The Tax Increase Paradox
Posted on November 19, 2012
A very smart friend of mine, who happens to work in Congress on the Republican side of the aisle, sent me an interesting email that I thought I would share with you with his permission. He prefers that I keep his name out of it:
An interesting paradox exists in the Taxmageddon/fiscal cliff battle.
Recent statements by Democratic members, staff, and pundits have raised concern about tax reform base broadening proposals, specifically about caps on itemized deductions and the like. The concern boils down to a heavier impact of these tax increases on the so-called Blue States. These statements lift the curtain on the paradox. It has been present since the 2001 tax relief package was developed. It is this:
- Taxpayers who benefit from the rate reductions in the top two brackets, i.e. the target of de-coupling, are disproportionately in higher cost of living, higher tax, Blue States.
- The taxpayers in those states tend to be concentrated in the most liberal, urbanized and suburbanized parts of those states which also are the highest income parts of those states.
- Because they are a significant part of the higher-end of the tax base, these taxpayers would also bear the burden of any base-broadening that would result in more revenue and an even more progressive tax code.
- That is, the tax burden of the President and Congressional Democrats’ agenda, by definition, falls on this group of taxpayers in either rate hikes or base broadening.
- Yet those taxpayers, since 2000, have been trending Democratic, and voted for Democratic politicians who advocate higher taxes on those taxpayers.
- The party that these high-income Blue State taxpayers have been opposing, has shielded these taxpayers from the bottom-line of their political choices.
- If Republicans concede higher revenue from this group, as part of a broader fiscal reform package, the same group is targeted whether from higher rates or a broader base.
- The Republican concession could make the paradox clear and make Democratic politicians accountable to the high-end of their base.
- Hence, the effort to find an opposition to that tax increase, in form, but not in substance, a tax increase these politicians will still be responsible for.
Just like the campaign, we aren’t seeing the same level of examination of the policy and fiscal implications of current entitlement policies, and everybody stipulates they are driving fiscal problems at the Federal and state levels.
On my point that Democrats should anticipate some political accountability within the high-end of their own base for the tax increase on those above $200,000/$250,000 thresholds, check the NYT exit polls: the high-end Blue State voters (proportionately, a higher part of that population went for Democrats in the higher cost, higher income Blue States). And then there’s this piece.
It takes a lot more income to live a moderate or high income life style in the Blue States (especially in the urban areas). Another way of saying it is that the real incomes, from a geographical perspective, are much lower, after tax, in those areas. The reality is that these high-income Democratic voters haven’t faced a tax increase since 1993. And they weren’t happy about it in 1994 when they had to pay it, but they’ve forgotten about it. They had the tech and housing bubbles of the Clinton years. Republican Congresses, partnering with Bill Clinton, enhanced incomes with the largest free trade agreements of a generation and that raised incomes. Interest rates dropped materially with a divided government in 1995. That was then. It is not now. There will be no Goldilocks economy, invention of the internet, or tech or housing bubble to cushion the impact of the higher taxes those Democratic voters will face.
The bottom line is Republicans have protected them from being economically accountable for the heavy tax policies advocated by the Democratic politicians they’ve supported. I found this quote from the author of Red State, Blue State, that I think fleshes it out:
What’s the single most interesting thing you discovered writing your book?
If I had to summarise one thing from Red State, Blue State that we discovered, it’s the fact that the biggest differences between red states and blue states are occurring at the upper-income level, rather than the lower-income level. If you look at high-income voters, America is very geographically and ideologically divided. If you look at lower-income voters, there’s less division. That was really our big point.
Explain a bit more.
If you compare states like New York and California on the one hand and Texas on the other, the lower-income voters in these states don’t differ so much. Obama did better among lower-income voters in New York than in Texas, but it wasn’t as different as the differences among high-income voters. Another way of saying this is that if you compare people’s attitudes from surveys in Republican-leaning states to Democrat-leaning states, low-income people don’t differ much, on average, in their social and economic attitudes. Low-income Americans tend to be economically liberal and fairly moderate on social issues. Upper-middle-class Americans, on other hand, vary a lot by region. In Republican states they tend to be very conservative on economic issues and moderate on social issues. In Democrat-leaning states, upper-middle-class or rich people tend to be moderately conservative on economics and liberal on social issues.
