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Tuesday, November 9, 2010

Raising the Tax Rates on High-Income Taxpayers: Pros and Cons

Nonna A. Noto
Specialist in Public Finance

The set of temporary tax provisions known as the “Bush tax cuts” is scheduled to expire on December 31, 2010. If Congress does not act beforehand, on January 1, 2011, these provisions of the tax code will return to what they had previously been in 2001 and 2003. Their expiration would mean an increase in federal income tax for most taxpayers.

During his presidential campaign, President Obama promised that he would not raise taxes on single taxpayers with income below $200,000, or married couples with income below $250,000. In its budget proposal for FY2011, the Administration proposed to extend the middle-class portion of the Bush tax cuts, but to allow several provisions favoring upper-income taxpayers to expire. Republican Members of Congress generally favor permanently extending the entire package of Bush tax cuts. Some Democrats favor extending all of the cuts, but only temporarily.

The Treasury Department has estimated that the Obama Administration’s set of proposals to raise taxes on upper-income taxpayers would collect $41 billion in additional revenue in FY2012 and $680 billion over 10 years, measured relative to the current policy baseline. This would reduce the net cost of extending the Bush tax cuts from $258 billion to $217 billion, or by 16%, in FY2012. It would reduce the net 10-year cost from $3.7 trillion to $3.0 trillion, or by 19%. These estimates do not include the interest costs associated with the borrowing required to finance the tax cuts.

This report focuses on the debate over whether the top two marginal tax rates should be permitted to rise back to their 2001 levels—from the current 33% back to 36%, and from the current 35% back to 39.6%. The analysis takes into account the relationship between the top tax rates on ordinary income, the tax rate on capital gains and dividends, and the alternative minimum tax.

In the fall of 2010, decisions about tax policy face two conflicting fiscal policy goals. For the long run, the dominant fiscal policy goal is deficit-reduction, which is likely to require some statutory tax increases. In the short run, however, the dominant concern of many observers is encouraging the economy to recover and produce more jobs. To them, raising taxes seems directly counter to the fiscal policy called for when the economy is weak. One compromise would be to extend some or all of the Bush tax cuts only temporarily, rather than permanently. Another compromise would be to extend only those Bush tax cuts thought to stimulate the economy the most, and to permit the other tax cuts to expire—to help reduce the deficit.

Arguments for raising the tax rates on high-income taxpayers start with the need to raise additional revenue and to signal the beginning of an effort by the United States to reduce its deficit. This policy is viewed as collecting revenue from taxpayers with the most income, who received the biggest Bush tax cuts, and who are least likely to reduce their consumption spending or work effort in response to an increase in their marginal tax rate.

Arguments against raising the tax rates on high-income taxpayers start with the bad timing of raising taxes in the midst of a weak economy. The wage and investment income of high-income taxpayers will already be subject to two newly enacted Medicare surtaxes, scheduled to take effect in 2013. Higher tax rates on ordinary income would encourage high-earners to convert some of their pay into lower-taxed forms of compensation. Higher tax rates in the top brackets are seen as a negative incentive for small business growth, investment, and employment. In general, higher tax rates increase tax evasion and economic distortions.

Date of Report: November 5, 2010
Number of Pages: 31
Order Number: R41480
Price: $29.95

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