Debt ceiling impasse: Which party is right about taxes?

The chasm that separates Republicans and Democrats in budget talks seems tough to bridge: One party insists on tackling the federal debt problem without "job-killing tax hikes." The other says any "balanced" approach should include some tax increases, not just spending cuts.

The impasse has big consequences.

If the two sides can't bridge that divide, it may be difficult to reach a fiscal shape-up deal that also would raise the nation's debt ceiling, so that the Treasury doesn't become unable to pay the nation's bills starting in August.

Is one side right?

Both sides can muster some strong arguments, but the reality may be messier than either side lets on.

Consider for starters those words "job-killing" and "balanced." The first comes from Republican House Speaker John Boehner, the second from President Obama.

Many economists say that now is the wrong time to raise taxes, given the weak state of the economy and consumer finances. In that sense, a tax hike could be job-killing. But economists can point to periods in history where taxes have risen and the economy has grown just fine. America in the 1990s is one example.

Moreover, Obama and Democrats aren't pushing to raise new tax revenue this year or next, but in 2013 and beyond. And a key element of discussions has been reforming the tax code so that it becomes simpler, with fewer deductions and loopholes. Some economists say that could be a win-win scenario, in which the government gains more tax revenue while nominal tax rates remain low and economic growth is little-affected.

As to whether a "balanced" plan needs to have both spending cuts and tax-revenue increases, finance experts say that's more of a political position than an economic fact.

The economic reality is that, over time, the government's current fiscal course looks unsustainable. National debt is rising because of a persistent pattern of spending that grows faster than revenue.

"We all agree we need to bring our fiscal house in order," says Roberton Williams, a senior fellow at the Tax Policy Center, a non-partisan research group in Washington. "The question is when ... and what is the composition [of the fix]."

To people who generally see government programs as useful and worth keeping if possible, the optimal fix might include new tax revenue. To people who think government is too large, the desired fix would focus squarely on spending cuts.

"It really does come down to an argement about the size of government," Mr. Williams says.

Both sides have deeply held principles at stake.

Democrats argue it would be outrageous to cut spending on numerous programs affecting the poor and middle class, if the most prosperous Americans aren't asked to chip in anything.

"I'm happy to work with you on tax reform that could potentially lower everybody's rates and broaden the base," Obama told Republicans this week, as long as it isn't "balancing the budget on the backs of middle-class families and working-class families."

Republicans say the essence of the fiscal problem is rising spending, so it's vital to address it as a spending issue rather than a tax issue.

Douglas Holtz-Eakin, an economist who served as an adviser to John McCain's presidential campaign in 2008, told a recent congressional hearing that he is "deeply concerned" about the risk of creeping tax hikes every time the federal budget problems prove hard to solve.

"The problem goes away for a little while," he said. "You go a couple more years. You bounce taxes up again. Pretty soon, ... that takes you to 30 and 40 percent of GDP, and you will – not to be a crazy supply-sider – you will kill the economy."

Mr. Holtz-Eakin's reference to a "crazy supply-sider" was pointed. A long-running controversy between Democrats and Republicans dates all the way back to the Reagan years, and the assertion of some so-called supply-side theorists that tax cuts would pay for themselves. The idea was that lowering tax rates boosts economic growth and reduces tax-avoiding behavior, and thus tax revenue rises.

Economists including Holtz-Eakin say the reality is not so simple. Tax changes can affect growth and personal behavior, they say, but those effects aren't big enough to allow tax cuts to pay for themselves over an extended time.

Harvard University economist Alberto Alesina has looked at track records in various nations, and concludes that a country in debt trouble will do best by fixing its problem through spending cuts. The alternative, raising taxes, is more damaging to economic growth, he concludes.

But tax rates are just one of many factors that affect economic growth. Germany has posted faster growth in GDP per capita in recent years than the US, for example, even though it has higher overall taxes.

The great tax debate is not just about overall tax levels, but also about how they should be distributed.

On that score, too, the reality is nuanced. Finance experts say it's not realistic to think that the nation's budget gap can be closed – even halfway – solely through new levies on high-income Americans. At the same time, some economists argue that making the tax code more progressive – such as charging higher taxes on the rich while lowering some other taxes – would help the economy rather than harm it.

Republicans have resisted such moves, while polls suggest that a majority of voters support that idea.