If you look at the very richest Americans – we don’t know about them from surveys, but we can look at campaign contributions – they’re very important campaign contributors for the Republicans. The rich supporters of the Republicans are very conservative economically. The very richest Americans are also very important contributors for the Democrats. But the rich supporters of the Democrats are not ultra-left economically. The richest people on the left don’t like the Republicans, they’ll support moderately higher taxes and so forth, but they’re not socialists. They’re not so extreme. So there’s an asymmetry there.
Certainly, in 2008, President Obama won the very cohort he decidedly said he wanted to tax. And a lot of Congressional districts that are solidly Democratic, skew toward higher income stats. In our area, examples would be those of Mr. Van Hollen (wealthy Bethesda and Potomac) and Mr. Connelly (Fairfax).
I’m not saying that the tax increase the Democrats are obsessing about won’t hit Republicans. It definitely will hit many Republicans. But it will hit a lot of Democrats, including Democratic majorities in Democratic states. My own sense is that voters in those cohorts skew harder Democratic the higher up the income scale you go. I suspect if you except out small business owners, ironically other than the investment managing types (hedge funds, private equity firms) Democrats frequently attack, you will find that those high income voters {--} the Democrats have targeted for a significant tax increase, voted overwhelmingly Democratic.
The politically honest and transparent outcome would be for Democrats, alone, to be accountable to their Democratic constituencies for the tax increases they adamantly seek. With a Republican House majority, that is a pretty hard result to bring about. Also, makes you wonder, why, they demurred on this policy in 2009-10 when they had a 60 vote Senate, a robust House majority, and the Presidency.
By contrast to high income Democrats, people who’ve run and built regular nuts and bolts or service businesses, with their own capital at risk, and their own credit on the line, along with their own entrepreneurial and management skill making up a lot of the goodwill in the business, will be the heart of the cohort who’ve voted Republican. It isn’t by coincidence that NFIB and other small business owner groups are solidly and unequivocally against the Democratic program of looking to them to resolve the lion’s share of the country’s fiscal problems. Unlike the Blue State high-income voters, these folks tend to have a granular appreciation for their tax burdens. That’s because their business finances and personal finances tend to interface. That’s not the case for the CEOs of publicly-traded companies, who are pushing for a tax increase, on the NFIB type business owners. The small business owners tend to run the numbers and tend to worry about what the President campaigned on, and, more importantly, the snowball effect of the further tax increases the Democrats will pursue as they avoid the entitlement problems at the federal and state levels. My sense is Democrats know they’ve lost this part of the high-income cohort, but don’t like the political baggage of this group opposing their program. If Republicans co-own the tax increase, then that takes the political edge off.
The smart money on the Democratic side must know that the other part of the cohort they want to hit hard (advocating raising rates and now, in the glow of their victory, broaden this group’s tax base as well), will feel a bit of a shock. They haven’t paid the higher taxes they’ve voted for 12 years. They won’t see much, if any, fiscal reform, when they do pay because their party is not ready to deal with the main source of our fiscal problems – outsized entitlement programs. What will their answer be? That has to be causing some nervousness. They always seem to be able to have the political skill to message themselves out of those kinds of boxes. And I think you’re seeing that nervousness with the Democratic objections to the deduction cap proposal.
My main point is that there has been a notion over the last 15 years or so, among the Democratic establishment, that tax increases on high-income taxpayers carry very little consequences. You’ll find academic economists who’ve never spent a minute advising anyone on a tax question passionately working this issue. They’ll add to the notion that higher taxes don’t matter with studies based on broad-brush macro data {--} designed to back up the result they want. They tend to dismiss the notion that taxpayers change behavior by responding to rates and incentives built into the tax base unless the incentive is an activity that they support. Republicans have largely protected Democratic constituencies, including a majority (at times and consistently a majority in Democratic states) of the taxpayers targeted for the President’s tax increase, from the consequences of Democratic policies. Ultimately, the reality of those tax increases, in whatever form, especially in a slow-growth economy, will be felt, should they be enacted. Republicans believe this and open the door only as part of grand bargain to move Democrats to do the responsible fiscal thing, reform entitlements.