The Magazine

Tax Cuts, Real and Imaginary

Obama's spending programs in disguise.

Sep 15, 2008, Vol. 14, No. 01 • By NEWT GINGRICH and PETER FERRARA
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Thirty years of Republican tax policy have now completely eliminated federal income taxes on the poor and lower middle-income Americans, and almost eliminated them on middle America.

The latest data from the Congressional Budget Office and the Internal Revenue Service show that the lowest 40 percent of income earners as a group actually receive net payments from the federal income tax system. (They get 3.8 percent of total federal income tax revenues instead of paying any income taxes.) The middle 20 percent of income earners pay 4.4 percent of federal income taxes. Thus the bottom 60 percent of income earners together, on net, pay less than 1 percent of all federal income taxes. (These workers earn 26 percent of national income.)

The data show that the top 1 percent of income earners now pay 40 percent of all federal income taxes, which is almost double their share of the national income. The top 10 percent pay 71 percent of federal income taxes, though they earn just 39 percent of the nation's pretax income.

This is a result of the across the board income tax rate cuts adopted by Ronald Reagan and the current President Bush, plus the Earned Income Tax Credit first proposed by Reagan in the 1970s, and the child tax credit enacted into law as part of the 1994 Contract With America.

Barack Obama claims to be proposing income tax cuts for low and moderate income and middle class workers, but Reagan Republicans have already eliminated most of their income tax liability. What Obama is calling tax cuts for the middle class is really a slew of refundable federal income tax credits that would primarily go to those who are paying little or no federal income taxes now. Such credits would primarily not reduce tax liability, but instead be checks from the federal government for child care, education, housing, retirement, health care, even outright giveaways. These are not tax cuts. They are new federal spending programs hidden in the tax code.

When Obama says that he will cut taxes for 95 percent of Americans, he is talking about his proposal for a $500 refundable income tax credit for all but the top 5 percent of income earners. For the bottom 40 percent of income earners, this will be just another check from the federal government rather than a reduction in tax liability. It is another sharp increase in government spending rather than any sort of tax cut. An arbitrary cash grant does not, moreover, do anything to improve the economy or incentivize productive business. That only comes from cutting tax rates. What Obama is proposing here is really quite similar to George McGovern's 1972 plan to send everyone a $1,000 check, which voters rightly saw as a crass vote-buying scheme rather than serious policy.

Obama also proposes to increase the top marginal tax rates for virtually every major federal tax. These increases would not come remotely close to financing the trillion dollars of increased direct federal spending Obama is promising--including a new national health insurance entitlement that would be bigger than any of the massive entitlement programs we already have and already have trouble paying for. Indeed, if the tax rate increases cause a serious enough economic decline, they will lose revenue on net.

Obama's plans are the opposite of tax reform. Instead of closing loopholes and lowering rates, he is creating new loopholes and raising rates.

But there is a real tax agenda that would benefit middle-America.

America has the second-highest corporate tax rate in the industrialized world, with a federal rate of 35 percent--rising to 40 percent on average with income taxes. The average corporate tax rate in the European Union countries is 24 percent. Even India and China have lower corporate tax rates. Ireland adopted a 12.5 percent corporate tax rate 20 years ago. Since then per capita income has soared from the second-lowest in the EU to the second-highest.

John McCain is proposing to reduce our federal corporate tax rate to 25 percent. The top income tax rates borne by noncorporate small businesses and investors should be reduced to 25 percent as well. Obama is taking the opposite tack, calling for increases in the income tax rates that small businesses pay and additional tax increases for larger corporations (such as the so-called windfall profits tax on oil companies that would only further hurt the American economy with higher energy costs).

With two-thirds of the American people now owning stocks, capital gains taxes are another middle America issue. Obama proposes to increase the top capital gains tax rate by 33 percent, which will cause a decline in the value of stocks held by middle-income families. History has also proven, time and again, that rising capital gains tax rates cost the federal government money. From 1968 to 1975, the capital gains tax rate was raised four times, and capital gains tax revenue fell by more than 50 percent. When capital gains tax rates were raised by 40 percent as part of the compromise in the 1986 tax reform act, revenues fell by 40 percent the next year, and by 1991 they had fallen by 63 percent.

McCain is proposing to retain the current capital gains rate of 15 percent. But to maximize economic growth for working people and middle-income families, the capital gains tax rate should be zero. The capital gains tax is just another layer of taxation on capital income. It taxes the present discounted value of future income that will be taxed again--multiple times, in fact--when it is earned. That is not fairness or good economic sense. Many of our international competitors maintain a zero tax rate on capital gains--including 14 out of 30 OECD countries, China, Taiwan, Hong Kong, and Singapore. Eliminating the capital gains tax would cause the stocks held by two-thirds of the American people to soar in value.

The most important middle-income tax issue, however, is payroll taxes--the taxes withheld by your employer to pay for programs like Social Security and Medicare. The federal payroll tax is now the largest tax most workers pay. With federal income taxes already abolished for the poor and lower middle-income workers, and almost abolished for middle-income workers, the next big tax cut for these working people would be the ability to utilize personal accounts for Social Security.

Over time, personal accounts could expand to replace the entire payroll tax and finance the same benefits. Instead of paying a tax, working people would be saving and investing in their own personal family wealth engine. With fully expanded accounts, average families could expect to accumulate a million dollars or more, even while paying in about 25 percent less than the current 15.3 percent payroll tax. Such accounts are estimated to pay at least twice what Social Security currently promises and provide the only real hope of addressing the long-term funding problems of Medicare without harming retirees.

This would be nothing less than a revolution in the personal prosperity of working people. McCain at least favors starting such personal accounts. But, as is so typical of Barack Obama, he would just slam the door on a truly revolutionary change, and hark back to the stale ideas of the 1960s or even the 1930s. Obama's tax policies would take America in exactly the opposite direction of the tax reform and threaten economic disaster in already difficult times.

Newt Gingrich is the former speaker of the House and chairman of American Solutions for Winning the Future. Peter Ferrara is director of entitlement and budget policy for the Institute for Policy Innovation, and general counsel of the American Civil Rights Union.