously -- ours has done it almost every year for the last four decades -- but not on this scale. Since paying down the massive debts run up to finance World War II, United States public debt has varied within a band from about 25% to 50% of GDP, with the debt growing on a manageable scale as the economy also grew-typically, outside of recession, that has meant a deficit under 3% of GDP.

When we last ran such large deficits on a prolonged basis (from the early 1980s to the early 1990s) our finances were bailed out by the end of the Cold War, which enabled drastic cuts in military spending. It's not easy to envision a similar resolution for the deficits projected for the next decade. If we keep current levels of government spending, or substantially increase them as Congress is poised to do with health care reform, massive tax increases will eventually be necessary to prevent a debt spiral that undermines the creditworthiness of the United States government. What form will these tax increases take?

New taxes on the wealthy aren't likely to suffice. In 2007, before the Great Recession, the top 5% of income tax filers (those with income over approximately $160,000) had income of $3.29 trillion and paid $676 billion in federal income tax. Raising another $800 billion a year (enough to close the budget gap in 2012) would require taking over a third of their remaining income in new taxes, an outlandish sum. And of course, many of those people have incomes below Obama's stated tax increase threshold.

An across-the-board income tax increase is also an unpalatable answer. A new study from the Tax Foundation finds you could raise an additional $800 billion a year if you raise all income tax rates by 87%, starting from the elevated 2012 baseline after the Bush tax cuts for the wealthy expire. That would mean a bottom rate of 18.7% and a top rate of 74.1%. However, that figure assumes people wouldn't work less even though their tax rates nearly doubled. In reality, dynamic effects would reduce revenue and an even larger tax increase would be necessary to raise the $800 billion. Even a more modest goal like cutting out-year deficits in half, to a manageable 2% of GDP, would require a move to drastically higher marginal rates.

These ugly choices will have lawmakers casting about for other options, and Europe provides a guideline for how to finance high government spending. Contrary to popular belief, (much) higher income tax rates on the wealthy are not a hallmark of European tax systems outside Scandinavia. European countries levy income taxes that are broadly similar to the American tax, even somewhat less progressive. The main differences that support the larger European public sector are higher payroll taxes -- politically undesirable for the same reason as a general income tax increase -- and the inclusion of value added tax in the revenue mix.

A VAT, which taxes businesses on the difference between the price of goods sold and purchased, is economically similar to a sales tax but more difficult to evade. Like most consumption taxes, VATs are regressive, but they've also proved to be a money machine for European governments, with rates gradually creeping up over time. Last month, Nancy Pelosi said a VAT is "on the table". Sen. Kent Conrad has made similar remarks.

Imposing a new, regressive tax might seem like a strange play for the Democrats, but it's not unprecedented. Remember the Obama pledge not to raise taxes on people making less than $200,000? He already broke it, less than two weeks into his term, when he signed a bill raising the federal cigarette excise tax by 61 cents a pack. The cigarette tax is the most regressive tax levied by the federal government. Indeed, President Obama smokes, but few other wealthy people do.

White House Press Secretary Robert Gibbs contends that Obama's pledge not to raise "any kind of tax" on middle income people didn't cover the cigarette tax. Obama might similarly claim a VAT doesn't violate his pledge because it's a tax on businesses, not people. Pelosi is already peddling that line, saying taxes on the middle class are out but the VAT might be in. Of course, the VAT is like sales tax, so it's a tax on the middle class (and the upper class, and the lower class) but in Washington, semantics can matter more than reality.

Democrats will likely contend that new regressive taxes are justified because they will fund programs that disproportionately benefit lower-income people. To a significant extent, that is true. But contrary to President Obama's campaign promise, shiny new government programs won't be free for most Americans.  Instead, they'll come at a cost of increased taxation, reduced incentives for productivity, and a less robust private sector.