President Barack Obama plans to raise the top two income tax
rates from their current 33 and 35 percent levels to 36 and 39.6
percent, respectively. This would undo the 2001 and 2003 tax cuts
for Americans earning more than $250,000 ($200,000 for singles) and
return the top rates to the levels of 1993 to 2000 during the
In addition to these tax hikes, the House of Representatives'
Ways and Means Committee, led by Chairman Charlie Rangel (D-NY),
favors another tax to fund the government takeover of the health
care system. The "Rangel plan" would levy a 1 percent surtax for
married couples earning between $350,000 and $500,000 a year, a 1.5
percent surtax on couple incomes between $500,000 and $1,000,000,
and a 5.4 percent surtax for couples earning more than $1,000,000.
For singles, the surtax would kick in for earners making more than
$280,000 a year, $400,000, and $800,000, respectively. It would be
phased in beginning in 2011 and could rise higher in future years
if Congress decides it needs more revenue to fund its
government-run health care system. Contrary to arguments made by
proponents of these tax hikes, tax increases in the early1990s did
not lift the economy to the highs experienced later in the
President Obama's and Chairman Rangel's tax hikes would increase
the progressivity of the already highly progressive tax code.
High-income earners pay substantially higher tax rates than do
lower-income earners. If passed, this increased progressivity will
damage economic growth by lowering the incentives to work, save,
and invest. This will stifle job creation, further slowing the
growth of already stagnant wages.
Those who support this tax increase point to several arguments
to boost their case. But when these arguments are scrutinized, it
is clear they do not hold up. Tax hikes on the rich will not
balance the budget or close deficits. High earners already have a
vast majority of the federal income tax burden, and the proposed
tax hikes will badly damage the economy at a time when it cannot
absorb any new negative shocks.
The President should scrap his plan to hike the top two income
tax rates and Chairman Rangel his plan to pile additional tax hikes
on high earners. Instead, they should propose to immediately cut
spending, including reforming entitlement programs, and extending
the 2001 and 2003 tax cuts for all taxpayers. Additionally, they
should propose further cutting tax rates to help the ailing
What Taxing the Rich Does to the
Myth 1: Raising taxes on the rich will close budget
Truth: Increasing the progressivity of the income tax
code by raising the top two rates will not close the deficit. In
fact, it will lead to more revenue volatility, which will
lead to larger future deficits.
A progressive income tax system collects increasing amounts of
revenue during periods of economic growth and decreasing revenue
during downturns. It does so mostly because of the volatility
of high earners' incomes. During periods of economic growth, their
incomes rise sharply and they pay increasingly higher taxes. But
because much of high earners' income stems from volatile sources,
such as capital gains, dividends, business income, and bonuses,
their incomes fall just as sharply during economic downturns as
they rose during good economic times and they have less income to
Unless Congress suddenly develops spending restraint, increasing
the progressivity of the tax code will only amplify the volatility
of revenue fluctuations and increase future deficits. When revenue
increases, mostly from high earners, during periods of economic
growth, spending would increase because Congress cannot resist
spending additional money. But, as history shows, when economic
growth slows and revenues fall, Congress does not cut back on its
spending largesse. Larger deficits would occur because the gap
between spending and revenue would grow compared to previous
Even if Congress ignores the long-term implications of more
volatility and decides to close the deficits by raising taxes
instead of borrowing as it is doing currently, it still cannot do
it just by taxing more of high earners' income. Congress would have
to decide to raise top rates to levels most Americans would
consider confiscatory. In 2006, the latest year of available data,
there was $2.2 trillion of taxable income for taxpayers earning
more than $200,000. Assuming the amount of income at that level
is similar this year, Congress would need to tax 80 percent of that
income in order to close the projected $1.8 trillion deficit. Tax
rates at such levels would significantly decrease economic activity
and taxpayers would likely avoid or evade paying them so the
revenue gains would likely never materialize.
Who Pays the Largest Chunk of
Myth 2: The rich do not pay their fair share.
Truth: The top 20 percent of income earners pay almost
all federal taxes.
The top 20 percent of all income earners pay a substantial
majority of all federal taxes. According to the Congressional
Budget Office (CBO), in 2006, the latest year of available data,
the top 20 percent of income earners paid almost 70 percent of all
federal taxes. This share was 4 percent higher than in
2000, before the 2001 and 2003 tax cuts.
When only looking at income taxes, the share of the top 20
percent increases even further. In 2006, the top 20 percent paid
86.3 percent of all income taxes. This was an increase of 6 percent
Myth 3: The income tax code favors the rich and
Truth: The bottom 50 percent of income earners pay
almost no income taxes and the poor and middle-income earners
benefit greatly from the tax code.
