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The Myth of a Return to Clinton-era Taxes

Wednesday, September 15, 2010

The claim that the president’s plan would only take the top tax rates back to Clinton levels isn’t quite right. Here’s why.

In a major speech about the economy last week, President Obama reiterated his support for letting most of the Bush tax cuts expire for taxpayers with incomes above $200,000 ($250,000 for married couples), while making the tax cuts permanent for all other taxpayers. The president defended his proposal by saying that, for high-income taxpayers, “the tax rates would just go back to where they were under President Clinton.” The president reminded his listeners that the economy grew at a rapid clip during the Clinton years, adding tens of millions of new jobs.

The analogy with the Clinton years is a little questionable. During those years, a Democratic president and Republican Congress worked together to restrain federal spending and balance the budget, a far cry from current policy.

In any case, as I explain in the September issue of the American Enterprise Institute’s Tax Policy Outlook, the claim that the president’s plan would only take the top tax rates back to Clinton levels isn’t quite right. Or, rather, it’s right for only the first two years of the president’s plan. Thanks to a little-known provision in the new healthcare law, the president’s plan will push the top tax rates for most types of income above Clinton levels in 2013 and thereafter.

If the Bush high-income rate reductions expire, it will be the Obama administration’s second move to increase the top marginal tax rates.

In 2010, the top income tax rate bracket for ordinary income is 35 percent. Besides wages and interest income, this income category includes profits from pass-through business firms—sole proprietorships, partnerships, and S-corporations. Under the president’s proposal, the top bracket will rise to 39.6 percent. A stealth provision that phases out high-income taxpayers’ itemized deductions will also be reinstated, adding another 1.2 percentage points to the effective tax rate, bringing it to 40.8 percent. Wages and some of the pass-through income will also remain subject to a 2.9 percent Medicare tax. These 40.8 and 43.7 percent tax rates, which will apply in 2011 and 2012, match the 1994 to 2000 rates—the same top bracket, stealth provision, and Medicare tax were in place then.

But the picture changes in 2013. Under the healthcare law adopted in March, the Medicare tax will rise that year, from 2.9 to 3.8 percent. Also, a new 3.8 percent tax, called the Unearned Income Medicare Contribution (UIMC), will be imposed on high-income taxpayers’ interest income and most of their pass-through business income that’s not subject to Medicare tax. So, under the president’s proposal, virtually all of top earners’ ordinary income will be taxed at 44.6 percent, starting in 2013. We’re not just going back to the Clinton-era rates of 40.8 and 43.7 percent.

A similar pattern holds for capital gains. Under the president’s plan, in 2011 and 2012, the top rate on gains, now 15 percent, will go to 20 percent, with the stealth provision adding 1.2 percentage points, sending the tax back to its 1997–2002 level of 21.2 percent. Starting in 2013, though, capital gains will also be hit by the UIMC, pushing the rate to 25.0 percent.

Under the president’s proposal, virtually all of top earners’ ordinary income will be taxed at 44.6 percent, starting in 2013. We’re not just going back to the Clinton-era rates of 40.8 and 43.7 percent.

Dividends may, or may not, face a much steeper tax increase. If Congress does nothing, the top dividend tax rate will rise from 15 percent today to the Clinton-era effective rate of 40.8 percent in 2011 and 2012, with the UIMC pushing the rate to 44.6 percent in 2013. To his credit, though, President Obama has called for dividend tax rates 19.6 percentage points below these levels, leaving dividends taxed much more lightly than under Clinton. It remains to be seen whether congressional Democrats will go along.

In short, if the Bush high-income rate reductions expire, it will be the Obama administration’s second move to increase the top marginal tax rates. The first shoe has already dropped, in the form of the UIMC. It’s bad enough that this tax received little attention or scrutiny before it became law, with nary a congressional hearing to explore its economic impact. More disturbing: even after the UIMC has been enacted, President Obama and others still overlook it when discussing where marginal tax rates are headed.

One marginal tax rate hike has already been adopted and another may be on its way, with significant damage to saving and investment incentives. The real question, though, is what lies ahead. Federal entitlement spending is projected to grow explosively in upcoming decades, driven by medical spending and, to a lesser extent, Social Security. Yet President Obama has pledged to raise taxes on only the top 2 to 3 percent of taxpayers. Observers across the ideological spectrum have recognized that, despite its wealth, this small group cannot supply all of the revenue needed to fulfill the government’s spending commitments. Trying to balance the books solely by taxing this group will send their marginal tax rates into the stratosphere.

The futility of this strategy will eventually become clear, forcing decisions to prune the government’s spending commitments or to tap a broader group of taxpayers to pay for them. But how long will it take before this reality is recognized? And how high will the top marginal tax rates have gone by then?

Alan D. Viard is a resident scholar at the American Enterprise Institute.

FURTHER READING: Viard earlier discussed “The Cap-and-Trade Giveaway,” “Keynes at the Border?” and, with Amy Roden, “The Tax That Spells Trouble for the Economy.” He has also explored “The High-Income Rate Reductions,” “The Small Business Tax Hike and the 97 Percent Fallacy,” and “State Taxation of Social Security Benefits: The Effect on Growth.”

Image by Rob Green/Bergman Group.

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