Tax the rich: A grown-up way to trim a deficit

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A funny thing happened in the wake of the Tea Party’s victory in the U.S. debt ceiling standoff a month ago. The populist splinter group of the Republican Party forced President Barack Obama and congressional Democrats to blink, agreeing to raise the legislated debt limit only on the condition that tax increases were kept off the list of options to reduce the budget deficit. In response, a number of high-profile beneficiaries of America’s relatively low marginal tax rates made a wildly different demand: “Tax us. We’re rich.”

Warren Buffett, No. 3 on Forbes’ list of the world’s richest people and most prominent among the low-tax dissenters, wrote an op-ed in The New York Times arguing that, in concert with budget cuts, Washington should raise taxes—especially on dividends and capital gains—for those earning upwards of US$1 million a year and even more on the 8,000 or so Americans making $10 million and up. He said his own tax rate last year worked out to just 17.4% of his income, less than anyone else in his office. After a decade of “coddling” the super-rich and people who “make money with money,” Buffett wrote, “it’s time for our government to get serious about shared sacrifice.” The mega-rich “wouldn’t mind being told to pay more in taxes,” Buffet added, “particularly when so many of their fellow citizens are truly suffering.”

And many of Buffett’s peers did support him. Asked if they agreed with Obama’s earlier proposals to raise taxes on the rich, Facebook founder Mark Zuckerberg and JPMorgan Chase CEO Jamie Dimon both said they did. A group formed last November calling itself Patriotic Millionaires for Fiscal Strength includes hedge fund manager Whitney Tilson, Frank Jernigan, an early software engineer for Google who has since retired, and actress Edie Falco. Henry Bloch, billionaire co-founder of tax tabulator H & R Block (and, in contrast to Buffett, a Republican), said in an interview with the Financial Times that, “it’s not going to hurt the wealthy to part with a little money.”

Starbucks CEO Howard Schultz has gone further, offering action as well as words. In an e-mail to fellow corporate leaders, he asked them to withhold political contributions to either party until they come up with a “fair, bipartisan” solution to the nation’s budget woes, something the 11th-hour deal passed by the Senate on Aug. 2 evidently wasn’t. As of Aug. 24, Schultz said more than 100 heads of large companies had agreed to sign on.

Similar gestures are being made around the world. In France, 16 huge-net-worth types, including L’Oreal SA heiress Liliane Bettencourt and Total SA chief executive Christophe de Margerie, signed a petition calling for a “special contribution” by the super-rich to help the country through its current budget crisis, which threatens France’s AAA credit rating.

“We are conscious of having benefited from a French system and a European environment that we are attached to and which we hope to help maintain,” the petition stated. “When the public finances’ deficit and the prospects of a worsening state debt threaten the future of France and Europe and when the government is asking everybody for solidarity, it seems necessary for us to contribute.” The French government subsequently announced plans to introduce a new levy on individuals earning in excess of €1 million a year.

The move to make the rich pay more to help indebted governments has not gone over well everywhere. Italy’s Silvio Berlusconi cancelled a planned “solidarity tax” targeted at the very highest earners—opposed by professional soccer players, among others—opting instead for measures to curtail tax evasion and eliminate tax breaks for co-operatives.

But the issue of raising taxes on the rich is most controversial in the U.S., where supply-side economics has over 30 years achieved the status of economic gospel, at least on the right of the political spectrum. First voiced in the 1970s by Arthur Laffer, an adviser to the Nixon administration who came from the conservative Chicago school of economics, it was embraced by the likes of Ronald Reagan and Margaret Thatcher and, consensus has it, went a long way to alleviating the stagflation of that era (though falling energy prices and interest rates, demographic shifts and yes, deficit spending contributed too).

The macro-economic context now, though, is very different from 1980. Many industries have been deregulated, competition is global and federal income tax levels are nowhere near the 40% top marginal rate of 1976-77. Not surprisingly, moves such as the extension of the Bush-era tax cuts in a then-lauded “deal” between the White House and Congress last December have produced diminished returns.

New York University economist Nouriel Roubini, influential since predicting the 2008 market crash, has repeatedly called for tax increases to be part of any deficit reduction plan, noting that state and federal government revenue as a share of GDP has been falling since the late 1990s and, at just above 15%, is at its lowest point in 60 years. Roubini’s research going back 15 years debunks the supply-siders’ notion that tax cuts end up increasing government revenue by stimulating growth. Reagan’s tax cuts, he notes, coincided with a ballooning of the federal deficit.

