Obama's plan to 'tax the rich': About time, or a big mistake?

The spending is staggering: $700 billion to rescue the banks, plus $787 billion to stimulate the economy. A $3.6 trillion US budget. Even as some Americans scramble to file tax returns before Wednesday's deadline, questions of who, exactly, is going to pay for all this seem to boil down to a simple answer: Tax the rich.

Some call it wealth redistribution or socialism; others call it cultural warfare. In any case, requiring the well-heeled to pay more is the most talked-about strategy for obtaining new revenue. But how much good will it do? And might it even do harm?

Of course, boosting taxes for the top two income brackets – as President Obama proposes – wouldn't happen until 2011 at the earliest, assuming Congress goes along. That move, plus other tax changes that primarily hit the wealthy, would bring in about $637 billion over 10 years – revenue intended to help curb a rampaging federal deficit.

Whether taxing the rich will do much to reduce the budgetary red ink – and whether it will act as a drag on job creation – are the battle lines along which the coming fight will be waged. Alas, history is an unreliable guide to the outcome. Perhaps all that can be said for sure is that "taxing the rich" will make a lot of struggling Americans feel better, but how it will affect the economy is mostly a mystery.

"The higher tax rates could potentially cause high-income workers – including small-business owners – to work less, to retire early, to switch jobs.... There are a lot of potential effects – and one is that they could act exactly the same," says Benjamin Harris, a senior research associate and tax specialist at the Brookings Institution in Washington, D.C., in an e-mail.

Jeff Swann, a denizen of the top tax bracket, does not expect to change the way he does business if the tax hike materializes. The co-owner of Point of Sale System Services in Shirley, Mass., says giving more money to the US government might even fulfill some small bit of patriotic duty.

"I'm a regular businessman with a small business, and I want to make as much money as possible," says Mr. Swann. "But if what I'm making puts me in the top 10 percent of American life, life is pretty good.... I don't need to run around and buy 10,000 shoes."

"Tax the rich" refers mainly to Mr. Obama's plan to raise the income-tax rate for joint filers earning more than $250,000 a year (or more than $200,000 for individuals). That would affect between 2.5 million and 3.2 million Americans – about 2 percent of the population – and come after more than a decade of increased concentration of wealth in the hands of the uppermost sliver of US society.

What is known about the economic consequences of higher taxes?

The tentative consensus is that, taking the economy as a whole, every dollar raised from a higher tax causes an economic contraction of about 40 cents, says Robert Carroll at the nonpartisan Tax Foundation, who served on the Council of Economic Advisers under President George W. Bush. The figure reflects research by economists across the political spectrum.

"Forty percent is not a small number," says Mr. Carroll. "You have a significant raising of the tax base," but you only get 60 cents on the dollar.

In the history of taxation, the wealthy have always paid a higher rate. But rates have swung wildly over time. Economists studying past rate changes have had trouble identifying clear effects.

Perhaps the best analog to Obama's plan is the 1993 tax hike under President Clinton. Congress raised rates to the same levels Obama is proposing for Americans making at least $250,000 a year. An economic boom followed Mr. Clinton's move.

That doesn't mean, however, that the two were necessarily related, says Joel Slemrod, an economist at the University of Michigan and the former editor of the National Tax Journal.

"[Obama's] proposal is to move back to top rates [that] the country had not that long ago, and it's hard to find evidence that they had a noticeable deleterious effect on the economy," Professor Slemrod says. "Having those tax rates then and knowing the economy did well doesn't prove what the role of tax rates was. It could be true that performance would have been even better without them."

Among economists there's an odd bipartisanship that taxing the rich a little more or a little less is not what's important. What's needed instead, they say, is a wholesale redress of looming issues such as large deficits and ballooning entitlement spending – something neither Democratic nor Republican presidents have been willing to attempt.

"It's a tiny change, but it's not raising much revenue either," says Daniel Feenberg of the National Bureau of Economic Research. "And it's totally irrelevant to what's going to happen to this country."

The way forward, economists say, will likely be a tax system very different from today's – one that acknowledges high deficits by raising taxes a lot or by cutting government spending a lot.