This widely propagated myth has found its way to the White House
Web site's tax page: "For too long, the U.S. tax code has benefited
the wealthy and well-connected at the expense of the vast majority
As shown in myth number 2, the top 20 percent pay almost 70
percent of all federal taxes and over 86 percent of all income
taxes. It is hard to see how the rich benefit from a tax code they
pay almost exclusively.
The bottom 40 percent of all income earners benefit greatly from
the income tax code. In fact, they actually pay negative income tax
rates because refundable credits, such as the Child Tax Credit and
the Earned Income Tax Credit (EITC), wipe out their tax liability
and pay out more money to them than they ever paid in.
Because of refundable credits, a family of four in the bottom 20
percent of income earners paid an effective income tax rate of -6.6
percent in 2006. As a result, such a family received $1,300 through
the tax code. A family of four in the second-lowest 20 percent of
income earners paid an effective tax rate of -0.8 percent and
received $408 of income through the tax code.
The stimulus bill created a new refundable credit and expanded
three others. This will further reduce the income tax burden of
low-income earners, to the extent they can pay less, and increase
the income they receive through the tax code.
The income tax burden of low-income earners has trended down for
years. In 2006, the bottom 50 percent of all income tax filers paid
only 2.99 percent of all income taxes. This was down 57 percent
from 1980 levels, when the bottom 50 percent paid 7 percent.
Altogether, historical trends and the recent tax policies in the
stimulus likely mean that when the data for recent years is
released, the bottom 50 percent of all taxpayers will have paid no
income taxes whatsoever.
Myth 4: It is all right to raise tax rates on the
rich-- they can afford it.
Truth: Just because someone can afford to pay higher
taxes does not mean he should be forced to do so.
The faulty principle of "ability to pay" holds that those who
earn more should pay proportionally more taxes because they can
afford to do so. Such thinking can be a slippery slope because,
technically, virtually anyone can afford to pay more taxes. The
ability-to-pay principle has no grounding in economics, as it
relies on a completely subjective judgment of fairness.
The tax code should collect revenue in the least economically
damaging way possible. Raising rates on the rich damages economic
growth because it reduces the incentives to work, save, invest, and
accept economic risk--the ingredients necessary for economic
Raising taxes on the rich hurts workers at all income
levels--especially low- and middle-income earners. The rich are the
most likely to invest. Their investment allows new businesses to
get off the ground or existing businesses to expand. This creates
new jobs and raises wages for Americans at all income levels.
Taxing more of their income transfers money to Congress that they
could otherwise have invested. This means the economy forgoes new
jobs and higher wages that the investment would have created for
less effective government spending.
There is a tax code that can collect more from the high earners
than from the lower earners without being a barrier to economic
growth: Under a flat tax, a taxpayer who earns 100 percent more
than another taxpayer pays 100 percent more taxes, but faces no
disincentive to earn more since he will pay the same rate on every
additional dollar earned.
The Economic Impact of Higher Tax
Myth 5: Higher tax rates in the 1990s did not hurt
economic growth, so it is all right to raise them to those levels
Truth: High tax rates in the 1990s were a contributing
factor to the 2001 recession and returning to those rates will
damage the already severely weakened economy.
The economy boomed during the 1990s for a number of reasons. One
key factor was an advance in information technology. Computers,
cell phones, the Internet, and other technological advances made
businesses more efficient. This increased profits and wages and
created numerous new jobs.
The 1997 tax cut that lowered tax rates on dividends and capital
gains from 28 to 20 percent was also a major factor helping fuel
the economic growth of this period. It strengthened the already
strong gains from the technology boom. The impressive growth of the
S&P 500 index after its passage is testimony to that fact. In
the year before the tax cut, the S&P 500 index increased by 22
percent. In the following year, it increased by more than 40
The economic benefits of the technological advances and lower
taxes on investment were strong enough to overcome the negative
impact of the higher income tax rates and the economy exhibited
impressive growth--initially. Even though the economy overcame high
income tax rates temporarily, it was not strong enough to resist
their negative pull forever:
A contributing factor to the 2001 recession was the oppressively
high levels of federal tax extracted from the economy. In the 40
years prior to 2000, federal tax receipts averaged about 18.2
percent of gross domestic product (GDP). In 1998 and 1999, the tax
share stood at 20.0 percent, and in 2000, it shot up to tie the
previous record of 20.9 percent set in 1944.
Taxes were high because the top income tax rates were 39.6
percent and 36 percent--the same rates President Obama and Congress
The economy is in a much more precarious position now than it
was in the 1990s. In June 2009 alone the economy lost 467,000
jobs. With no new innovations like those that
created economic growth in the 1990s on the horizon to jump-start
growth today, the economy simply cannot afford tax policies that
will destroy more jobs and make it more difficult for the economy
Myth 6: The 2001 and 2003 tax cuts did not generate
strong economic growth.
