What Schumer Gets Right and Wrong on Taxes

Senator Charles Schumer of New York gave a speech yesterday criticizing two pillars of the bipartisan tax reform framework that has emerged in recent years: That the top income tax rate should be cut, and that reform should be revenue neutral.

Schumer's speech is thoughtful and worth reading in its entirety. It makes two excellent points that aren't heard often enough, and it repeats one major error that it shares with most tax ideas from both parties.

Schumer is right that tax reform needs to raise significant revenues, not achieve revenue neutrality. In 1986, when we last enacted a bipartisan, revenue-neutral tax reform, the public debt and projected deficits were much smaller than they are today. Now, debt and deficits are large and federal tax receipts are an unusually small share of the economy. We need a tax increase.

He's also right that there is no need to cut the top tax rate on ordinary income. A top rate of 35 percent is well to the left of the peak of the Laffer Curve, indicating that the economic growth that comes from further rate reductions will be small relative to the revenue loss.

A commitment to a lower top rate makes it hard for tax reform to achieve key goals, such as raising revenue and avoiding a downward shift of the tax burden. Indeed, the arithmetic troubles of Mitt Romney's tax plan stem from his promise to bring tax rates down across the board; he could easily meet his pledge not to raise taxes on the middle class if he did not drop the top tax rate from 35 percent to 28 percent.

What Schumer gets wrong is his contention that the burden of a major tax increase can fall entirely on high earners. In the speech, he lays out his hope to raise $1.5 trillion over ten years, solely from people at the top end of the income spectrum. To do so, he would restore Clinton-era tax rates on ordinary income, raise capital gains taxes, and do targeted reductions in tax preferences for the wealthy.

By itself, this goal is achievable. Roughly, it means that taxpayers making over $200,000 would have to go from paying about a 22 percent effective income tax rate to about 26 percent. That just about matches their tax burden in 1998: 26.3 percent, and as Schumer notes, the sky didn't fall then.

But our budget situation is different than it was in 1998. Schumer's revenue target matches the President's from his 2013 budget, and the President's plan only collects taxes equal to 19.2 percent of GDP over the next decade. While that's in line with historical averages, it's not high enough to close our chronic budget gaps, due mostly to the expanding cost of health care entitlements; we likely need revenues to be closer to 21 percent of GDP.

Other aspects of our tax code have changed since the 1990s. Schumer calls for higher taxes on high incomes and capital gains to match the levels under Clinton. But starting in 2013, the Affordable Care Act imposes new Medicare taxes on high earners that add 3.8 percent to their effective tax rates on capital gains and 0.9 percent on ordinary income. So, if we restore the income tax to 1990s levels, the overall tax burden on high earners will exceed what it was under Clinton, especially on capital gains.

Schumer said in his speech that 50 percent, the top ordinary income tax rate before 1986, was too high, and that while he thinks the capital gains tax rate should be raised, it should be lower than 40 percent. When you combine the federal income tax and Medicare tax (which did not apply to high incomes at all before 1993), Schumer's proposals would take you to a top rate of 43.4 percent on ordinary income and 23.8 percent on capital gains.

So, Schumer's plan doesn't raise enough revenue to put the budget on sound footing and, by his own measures, is pushing the desirable limit on the top rate on ordinary income. Perhaps Schumer is prepared to go a lot higher on the capital gains tax rate, but that is not the sense I get from his remarks. Schumer appeals to the historical tax treatment of capital gains, which has typically meant a rate around 25 percent; and to the treatment in the wake of the 1986 tax reform, when the rate was 28 percent. Since capital gains are a much smaller pool than ordinary income, and since taxpayers respond to high capital gains tax rates by not investing or not realizing gains, adding a couple more points to the rate will not generate a lot of revenue. If Schumer thinks the top capital gains rate should go into the mid-30s (a bad idea, incidentally) he should say so.

The more logical missing revenue piece is something Schumer has foresworn: a middle-class tax increase. In the speech, Schumer criticizes the Simpson-Bowles plan for containing a middle class tax increase, noting that it would raise taxes on households making $100,000 by more than $1,000. If Schumer really isn't prepared to tell households with incomes around the 75th percentile that they will need to pay about 1 percent more of their income in tax, then he must not have much faith in the value of federal government spending.

A middle-class tax increase could take the form of shrinking credits and deductions not just at the top but for people with moderate and moderately-high incomes. Many commentators (including me) have called the elimination of such preferences a "problem" with Mitt Romney's tax plan, but it's really only a problem so long as the expansion of the middle-class tax base is used as a way to cut taxes for the rich. It is a perfectly reasonable way to shrink the deficit.

In general, as the tax burden rises as a share of the economy, the tax code should get less progressive. This is for two reasons. One is that economic losses due to taxation, also known as "dead-weight loss," are a function of the tax rate squared. Taxing the rich is much more economically costly when their income tax rate is already 40 percent than when it is 20 percent, so taxing the rich is a less desirable way to fund each incremental dollar of government spending. This is why European countries with relatively high levels of government spending rely on broad and modestly regressive taxes like a Value Added Tax: that's the only economically viable way to finance an increasingly large government.

The other reason is that rising taxes are mostly going to fund entitlement programs that are either modestly progressive, like Social Security, or strongly progressive, like Medicaid. Insisting on increasing tax progressivity when paying for these programs misses the forest for the trees. To the extent the federal government is doing valuable things, politicians should make the case that people across the income spectrum should be willing to pay for them.

By not saying so, Schumer is pandering to his political base. New York has lots of families making between $100,000 and $250,000 that benefit extensively from tax deductions because of big mortgages and big state income and property tax bills. Many of these families don't "feel" wealthy and think they should be sheltered from the coming tax increase. They're wrong.

Schumer is on the right track in saying that tax reform shouldn't cut the top rate and should produce significantly higher tax receipts from top earners, though unlike Schumer, I'd take as much of that new revenue as possible from ordinary income rather than capital gains. If he admitted the tax increase can't fall just on the wealthy, he would really be on to something.

(Josh Barro is lead writer for the Ticker. E-mail him and follow him on Twitter.)

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