Should the Rich Pay More Taxes?

Of course, they should. And in a growing economy they would be. But raising the marginal tax rates on the "rich" actually produces little extra revenue, especially, given the flawed, loophole riddled tax code that we have in the United States. The question of how to increase revenue without discouraging economic growth has fortunately been answered by our experience with the 1986 tax reform. Economist Martin Feldstein explains.

The Tax Reform Act of 1986, enacted 25 years ago last Friday, showed how a tax reform that includes lower rates can change incentives in a way that grows the tax base and produces extra revenue.

How does this work?

This dramatic increase in taxable income reflected three favorable effects of the lower marginal tax rates. The greater net reward for extra effort and extra risk-taking led to increases in earnings, in entrepreneurial activity, in the expansion of small businesses, etc. Lower marginal tax rates also caused individuals to shift some of their compensation from untaxed fringe benefits and other perquisites to taxable earnings. Taxpayers also reduced spending on tax-deductible forms of consumption.

The path ahead for the Congress to raise the revenue needed to run the government and grow the economy is straightforward. The Economist editorializes

Make sure the rich pay their share, but in a way that makes economic sense: you can boost the tax take from the wealthy by eliminating loopholes while simultaneously lowering marginal rates.

The growth that results from fewer economic distortions in the tax code can also spur job creation in the economy.

Serious talk about reforming our dysfunctional tax code is a winner for the Republican nominee for President. This is why I am encouraged to see Rick Perry come out for a flat tax, although I am less impressed to find that he would give taxpayers the option of filing under the old system. Since the wealthiest have the most impact on the economy, this undermines the outcome of increased growth from a flat tax. Herman Cain's 9-9-9 plan also pushes the conversation, but a new national sales tax, on top of income taxes is irresponsible because there is no limitations on future Congress' ability to hike both rates.

I think the best plan would involve lower marginal rates for all forms of income, but an end to all deductions and loopholes, including the mortgage interest rate deduction. I would be willing to consider a charitable deduction, but that might be all. The same is true for the corporate tax code. All of the special tax breaks need to come out and profit should be calculated using generally accepted accounting principles. Top marginal rates around 20% and a corporate tax rate of 20% would be achievable. I am in favor of keeping corporate taxes rates and personal income tax rates the same to prevent shifting between retained profits and income, available to owners of corporations. Better to cause all business decisions to be unbiased by tax code considerations. The only way I would favor a national sales tax would be if the 16th amendment were repealed.

Mr. Feldstein concludes.

Combining that base broadening with a 10% cut in all tax rates would be revenue neutral in a traditional static analysis. But the experience after the 1986 tax reform implies that the combination of base broadening and rate reduction would raise revenue equal to about 4% of existing tax revenue. With personal income-tax revenue in 2011 of about $1 trillion, that 4% increase in net revenue would be $40 billion at the current level of taxable income, or more than $500 billion over the next 10 years.

The Joint Select Committee should insist on counting that revenue as the starting point for a serious deficit reduction plan.