Truth: The tax cuts generated strong economic
The 2001 and 2003 tax cuts generated strong economic growth. The
2003 cuts, however, were more effective at creating economic growth
because Congress designed them expressly for that purpose. They
worked better because they increased the incentives to generate new
income by accelerating the phase-in of the 2001 reduction in
marginal income tax rates, and by reducing rates on capital gains
and dividends, lowering the cost of capital which is critical for
economic recovery and growth.
Lower income tax rates generally promote growth, but since the
2001 cuts were phased in over several years, they did not kick in
quickly enough to change the behavior of workers, businesses, and
investors to help boost the ailing economy, so growth remained
sluggish. The 2001 cuts also increased the Child Tax Credit from
$500 to $1,000 a child. Although a large tax cut from a revenue
perspective, the increase in the Child Tax Credit did nothing to
increase growth-promoting incentives. Recognizing that the slow
phase-in of rate reductions was not generating economic growth,
Congress accelerated the rate reductions to increase the incentives
to work, save, and invest during the 2003 cuts.
The 2003 tax cuts also lowered rates on capital gains and
dividends, generating strong growth by decreasing the cost of
capital, which caused investment to increase. More investment
meant that more money was available for start-up capital for new
businesses and for existing businesses to expand operations and add
new jobs. The rate cuts on capital gains and dividends also
unlocked capital trapped in investments that paid lower returns
than otherwise could have been earned if the tax did not exist.
This generated economic growth by allowing capital to flow freely
to its most efficient use.
The increased incentives to save and invest, coupled with an
acceleration of the cuts on marginal income tax rates, were a major
reason economic growth picked up steam almost immediately after the
2003 tax cuts:
The passage of [the 2003 tax cuts] started a different story. In
the first quarter of that year, real GDP grew at a pedestrian 1.2
percent. In the second quarter, during which [the 2003 cuts were]
signed into law, economic growth jumped to 3.5 percent, the fastest
growth since the previous decade. In the third quarter, the rate of
growth jumped again to an astounding 7.5 percent.
Unfortunately, President Obama and Congress plan to increase the
income tax rates and taxes on capital gains and dividends. This
would reverse the beneficial effects of the 2001 and 2003 cuts and
further slow economic growth during this severe recession.
Myth 7: Raising the top two income tax rates will not
negatively impact small businesses because only 2 percent of them
pay rates at that level.
Truth: Raising the top two income tax rates will
negatively impact almost three-fourths of all economic activity
created by small businesses.
Small businesses are a vital component of the economy. They
create jobs for millions of Americans and are a major factor
driving economic growth.
Evaluating tax policy on the number of small businesses that pay
the top two rates is not the proper way to determine the impact of
raising those rates. What is important is how much small-business
income is subject to the top two rates. This measures the extent to
which the top two rates affect the economic activity that small
Using this more accurate metric, it is clear that the top two
rates have an enormous impact on small businesses. According to the
Treasury Department, 72 percent of small business income is subject
to those rates.
The amount of small business income subject to the top two rates
is high in relation to the number of businesses that pay the rates
because these businesses are the most successful. As a result they
employ the most people and generate the most economic activity.
Raising rates on these successful businesses would damage the
economy at any time, but doing so now will only cost more people
their jobs. Highly successful small businesses faced with higher
tax rates will cut back on plans to expand, hire fewer workers, and
lower wages for current workers at a time when the economy
desperately needs them to expand and create more jobs.
Higher rates also discourage would-be entrepreneurs from
entering the market. This will negatively affect long-term
economic growth because businesses that otherwise would have been
created and added jobs to the economy will never get off the
The many arguments used by proponents of higher taxes ignore
basic economic facts and distort the positive benefits of the 2001
and 2003 tax cuts.
The truth is that the 2001 and 2003 tax cuts were a major factor
behind robust economic growth between 2003 and 2007. Undoing those
tax cuts now for any taxpayers would inflict unnecessary damage to
a struggling economy and needlessly cost many more Americans their
Adding additional higher surtaxes on high earners to fund a
government takeover of the health care system would only do more
damage to the economy and lead to more lost jobs and lower economic
Instead of imposing these economy-injuring tax hikes, Congress
should close budget deficits and spur economic growth by:
- Immediately cutting spending, including reforming the Social
Security, Medicare, and Medicaid entitlement programs, in order to
get long-term budget deficits under control;
- Make the 2001 and 2003 tax cuts permanent for all taxpayers;
- Further cut tax rates on workers and investors.
Raising taxes on the rich will hurt the economy at a time when
the U.S. can least afford further damage.
Dubay is a Senior Analyst in Tax Policy in the Thomas A. Roe
Institute for Economic Policy Studies at The Heritage