Three Tax Hikes That Could Save The U.S. Economy (And Three More That Could Destroy It)

As the debt-ceiling debate escalates, U.S President Barack Obama says federal tax hikes are necessary to close the U.S. budget deficit.

Although Republicans then said that tax hikes were "off the table," this statement is like a toddler who threatens to hold his breath until he turns blue if you make him eat spinach.

Given that our elected leaders in Congress just can't seem to curb their spending addiction, some types of tax hikes have to happen.

But I can show you three tax increases that Congress should pass.

As a taxpayer, that statement will probably make you wince.

But once I've made my case, I'm betting the investor in you will agree with me. These three federal tax increases could save the U.S. economic recovery.

Let's take a look ...

Federal Tax Increases We Don't Want to See

Let's ignore the debt-ceiling debate for a minute and just consider the health and welfare of the U.S. economy.

There are a number of federal tax increases that would be very bad for the U.S. right now.

One example: Boosting the corporate tax rate above 35%.

Except for Japan, the United States has the highest corporate tax rate in the Organisation for Economic Co-operation and Development (OECD).

But corporations don't actually pay that base tax rate. They are able to keep profits overseas in tax-free jurisdictions and employ leasing and other tax breaks.

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Instead of raise corporate taxes, it would make much more sense to lower the rate - maybe to 30% - and close the loopholes. Without those loopholes, companies would have to pay their taxes instead of dodging them. And the "yield" (what's actually collected by the IRS) would be the same or even a little higher.

Similarly, it makes no sense to increase the 15% tax on dividends.

Corporations pay dividends out of their after-tax income. The tax on dividends means those companies actually suffer from a "double-taxation" rate of about 47%.

This encourages companies to fool around with stock options, repurchase agreements and with overpriced acquisitions. And that rips off ordinary shareholders and reduces the economy's efficiency.

The best system would be to make dividends tax-deductible at the corporate level and then tax them as ordinary income at the individual level.

We would benefit as investors and shareholders, because it would put more money in our pocket.

And it would make shareholders very hostile to tax shelters and other management gambits because they reduce the dividends investors receive.

Increasing individual rates of income tax and capital gains tax is also economically inefficient, but less so.

Learning From the Laffer Curve

The Laffer Curve is a way of demonstrating the relationship between government tax revenue and tax rates.

According to Arthur Laffer, tax-rate increases above a certain percentage decrease the amount of money the government can actually collect from those taxes.

Think of it this way: If the government took a 100% tax on your earnings, you would have no reason to earn any money - neither would anyone else. The net result would be zero tax revenue.

At a 90% tax rate, the government would make some money but not very much... and so on, down the line.

That's a very important truth. But there's a catch.

The government makes less money when they increase taxes - but only at very high rates.

At lower tax rates, the Laffer Curve is much less effective.
The effect for increasing capital-gains tax from 15% to 20% would be modest. And tax revenues would only be slightly less than those expected by simple mathematics.

But The Laffer Curve affects capital gains at lower levels than income tax: That's why the 35% capital-gains-tax rate of the 1970s appears to have yielded less than the 28% rate that succeeded it.

We saw a similar effect in 2001, when the top income tax rate was reduced from 39.6% to 35%. The gain from reducing the tax rate was modest, and it didn't outweigh the loss of tax revenue.

Since 2001, however, Congress has added a Medicare surtax, and from 2014 onward there's an additional 3.8% surtax on top investment incomes.

When you include state taxes (which have also risen in many cases), high-income taxpayers are now subject to a top rate of more than 50%. At that point, the Laffer Curve effect substantially reduces the additional income from tax rate increases, though it probably does not eliminate it altogether.

That means restoring the rates on the highest income brackets to pre-Bush (II) administration levels will make the government much less money than congressional computer models predict.

And it will mess up the economy, too.

The Three Federal Tax Increases We Need to See

There is no Laffer Curve effect from closing loopholes in the current tax code.

One of those loopholes is a $6 billion in annual subsidies to ethanol producers. Republicans would like to end this subsidy. And I agree.

It will produce additional revenue, including more returns from gasoline taxes as oil refiners change the mix they sell to gas stations. It will also make the economy more efficient and reduce a wasteful farm subsidy.

The same applies to several "tax preferences" in the tax code for individuals. The largest of these are the tax deductions for:

  • State and local taxes.
  • Home-mortgage interest.
  • Charitable contributions.
  • Health-insurance premiums.
  • And pension contributions.

Of that group, the following three deductions could be eliminated - making three tax increases that could help save the U.S. economy:

  • The tax deduction for home-mortgage interest cost $89 billion in the 12 months that end in September. And for the most part, it only benefits those living in high-cost areas.

    At today's interest rates the deduction on a 4.5%, $300,000 mortgage is only $13,500 - barely enough to make it worth "itemizing" for those with no other major deductions.

    Getting rid of the deduction would reduce house prices in high-cost areas, and push the wealthy to invest in productive industry - instead of in vulgar "McMansions." It should go.

  • The deduction for state and local taxes costs the government $38 billion. And the tax-exempt interest from municipal bonds costs an additional $31 billion each year.

    Getting rid of these deductions would push people out of high-tax states like California and New York. And as a New York resident, I object to this!

    On the other hand, making interest on municipal bonds tax exempt pushes them into their own little market - separate from corporate bonds. And just like all small markets, the municipal bond market is very inefficient.

    The federal government would save money by abolishing the exemption and paying (somewhat less) money directly to the states.

  • The tax deduction for charitable contributions costs $50 billion. And the government loses another $50 billion - or more - each year on other tax benefits for charities.

    The idea that some Wall Street trader can tax-deduct his $1,000 charitable dinner that boosts his flashy social life is offensive. And members of the super-rich set take huge advantage of this deduction, while normal people are much less able to do so.

    And while the rich protect their wealth with donations, many of the charities they chose to support help no real cause.

    There are many charities that do great work. Unfortunately, there are just as many "charities" that are actually scams, huge pointless bureaucracies or thinly disguised political manipulation.

    The economy would benefit if those "charities" were forced to close or combine.

    At the very least, the charitable deduction should be limited to the 28% tax rate, so that the millionaire's charitable dinner and the middle-class person's donation to his church are treated the same by Uncle Sam.

The other two deductions - health insurance and pension contributions - are justified, even if they are expensive:

  • The deduction for health-insurance contributions cost $174 billion in 2011.

    Eliminating it would "level the playing field" between employer-provided and self-provided health insurance, which is a good thing.

    But increasing the cost of everyone's health insurance is not attractive. People don't incur healthcare expenses for fun.

    A tax credit - as opposed to a tax deduction - would "level the playing field" in the same way without impoverishing those with poor health.

  • Pension, 401(K) and IRA deductions cost the government $120 billion. No doubt here - I would keep these: They encourage saving, which God knows the U.S. economy needs.

So if you're frustrated by everything you're reading about the debt ceiling, write your congressman, and tell him or her: If you must increase taxes, here are three ways to boost revenue without hurting the American public.

Other federal tax increases would damage the feeble economic recovery - some of them could even push the economy into another recession.

At worst, the increases outlined above would be neutral. At best they could actually help the U.S. economy move forward.

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