Investment Tax Rates and the GDP, Senate Proposals on Tax Policy

As the 2012 election campaign looms closer and there is a general debate about GOP candidate Mitt Romney's effective tax rate (around 17%), the Senate is currently debating two separate proposals regarding tax policy and the expiring tax cuts.

Senate Republicans would allow nearly all of the 2001/2003/2010 tax cuts to continue through at least 2013. As promised, they'd keep low rates on both ordinary and investment income. They would retain an estate tax but only on bequests in excess of $5 million, and at a 35 percent rate. It also appears as if they'd allow a package of low-income tax cuts enacted in 2009, including expansions of the Earned Income Tax Credit and the Child Tax Credit, to expire.

As a result, an average household would pay about $2,000 less than if Congress allowed all the tax cuts to expire. Middle income households would pay about $1,100 less.  However, the highest-income 0.1 percent  (those making more than $2.8 million) would be on average $391,000 better off than under current law.

For their part, Senate Democrats would extend all the tax cuts for those making $200,000 (couples making $250,000) or less. However, they'd let most tax cuts expire for high-income taxpayers.

In the Democrats' plan, the top two rates would revert to 36 and 39.6 percent. Capital gains and dividends would be tax-free for those in the bottom two tax brackets, taxed at 15 percent for those in the 25, 28, and 33 percent brackets, and taxed at 20 percent for those in the top two brackets. The Democrats would extend the AMT patch for 2012 only (the AMT fix technically expired at the beginning of this year). More detail on each plan can be found using this Cheat Sheet developed by the Tax Policy Institute.

Independent of the debate regarding ordinary income rates, I find interesting the debate regarding 'investment' tax rates – specifically capital gains and dividends. Over the last several years policy makers have debated the effect of tax rates and investment – both sides generally agreeing that increasing tax rates on 'investments' might hamper growth of the economy, with the Democrats generally rallying that it's not fair that such great income levels should pay at such a low effective tax rate – even though the absolute amount they pay in taxes still accounts for the vast majority of all tax revenues collected.

Below is a table that highlights the effective tax rates of the top 400 income earners from over the last several years:

A few interesting observations:

1. The top 400 do in fact derive their income from 'investment' like sources, as evidenced by the fact that they weren't all in the highest tax bracket even in earlier years.
2. For the majority of these folks, rates have decreased as tax policy has changed to, in theory, encourage investment.
3. There does not appear to be a correlation between these rates and GDP growth – as evidenced by looking at historical GDP data over the same period of time.

I am not advocating a change in rates one way or the other, the only thing I do advocate is that the current level of deficit spending is unsustainable, and while policy makers continue to maintain gridlock, we are not likely to experience any significant change in our economic outlook as we continue to look like buffoons instead of problem solvers.

Interestingly, there is also no correlation between any tax rate and GDP growth, as all gains end up proving to be temporary in nature when analyzed over time, even the Reagan tax cuts. What we do know is that we all have the potential to pay more if the Bush Tax Cuts expire, which in theory may mean less available for consumer spending.

What do you think – would the economy be better off if we all had more money in our wallets, but a growing deficit with our only way out a reduction in government spending, including deep cuts to entitlements and defense? Or would we be better off all feeling the pain in a 'tax more, cut some' way as proposed by the Simpson Bowles Plan?