Who would the tax increases hurt?

This week, Sen. Joe Lieberman (I-Conn.), who caucuses with the Democrats, addressed a local chapter of the Chamber of Commerce in Middlesex, Conn. “In our current economic situation, we cannot risk the economic headwinds that would be caused by tax increases,” he said. “We need to keep as much money as possible in people’s pockets and business’s bank accounts.”

The senator continued: “I know that many people, including the president, have argued that the tax cuts should not be continued for people making more than $200,000 a year, but to me these are the people we need to be using their income to spend and invest to spur growth and job creation. The fact is that the top three percent of American income-earners account for 25 percent of the consumption in our economy.” He also argued that the tax increases would hurt small businesses — which, as the traditional engine of job growth in the United States, have created about two-thirds of the country’s new jobs over the past 15 years.

With that, Lieberman declared which side he is on in the big economic debate roiling Washington now that Congress is back in session. On Dec. 31, the 2001 and 2003 Bush tax cuts expire, meaning all income tax rates will revert to higher levels unless Congress takes action before then. The White House pushed hard over the August recess for Congress to extend the tax cuts for lower- and middle-income earners, but to let the cuts expire for individuals making more than $200,000 a year and for households making more than $250,000 — the top 2.1 percent of filers. Many, though not all, Democrats agree with the plan. And Republicans have said no to any tax increases but need to let a Democratic proposal come to a vote to prevent all the Bush tax cuts — including cuts to the estate, capital gains and dividend taxes and an expansion of the child-care tax credit — from sunsetting.

The tussle — or, in President Obama’s terms, the “wrestling match” — is coming down to that two percent of tax filers and the $60 to $80 billion a year they would provide to the Treasury if their top marginal tax rate increased. The debate hinges on two central questions: What would the rich would do with their extra money, should the tax cuts stay in place? And what impact would those choices have on the economy?

Lieberman and Republicans are arguing that if Democrats hike taxes on the wealthy, they will ratchet back spending, hurting the recovery. “[The Obama tax plan] is a bad idea,” argues Sen. Chuck Grassley (R-Iowa), for instance, saying raising taxes will cause more unemployment. “People are eager for reliable, well-paying jobs. Entrepreneurship provides those jobs. And entrepreneurs often pay taxes at the top marginal tax rates because they’ve worked their way up to those income levels.”

It’s not clear, however, that the rich spend the money they keep under lower income tax rates. There is economic evidence that the rich tend to spend tax rebates — checks that come in the mail, rather than incremental changes on a pay stub. Federal Reserve economists Julia Lynn Coronado, Joseph Lupton and Louise Sheiner, for instance, found that the rich spent more of their child-care tax credits in 2003 than poorer Americans did. But the same is generally not true for income taxes.

In this particular case, economists say that the wealthy probably would not spend the money, were the Bush cuts extended. “Policies that temporarily increased the after-tax income of people who are relatively well off would probably have little effect on their spending because they generally would be able finance their consumption out of their income or assets without such a change,” Douglas Elmendorf, the head of the Congressional Budget Office, said this year, finding tax cuts the least stimulative of 11 policy options. He argued that tax cuts would increase spending for lower-income workers, who have less in savings and tend to spend more of their paychecks anyway.

Economists from Moody’s Analytics, in an analysis of Federal Reserve data going back to 1989, came to the same conclusion. In a report released this week, Moody’s economists found that spending is far more impacted by the business cycle, such as the fluctuation of stock prices, than tax cuts.

Nevertheless, some Republicans argue that the money the rich save would still have a positive economic impact. Speaking on the Senate floor yesterday, Sen. Jon Kyl (R-Ariz.), for instance, noted that people do not save money by burying it in their backyard. “Any person who saves money either puts in the bank…or they invest in a stock or a bond, equities usually,” he said. “Well, what is that investment [doing]? It is providing capital to business.”

He went on to argue that increased saving has a larger impact on employment than increased spending does. “Money that is saved [has] a direct impact on job creation, because it directly provides capital,” he said. It is true that saving provides capital to businesses. But, U.S. companies are currently sitting on $1.8 trillion in cash. Economists generally argue that businesses are not hiring workers due to uncertainty or, obviously, because consumers are not spending.

The bigger debate over the impact of the tax cuts centers around small businesses. Millions of small businesses use the individual, rather than corporate, tax process. If they make earnings of more than $200,000 or $250,000 a year, under the Obama proposal, their top marginal tax rate would go up.

Republicans, recognizing small businesses as crucial to job growth, have staunchly objected to Democratic plans to allow that to happen. Sen. Mitch McConnell (R-Ky.), for instance, yesterday argued, “Only in Washington could someone propose a tax hike as an antidote to a recession. And this is no small tax hike. The tax hike the administration is proposing, according to the IRS, would apply to half of all small business income in this country. And an analysis by the National Federation of Independent Business shows that businesses that employ 20 to 250 people would be hardest hit. All told, according to the nonpartisan Joint Committee on Taxation, hundreds of thousands of small businesses would see their taxes go up next year under the administration’s plan.”

The Joint Committee on Taxation does estimate (PDF) that 750,000 individual tax filings with business income — about 3 percent of all tax filings with business income — would see higher marginal rates. The problem is in sorting out whose filings those are. Business income filed on an individual return might stem from anything from a hedge fund to a lemonade stand to a person who makes money selling items on eBay. The number and kind of small businesses that might see taxes on their profits rise is impossible to determine without access to private IRS files.

Still, Dean Baker of the Center for Economic and Policy Research, estimates that the tax hit would not be too high for most small businesses. For one, the marginal tax increase impacts earnings, not revenue. A business would need to be clearing more than $250,000 a year after salaries and other costs in order to see a tax hit. And then, it would likely be small. “For the $250,000 to $500,000 a year bracket,” Baker notes, “the estimated tax hit is $700. That isn’t enough to hire anyone.”

Other groups have also estimated that the impact would not be great. Citizens for Tax Justice, for instance, examined (PDF) “data on individuals who get more than half of their income from a business that they actively operate.” Only five percent would lose any portion of earnings — many of whom would be partners in law firms, hedge fund managers and accountants.