Washington’s Deficit Attention Disorder: The Real Fiscal Illusion

Tyler Cowen’s latest New York Times column proposes to explain the frightening state of the federal government’s finances as a manifestation of “fiscal illusion,” a term used generally to describe a supposed inability of taxpayers to discern the full extent of their true tax liabilities. I confess that I do not find this explanation as persuasive as does Prof. Cowen, for two reasons: 1) As far as I am able to tell, it does not explain why the federal deficit has recently exploded, as opposed to having always been problematic; and 2) It completely ignores the fact that the rise of the Tea Party movement is in large part due precisely to the fact that taxpayers seem substantively more worried about the federal deficit than either the President or a majority of the members of Congress.

If anyone of prominence in the current budget debate seems under the spell of fiscal illusion, it is those on the left (cf. Michael Moore) who think that the source of our woes can be attributed to the reduction in the top income-tax rate enacted under George W. Bush and recently extended with the concurrence of  Barack Obama. A brief numerical exercise is sufficient to show why this is a mistaken belief, and why a key step in balancing the budget–along with truly massive spending cuts–is to raise tax rates at the lower (but not lowest) end of the scale.

The key point is quite simple: there are many, many times more “middle class” households than there are “rich” ones. According to Internal Revenue statistics, over 70 percent of all returns filed in 2008 (the most recent year for which data are posted) were taxed at a top marginal rate of 15 percent or less (about 10 percent of those payers were paying taxes on capital gains). This tax rate is the top rate for any married couple filing jointly with incomes between about $17,000 and $69,000 per year. Because this tax bracket is where the vast majority of households are found, this is where a large part of all taxable income is to be found. By contrast, only about 1 million filers were taxed at the top marginal rate of 35 percent. While those households have a lot of income, there simply aren’t very many of them compared to us ordinary folk.

I undertook a very simple arithmetic exercise, which was to see how tax revenues would change in response to certain changes in marginal tax rates, leaving the income brackets themselves unchanged, and assuming no behavioral responses whatsoever to changes in the incentives to earn income. This is by no means a formal analysis–this is simply a back-of-the-envelope calculation for purposes of a humble blog.

What I found was surprising to me, so perhaps it will be of interest to my handful of readers. Here are the most salient results:

Raising the 25% marginal rate to 28% and raising the 28% rate to 31%, while leaving all other rates (lower and higher) unchanged, would increase the taxes paid by every household above $69,000 in joint income. Total taxes paid by every household with joint taxable income above $212,000 would increase by the same amount, about $4,300. Taxes paid by households with incomes between $69,000 and $212,000 would rise in accordance with their incomes. Taxes paid by households with joint income below $69,000 would not increase at all. The additional revenue yielded by this change in the tax code would be about $50 billion per year in 2008 dollars, without any reduction in the incentives to earn income at all among those earning more than $212,000.

But our fiscal situation is dire, and an extra $50 billion annually will scarcely make a dent in our $1 trillion+ deficit. What else can we plausibly do?

We can most certainly consider raising taxes on those with the highest incomes. So let’s consider an increase in the top marginal rate from 35% back to its 1999 value of about 40%. If there were no corresponding reduction in income earned (or not sheltered) by those in the top bracket, this would about another $47 billion or so. Of course, the assumption that these taxpayers would not respond to higher rates is false, but the available evidence suggests that revenues nevertheless would rise significantly in this range. In any event, the point is that returning to the Clinton-era top rate would still not get us anywhere close to budget balance.

For a real revenue harvest, it is necessary to tax the middle class. For example, if the top rate assessed on incomes in the $17,000 to $69,000 range (recall that these are taxable, joint incomes) were hiked from 15 to 20 percent, total tax collections would rise by something on the order of $140 billion. This starts to become serious money, although it is still not enough to come anywhere close to closing the deficit under the rosiest assumptions.

Here is where we stand, then: A vigorous round of tax increases can only raise, at best, less than $240 billion per year. The tsuami of deficits we are looking at over the next several years, which we would be quite fortunate to see fall to as low a figure as $774 billion per year in ten years, requires spending cuts that are eight or nine times as great as the “painful” $61 billion pushed for by the GOP House freshmen and recoiled at in horror by the rest of Washington.

If you want to find “fiscal illusion,” don’t look to us ordinary taxpayers. Instead, listen to those on the inside, like Illinois Senator Dick Durbin, who thinks that $6.5 billion in spending cuts is quite adequate to solve our financial woes. Well, perhaps “thinks” isn’t quite the right word to describe the mental activities of Sen. Durbin or anyone else who’s not a Tea Partier, at least in spirit. To those who understand the situation, however, repealing DemoCare seems like the obvious way to start climbing out of the fiscal abyss.

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One Response to Washington’s Deficit Attention Disorder: The Real Fiscal Illusion

  1. Pingback: “The Economist” Lands Out of Bounds | Sandy McHoots Speaks Out

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