Without delving into such macroeconomic theory, what people like Buffett seem to be saying is that, political posturing aside, the grown-up way to trim the deficit will inevitably involve some measure of tax increases on wealthy Americans—for example, to the level of the late 1990s, by all measures a prosperous time. In fact, this kind of negotiated tax increase might be a far preferable outcome for the world’s savers, investors and high-income earners than the increasingly likely alternative: persistent uncertainty over the global financial system or the consummation of that uncertainty in an asset-value-destroying economic downturn.

Conservative pundits steeped in what George H. W. Bush, running against Reagan for the Republican presidential nomination in 1980, famously called “voodoo economics,” have retorted that Buffett and his limousine-liberal ilk should instead voluntarily pay more to the federal treasury, pointing out the existence of such a provision in the tax code. Republican presidential candidates Rick Perry and Michelle Bachmann have both suggested that Washington should instead turn to the nearly half of American households that pay no federal income tax to raise revenue.

There may well be a silent majority of super-rich strongly opposed to tax hikes who are funnelling campaign funds to anti-tax politicians to do their talking for them. However, the existence of even a few wealthy “job creators” (to use a Tea Party term) who concede the need for higher tax rates undermines the characterization of Obama’s proposals as “class warfare.”

Moreover, there appears to be a growing disconnect between the intransigence of Republican lawmakers and presidential candidates and the broader public. A CNN poll in August found 63% of Americans favoured higher taxes on businesses and rich citizens. A GfK Roper poll sponsored by the Associated Press and conducted around the same time showed 69% felt taxes would have to be increased to balance the budget, compared to just 29% of Americans who felt it could be balanced without raising taxes.

Beyond its core constituency, meanwhile, the Tea Party’s appeal and credibility is sinking. A series of polls conducted following the debt-ceiling debate indicates that while support for the small-government movement remains firm at around a quarter of eligible voters, opposition to the movement has roughly doubled, to about 40%. “As the Tea Party has become more familiar, its image has grown less positive,” wrote analysts from Pew Research. “Those who followed the debt-ceiling debate very closely have more negative views about the impact of the Tea Party than those who followed the issue less closely.”

More broadly, approval ratings for Republican leaders in Congress are in free fall, down to 22% in a Pew Research poll conducted in late August, from 36% in February. Deficit reduction has fallen as a priority since the spring, and now ranks on a par with spending to stimulate the economy.

None of this shift in popular sentiment is likely to soften the debate within the “supercommittee” of six Democratic and six Republican lawmakers who have until Nov. 23 to find a way to close the 10-year budgetary gap by another $1.5 trillion. This is not an election year, and the Tea Party representatives who will ultimately vote on any resulting budget bill have no interest in compromising the strident small-government beliefs that helped get them elected. Moreover, as the one faction in Congress willing to see the U.S. government default on its debt, they have greater influence than their numbers would suggest. If the supercommittee’s bill is not passed by Dec. 23, cuts to entitlement programs kick in automatically—a not undesirable result for extreme budget hawks. Such an outcome would be undesirable for the world’s investors, however, which explains why ratings agency Standard & Poor’s moved to downgrade U.S. treasury bills to AA+ after the debt-ceiling deal had been reached. “The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed,” S&P analysts explained in announcing the downgrade. “We have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.”

So what’s likely to happen this fall? Bill Frenzel, a retired congressman and guest scholar at the Brookings Institution, believes the budget committee can cut enough around the edges to fulfill its mandate without tackling the big budget questions—and calling for tax hikes that Republican members would likely reject. “The supercommittee will achieve its $1.5-trillion goal the old way, with some domestic discretionary [cuts] and tinkering with some entitlements that are least harmful,” he says.

That pushes the real budget showdown into 2012, an election year not only for the executive branch but for a third of the Senate and the entire House of Representatives.

Given that this is the issue on which the parties essentially differentiate themselves from each other, it’s likely to be a hot one, regardless of the compromises from both sides Warren Buffett and a majority of Americans are seeking. And for the stock and bond markets, it means another year of uncertainty.

This column originally appeared on CanadianBusiness.com.