Real Clear Markets

Kick the Cliff Down the Road, Then Start Negotiating

With the election and Thanksgiving out of the way, the rest of the year is shaping up to be an epic showdown between Democrats and Republicans over tax policy and how to avoid going over the fiscal cliff. At this point there appears to be little room for optimism that either side will give enough ground to avert the spending cuts and tax hikes that will otherwise go into effect within weeks. How markets—and voters—will react to the resulting contractionary pressure will likely depend on the extent to which the "cliff" is recognized to be potentially no more than a slope and on the actions Democrats and Republicans take to make the downward slide a gentle one.

One thing is clear at this point, however: Democrats have won the game to frame the debate. Ostensibly, the 2011 budget deal that brought us to this point was about the proper size of government and about calibrating spending and revenues in order to stabilize long-term federal finances. However, the positions staked out by both sides have effectively narrowed the debate considerably. One side wants continued low taxes for the vast majority of Americans and higher taxes on top earners. The other prioritizes continued low taxes for rich and poor alike. Democrats want higher revenues and see little upside to propose spending cuts. Republicans want lower revenues and lower spending but would rather hold the line on taxes than emphasize the spending cuts laid out in their recent House budgets.

With spending levels an afterthought, and with consensus around continued low rates below the top two income tax brackets, the entire debate is now about whether or not to continue the tax rates that the highest-earning Americans pay on the income they receive above $200,000 to $250,000. If that seems arcane, it is, which is why Republicans are losing the more pithily-put debate over "whether the rich should pay higher taxes." This disadvantageous framing, in turn, explains why Republicans appear increasingly willing to give ground on their basic position that federal revenues should not increase.

The bipartisan focus on the top tax rates is strange given the long-term fiscal challenges we face as a nation. For starters, the long-term budget development that dominates other expected changes in the next 50 years is an increase in spending. In particular, Medicare and other health care spending will nearly double in the next 35 years as a share of the economy, approaching the amount we currently spend on everything else outside of Social Security. Taxes as a share of the economy will have to rise to a level never before seen in the U.S. in order to pay for that increased spending. It can't be paid for by tax hikes on the rich (especially relatively small ones of the sort we are currently debating). Indeed, even if we go over the fiscal cliff and stay put in the ravine, we can only afford projected federal spending if we don't cut any taxes in the future and if the unrealistic provider cuts and other provisions of the Affordable Care Act are faithfully implemented.

Another reason that the focus on top tax rates is inordinate is that federal taxes in America are already more progressive than in our peer countries, as economist Veronique de Rugy has shown. Indeed, according to research by inequality experts Thomas Piketty and Emmanuel Saez, in 2004 the top one percent of "tax units" (essentially, the top one percent of returns) received 20 percent of income but paid 26 percent of federal taxes (including payroll and corporate taxes). The top tenth of the top one percent received 9 percent of income and paid 12 percent of taxes. For the top one percent of the top one percent, the figures were 3 percent and 5 percent.

The richest Americans have received a greater share of income over time, but their share of the federal tax bill has gone up accordingly. Congressional Budget Office data show that the top one percent of households received 9 percent of income in 1979 and paid 14 percent of federal taxes (including payroll, corporate, and excise taxes). In the peak year of 2007, they took home 19 percent of income and paid 27 percent of taxes. Their taxes went down over this period from a 35 percent average rate in 1979 to a 28 percent rate in 2007, but they went down by even more among the middle class and poor.

Viewed through this recent history, the problem with our long-term budget is not that the rich do not pay enough taxes; it is that as a nation, what we want will cost a lot more in the future, more than what we want to pay. This conversation will be a difficult one under the best of circumstances. For now, we should extend the tax and spending provisions about to expire, push the sequester off, and kick the cliff down the road a year in order to give the long-term issues the attention they deserve.