Most Republicans in Congress have pledged never to raise taxes, no matter what. But that rigid stance may end up costing Americans more than overt tax hikes would.
The recent failure of a congressional "super committee" to come up with ways to pare the $15 trillion national debt largely came down to a battle over taxes. There are several thorough blueprints for how to fix America's mushrooming debt problem, and virtually all of them call for a mix of tax hikes and spending cuts. Some budget experts prefer a roughly equal mix of the two. Others would tilt the balance more heavily toward spending cuts with, say, $3 of spending cuts for every $1 of new tax revenue.
It's possible to fix the debt without raising taxes, but for that to happen, Congress would have to eviscerate the three most expensive items in the federal budget: Medicare, Social Security, and defense. But Medicare and Social Security are very popular, and there's a powerful constituency for defense spending. That helps explain why 62 percent of Americans say the best way to solve the debt problem is with a combination of spending cuts and tax hikes, according to Pew Research. Only 17 percent favor spending cuts alone.
Republicans have a different idea, however, refusing to consider tax hikes in the recent debt-panel negotiations. Their basic strategy is to bleed the government of revenue, forcing it to shrink, therefore allowing most Americans to pay less in taxes. Without any concessions on taxes, Democrats refused to back the big cuts in social programs that Republicans wanted. Result: Deadlock.
The irony, however, is that Republicans' refusal to raise taxes now may result in higher taxes later. It may also cost Americans more in other ways, which would be the equivalent of tax hikes, because money would leach out of their pockets. Here's how:
The end of temporary tax cuts. Two big tax cuts are set to expire, unless Congress takes action to extend them. The first is the payroll tax cut that lowers the federal withholding used to fund Social Security from 6.2 percent to 4.2 percent. That reduction saved a typical taxpayer with a $50,000 income about $1,000 in one year. It's set to expire at the end of December. Much bigger tax cuts will expire at the end of 2012, when the Bush-era reductions (extended for two years by President Obama) run out. If Congress does nothing, tax rates will rise for nearly all taxpayers. The impact would reduce disposable income throughout the economy and almost surely curtail spending. If the economy's weak enough, that alone could trigger another recession.
The conventional wisdom is that politicians will never allow "temporary" tax cuts to expire, effectively making them permanent. But two factors could undermine such automatic renewals. First, the inability to agree on tax policy in the super committee—which consisted of just 12 legislators—foretells broader inaction in Congress. The super committee had the authority to address all tax extensions, and could have devised a plan to make some of them permanent while closing loopholes and raising revenue in other ways. It didn't.
Second, the United States can't afford the growing mismatch between spending and revenue much longer. Nobody's sure when the crunch point will arrive. But when it does, interest rates on treasury securities will start to rise, similar to what's been happening in Italy and Spain. If they go up by enough, it will unnerve the financial markets, forcing some kind of action. Allowing temporary tax cuts to expire would be one expedient way of resolving a crisis. Republicans may feel this will be the ultimate moment of brinksmanship, when they finally have leverage to cut social programs. But support for that idea is weak now--partly because the federal tax burden today is well below historical levels--and there's no obvious reason why that would change. So Republicans could very well lose that game of chicken.
A stock-market rout. Investors would welcome tax hikes if they helped stabilize the American debt problem, because that would be a big plus for financial markets. As everybody knows, uncertainty is one of the worst enemies of financial markets, and the U.S. debt overhang is becoming one of the biggest question marks in the global economy. It has to be resolved at some point, and there only two ways to do it: cutting spending and raising taxes. But the mix of remedies, and the timing of a credible plan, are extremely important. Addressing the debt soon would allow flexibility in terms of phasing in changes, spreading them out over a long period of time and giving everybody affected a chance to prepare. But the more Congress delays, the greater the odds of a short-notice crisis requiring quick action that catches many by surprise.
We've already had a glimpse of how dysfunction in Washington can thrash the stock market. After Standard & Poor's downgraded the U.S. credit rating last August, the S&P 500 stock index fell by nearly 7 percent in one day. That seemed to reset the whole market at a lower trading range. Another downgrade would probably send stocks plunging again. Problems in Europe have obviously had a lot to do with the volatile stock market lately, but it would be extremely foolish to ascribe all of the market's woes to Europe while absolving U.S. policymakers. If there's ever an American debt crisis similar to what Europe is going through, it will be a financial calamity, swamping anything happening overseas.
Republicans have stood fast against Democratic demands to raise taxes on the wealthy. In one sense, there's wisdom to that, because the U.S. debt is so large that taxing the wealthy, even at 99 percent, wouldn't come close to solving the problem. So at some point, higher taxes on the middle class seem inevitable. But the Republicans' anti-tax tactics may harm the wealthy anyway, since they tend to have the biggest stake in the stock market. In addition, many middle-class families rely on stocks for their retirement plans and investing portfolios.
Consumer confidence generally follows the stock market up or down, because many consumers gauge their overall wealth by whether their investments are making or losing money. While a falling stock market isn't the same thing as a new tax, it has the same effect because it detracts directly from household wealth. It may even do more harm to confidence than higher taxes, since it tends to represent an unexpected loss that's hard to plan for.
A weaker economy. Many business leaders consider the dysfunction in Washington to be one of the biggest threats to the U.S. economy. People who run companies are smart enough to know that a debt crunch is coming. It won't be good and it might be terrible. Instead of the lower corporate tax rates that might come with a coherent tax-reform plan, a crisis might require higher tax rates, imposed rapidly. Or, there could be another grueling recession, caused by sharp cutbacks in government spending, which would once again curtail demand for many goods and services. There could also be another credit crisis that interferes with the routine short-term borrowing that companies rely on for day-to-day operations. Anything that sends share prices lower strains corporations, especially if it's not related to fundamentals of the business.
So CEOs watching the destructive brinksmanship in Washington are extremely reluctant to hire or spend money, except when absolutely necessary to meet demand. That contributes to the notorious "negative feedback loop" in which anxious consumers and cautious businesses all hunker down, with nobody willing to crank up the spending that will help the economy grow. The inevitable result is weak hiring, more layoffs, depressed incomes, and economic stagnation that makes it harder for most people to get ahead. As onerous as taxes may be, many people, if given the choice, would probably be willing to pay more to the government out of a growing paycheck than to keep more of a shrinking paycheck.
When government works right, policymakers take actions that help boost confidence and get the economy back on track, especially when it's the government's own debt that's causing the problem. When government works poorly, elected officials try to push the cost of the problems they've created into the future. With every missed opportunity, the bill gets bigger.