President Obama claims he wants to raise taxes on “the rich,” while Republicans object to the rich paying their fair share. That fits on a bumper sticker, but it is not a fair summary of the dispute. The president wants to raise the marginal tax rates on people earning more than $250,000 per year, while Republicans propose putting a cap on deductions of “the rich.” The legal and economic differences between raising tax rates and raising taxes by limiting deductions are striking.
History shows that if the president increases the top marginal rate from 35 percent to 36.9 percent, he will increase “tax planning,” which reduces tax revenues. Increasing marginal rates makes tax lawyers richer by giving wealthier people a good reason to hire tax lawyers. The government loses because many tax strategies are profitable at higher marginal rates but not at lower marginal tax rates. (Trust me, I’m a lawyer.)
Putting a cap on the maximum amount of deductions avoids the fight with interest groups favoring their particular deductions. Capping deductions does not hurt lower-income workers because they don’t take deductions. In 2009 (the most recent year available), there were 140 million tax returns, but only 45 million — fewer than one-third — itemized their deductions. The average deduction of someone earning $75,000 to $100,000 per year in 2009 was a little more than $22,000, while the upper 2 percent itemize a lot more.
Let us assume that Congress limited all itemized deductions at $25,000 a year, adjusted for inflation, using the current tax laws with the Bush tax cuts. That would raise nearly $1.3 trillion in extra revenue over the next decade.
If Congress limited the deduction cap to $17,000 — a figure that Mitt Romney proposed — the government would raise nearly $1.8 trillion in extra revenue while not raising marginal rates at all. Indeed, that would raise so much extra revenue that Congress could substantially reduce marginal rates at all levels. That would really make the economy soar.
When the government has lowered marginal tax rates, the economy has grown faster and the government has raised more revenue through taxation. If the purpose of raising taxes is to raise more revenue, the government should lower marginal rates and impose a cap on deductions.
Consider what President John F. Kennedy did. He made the tax structure substantially flatter, and reduced the highest bracket by 21 percentage points. Was JFK a secret Republican, a capitalist tool intent on hurting the poor in order to cut taxes for the rich? Hardly.
In 1965, the first year for which JFK’s new rates applied, high-income taxpayers declared more taxable income and paid more taxes than they would have paid under the old law. Those earning more than $500,000 annually, for example, paid $701 million in federal taxes before the JFK tax cuts and $1.02 billion after the tax cuts. That trend was true at every level. Tax collections grew more than 8.5 percent annually, and unemployment dropped to 3.4 percent. Now we seem to accept unemployment hovering around 8 percent as the new normal.
In 1963, JFK proposed reducing the capital gains tax to 19.5 percent, while Mr. Obama wants to raise the capital gains rate to 23.8 percent (which includes a 3.8 percent tax to help finance Medicare) and tax dividends at the 36.9 percent for richer taxpayers. JFK wanted a lower tax on capital because he knew it would help the investment that leads to jobs.
Mr. Obama said he wants to raise capital gains rates even if the government raises less revenue when it raises rates. At higher prices, fewer people sell. Still, the president said, it is “fairer” to do that. Apparently those who think the point of taxes is to raise revenue, not reduce it, are just plain wrong.
Other Democrats besides JFK have supported reducing marginal tax rates. During the 1992 presidential primaries, then-California Gov. Jerry Brown advocated a flat tax. In 1982, Leon E. Panetta, then a Democratic congressman from California, introduced a flat tax. The following year, Rep. Richard Gephardt of Missouri proposed a flat tax.
Why does Mr. Obama insist that the Republicans agree to raise income tax rates? That would break a core Republican campaign pledge, akin to when the Democrats persuaded President George H.W. Bush to break his core pledge: “Read my lips — no new taxes.” It may be a good campaign tactic to force the other side to break its pledge, but it is not a good way to raise revenue. President Kennedy used the right tactic — and it worked. Mr. Obama is no John F. Kennedy.
Ultimately, the issue is whether tax lawyers and tax accountants or the federal government will secure the extra revenue.
Ronald D. Rotunda is distinguished professor of jurisprudence at Chapman University.