The critical facts that no one mentioned in the debt debate

Aug 25, 2011

Hiking taxes on the rich has a long history of backfiring. Let's learn from history.

Is it socially and politically okay to do what we've just done -- commit to cutting federal spending by trillions without asking anyone to pitch in by paying higher taxes? The answer is yes. In this case it's definitely okay, current market fluctuations notwithstanding. But the reasons have nothing to do with anything said by either side in the debt ceiling debate. And if we do get higher taxes down the road, as we may, they're unlikely to be a social boon for the nation or a political win for anyone.

Both sides tried to claim the moral high ground in this debate. President Obama said it was unfair to cut programs that benefit the middle class without making "millionaires and billionaires" pay higher taxes. Republican leaders said raising taxes slowed the economy and cost jobs, which we couldn't afford with unemployment over 9%.

Far more important is what neither side told us. Taxes are going up anyway, on millionaires, billionaires, and everybody else, because the Bush tax cuts expire at the end of next year. As a result, estimates the Congressional Budget Office, federal tax revenue over the next decade will be greater by $3.5 trillion (or about 10%) than it would under a continuation of current policy. The spending cuts in the debt deal would reduce federal spending by about 5% over the next decade. So it looks as if we'll all be pitching in plenty.

But what about appearances? For the sake of social harmony, shouldn't the rich be seen to bear a greater share of this burden? Consider a couple of other things nobody is telling us. Raising taxes on millionaires and billionaires in the U.S. accomplishes little and sometimes nothing. Maryland raised taxes on millionaires in 2008, and so many millionaires left the state that tax revenue from the group didn't rise as intended, but fell dramatically. New York tried the same thing, after which then-governor David Paterson, a liberal Democrat, said, "I won't make that mistake again." He was succeeded by another liberal Democrat, Andrew Cuomo, who faces a huge deficit but strongly opposes renewing the millionaire's tax.

The reason for these surprising facts is that the U.S. already leans harder on the rich than any other developed nation. Research from the OECD shows that the richest decile pays a higher proportion of the nation's taxes in the U.S. (45%) than in any of the organization's 23 other member countries. That top decile also earns a higher proportion of total income in the U.S. (33.5%) than in most other countries, but when you compute the ratios, as the nonpartisan Tax Foundation has done, the U.S. puts the heaviest tax burden on its rich. Trying to extract more from them doesn't work.

And yet -- isn't the U.S. taxed less overall than other developed nations? Yes, it is, but not because our combination of property, payroll, corporate, and personal income taxes is much different from theirs. On the contrary, says the OECD, they're almost identical. The developed economies seem to agree on the most that can be extracted through those taxes (it's about 23% of GDP). The difference between us and them is that they all additionally impose a VAT -- a value-added tax -- and we're the only developed nation that doesn't. So if we're going to raise significantly more tax revenue to help reduce the debt, that's where it is likely to come from.

Whether that happens depends on the most frightening word in Washington: Medicare. Until we address its ballooning costs, we haven't even touched our debt problem. Unfortunately, the new debt deal explicitly prohibits cutting Medicare by more than 2%. If our leaders remain too weak to confront the main element of our fiscal crisis, then it's not hard to imagine a future in which we let Medicare balloon, impose a VAT to cover the costs, and sink into our own version of Eurosclerosis.

Is debt reduction without a tax increase okay? There's no need to worry about it, since we're going to have a tax increase. Instead let's keep the focus where it belongs. Is debt reduction without major Medicare reform okay? That one's easy: No.

This article is from the September 5, 2011 issue of Fortune.

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