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This morning, House budget committee chairman Paul Ryan (R.-WI) unveiled his budget proposal, which took aim at the culture of debt financing that most analysts agree is in the process of crippling the American economy. Utilizing a mixture of spending cuts and supply side tax cuts to promote growth, it stands little chance of passing through the Senate, which has not passed a budget since April 2009. If it were to do so, it would almost certainly be vetoed by the President.
The President's own proposed budget aims to spur the economy by increasing both federal spending and taxes on wealth-creators. It won't even reach the floor of the House, as the Constitution reserves the privilege of beginning the appropriations process to the House of Representatives, which is currently controlled by Paul Ryan's party.
That the two budgets take completely different paths to restoring the economy is indicative of the depth of the political divide in the US. Yet one represents a bold, forward-thinking, hard-headed approach, while the other is stuck in the past and represents a failure to understand the dynamic nature of the US economy.
For instance, the President's plan assumes that taking money away from wealth-creators by increasing the tax rate on wealthy Americans and redistributing it in the form of increased federal spending on infrastructure and schools will actually stimulate the economy. However, as economist Art Laffer famously explained with his “Laffer curve,” higher tax rates don’t automatically equal higher tax revenues. His assumption was a fairly obvious one—that is, at a 100 percent tax rate, people will have no incentive to work, and will change behavior to avoid paying any tax, much like the behavior witnessed in the failed communist economies in Russia and China (a current example is Greece). At some point then, increasing taxes actually lowers tax revenue to the government.
This point has been the subject of much debate, but one idea that’s not debatable is that in an international market, internationally uncompetitive tax rates will drive economic activity elsewhere, which will lower economic output and decrease what the government takes. This is exactly the situation that the Obama budget creates. It would tax dividends at the normal income tax rate, which would raise that rate from 15 percent to 43.4 percent, and it also raises the capital gains tax from 15 percent to 23.8 percent. These taxes are actually placed on top of the existing corporate income tax, which taxes the profits that then go to investors in these two forms. In other words, the Obama budget would create an effective capital gains tax rate of 50.5% and a dividends rate of 63.2%. The average OECD corporate tax rate is already 26 percent compared to America’s 39 percent.
Historical examples where tax rates were cut and tax revenues remained constant or increased are plentiful. The two largest rate cuts in American history were in the 1920s under Treasury Secretary Andrew Mellon, which cut top personal income tax rates from 73 percent to 24 percent, and under President Reagan in the 1980s, which cut the rate from 70 percent to 28 percent. In both cases, tax revenues over the eight years that the two men held office increased. In the 1920s, tax revenues increased 4.2 percent per year, and in the 1980s, revenues increased by nearly 65 percent from 1981-89. Even as a percentage of GDP, the difference in revenue between Reagan’s first 20 percent rate cut in 1981 and 1980 was negligible, less than 0.2 percent.
It is these examples that inspire the Ryan budget plan, with its emphasis on pro-growth tax reform. Its two major features are a significant simplification of the tax system for individual wage earners, removing many of the loopholes and complexities that give the IRS so much power, and significant corporate tax reform, lowering the rate to 25 percent and allowing companies to repatriate foreign earnings at no penalty, something Apple Corp. called for yesterday.
The problem is that there is so little common ground between these two positions that there is no room for compromise. Indeed, it could be argued that the constant compromise between these positions during the Clinton and Bush years is what got America into its current debt problems.
It remains to be seen if the eventual Republican Presidential candidate is as clear-headed about what needs to be done to solve America's budget problems as Paul Ryan. The Congressman himself has already been attacked for wanting to throw grannies off cliffs for wanting to reform Medicare. It will take a great deal of resolve and excellent communication with the American people to ensure that something like the Ryan budget passes next year. Yet without such a plan, there is little hope for the fiscal future of the Republic.