It takes investment to get sustainable economic growth. We can’t spend our way to growth. We have to save some of the stuff we make today and use it to create new, higher value, tomorrow. If we produce and consume it all, then our economy lives “hand-to-mouth” and we do not grow.
Investing is risky. There is no guarantee that the investment will pay off. Investors weigh many possible scenarios when determining whether or not to make an investment. If the expected return on an investment does not meet an investor’s next best opportunity for his cash, he will forgo that investment.
The expected rate of return compared is the after-tax rate of return. The higher the tax on returns, the more investments will be foregone. So why is Congress trying to discourage investment at a time when the economy desperately needs investment to start growing again?
Because in order to get a deficit neutral score from CBO the legislators needed to find more ways to squeeze revenue from taxpayers. Unfortunately increasing taxes from things that produce economic growth will cause the deficit to increase in a dynamic economy. Slower economic growth will result in fewer jobs and less tax revenue.
As revenues fall, the government must either cut spending or borrow more money. As the government borrows more, there is upward pressure on interest rates. Higher interest rates can crowd out private sector investments, which further slows growth..
The downward trajectory, the Senate and Reconciliation bill puts the economy on in the early years to pay for benefits in later years, are too steep to get out of. In just ten years, the Senate bill (without the large tax increases on investment), slow the economy enough to lose 690,000 jobs per year and add $755 billion to the debt. The Reconciliation bill then slaps the economy by increasing taxes on high-income individuals’ wages and on their growth producing investment income. A 2.9% tax on investment is estimated to cause interest payments on the debt to be $12.4 billion higher over just ten years and slows the economy further eroding household disposable income by an estimated $17.3 billion dollars per year. The Reconciliation bill is worse; it places an even higher 3.8% tax on investment income thereby increasing the after-tax rate of return threshold on those considering investing. When combined with the expiration of President Bush’s tax cuts, the tax rate on capital will be increased by over 50% for some taxpayers.
With slowing growth and rising deficits, it is no wonder that Standard and Poor’s is warning the U.S. about down-grading its debt. People who say “all you need is your health” perhaps do not realize how difficult it is to get quality health care in an unhealthy economy.
Raising taxes does not mean more overall revenue, recently seen in Montgomery County, Maryland, which has had a particularly bad fiscal year after a recent tax hike. The county, which is just across the northern border of the District of Columbia, saw many residents making over $1 million move out when a tax hike was introduced in 2008, and now there are not enough high-income residents in the county to pay their share of taxes. The result of the high tax flight? The county now runs a budget deficit.
The drop in revenue was not entirely due to the recession but rather to unfortunate fiscal policy that drove away the highest earners in the county; Montgomery officials said that after the increase in taxes, the tax revenue dropped 13 percent between 2008 and 2010, while actually rising 40 percent before the tax increases, in 2005 to 2007.
In the Washington Post’s report, county executive Isiah Leggett sums up the situation nicely in a recent session with council members: “Remember what I said years ago. This is a structural deficit. Structural.” What Mr. Leggett means is that the county government has been growing quickly in recent years, and now, since some high-income individuals have moved out, the county cannot cut spending as quickly as revenue has dwindled.
Let us set aside the similarities between Montgomery County’s tendencies to grow with our federal government’s desire to expand under the Obama Administration; this lesson– that increased taxes do not necessarily lead to higher revenues– should be noted by President Obama. The county’s revenue problem is a specific example of the results of the Laffer curve, which says that government can raise taxes up to a point in order to increase revenue, but after that point total revenue actually starts to decrease with higher tax rates.
What is especially worrying about the difficult choices that must be made by Montgomery County officials to cut costs is that 250 government jobs may be lost in order to close the budget gap. Now is an especially unfortunate time for people to lose jobs, and raising taxes makes job creation harder in both the public and private sectors.
The President has stated previously his plans of a tax hike for American households with high incomes. Although Americans might not be able to move to different states in the event of a tax increase, the ones with the most money will be able to manipulate their taxable income and finances, with the help of crafty lawyers, which on a larger scale could very well have an effect similar to what has occurred in Montgomery County. Remember, there were federal revenue shortfalls in the 1950s and 1960s when individual income tax rates exceeded 70 percent. Let us learn from the mistakes in this region so that we may not have to repeat them on a much larger scale.
Aleksey Gladyshev is currently a member of the Young Leaders Program at the Heritage Foundation. For more information on interning at Heritage, please visit: http://www.heritage.org/about/departments/ylp.cfm