Republicans should unequivocally accept rate increases -- immediately. It would reduce the deficit and suddenly turn the spotlight on Democrats' steadfast refusal to reform entitlements.
Given that our structural deficit overwhelmingly reflects a spending problem and not a revenue problem, it is unfortunate that the Democrats have succeeded in making the opening battle in the fiscal cliff a fight about tax rates. But succeed they have. We won't have a serious debate about spending before we've determined the marginal income tax rates paid by the top two percent of Americans.
Though some Republican members of the House and Senate have signaled a willingness to raise tax revenue and even tax rates, it remains far from clear whether the Republicans will agree to President Obama's demand that rates on the highest-income two percent of Americans increase. The Republicans are wrong to be so opposed to raising rates. In fact, they should unequivocally accept rate increases.
It has been said that a conservative is a liberal who has been mugged by reality. Conservatives risk acting like liberals if they do not acknowledge this simple reality: tax rates are going up. Either we fall off the cliff and the rates return to where they were under President Clinton, or we cut a deal that keeps rates lower than they were in the 1990s.
It's really just that simple.
Given that, why are most Republicans holding so firm against rate increases?
BAD POLITICS, OR BAD POLICY?
Part of it surely has to do with their brand. We don't need two parties that increase tax rates, I often hear.
This concern is not particularly impressive. Will it be good for the brand to stonewall any agreement and be blamed for forcing the economy back into recession that will add over one percentage point to the unemployment rate -- all over a tax increase that will apply to only the top two percent of Americans? Especially when only about half of them vote Republican? If the GOP refuses to raise rates and we fall over the cliff, then President Obama will immediately call for tax cuts for the bottom ninety-eight percent of earners. Will it be good for the Republican brand to have the Democrats emerge as the champions of middle-class tax cuts?
Another possible answer, of course, is that the Republicans genuinely believe that raising top rates by a few percentage points is bad economic policy.
Here, they have a good point.
It may surprise you to learn that, according to a 2010 Tax Foundation report, more business income is taxed under the individual income tax code than under the corporate tax code -- which means that an increase in the top tax rates will affect a lot of business activity. Nearly half of all business income reported on individual returns is earned by business owners who would be affected by the increases in the top rates. Perhaps most to the point, more than one-third of the new tax revenue generated by a high-income rate increase on the wealthy would come from business income.
Economics 101 tells us that if you tax something you get less of it. Raising the top tax rates, then, will result in less business income, less investment, less research and development of new technologies, fewer new businesses, and, perhaps most importantly, slower long-run growth.
But the harm of higher marginal tax rates must be balanced against the good.
We've seen four straight years of trillion-dollar budget deficits and we're sitting on sixteen trillion dollars of debt. We know that the only way to solve our long-run structural deficit is to rely much more heavily on spending cuts than on tax increases. But given the size of our deficit and the demographic challenges facing the country, not to mention the political realities inherent in economic policymaking, any fiscal solution will include an increasing the amount of revenue flowing into the federal treasury. Raising tax rates on the highest-income Americans -- while very far from a sufficient solution to the problem, and certainly not the best way to raise revenue -- will help to bring down the deficit.
George Will has noted that "the proper name" for the fiscal cliff is "the Democratic Party's agenda" because the Democrats would be much happier to go over the cliff -- with its tax increases and defense cuts -- than would the Republicans. Is the Obama administration willing to hop off the cliff if high-income tax rates are not increased? "Oh, absolutely," said Treasury Secretary Timothy Geithner, on December fifth. "There's no prospect in an agreement that doesn't involve the rates going up on the top two percent of the wealthiest."
Republicans need to recognize their weak negotiating position and structure a deal to keep rates as low as possible -- lower than where they will automatically be if no deal is made.
HOW TO MAKE A DEAL
How to structure the deal? Publicly and unequivocally accept rate increases, but insist that they come paired with true spending cuts. Agree only to pass a tax rate increase, but not all the way to the Clinton rates, if it paired with a bill which includes true entitlement reform. Or, if there's not enough time for that, agree to a one-year rate increase that's paired with a few structural reforms, like increasing the Medicare eligibility age or means testing, with the understanding that the bill will be renewed the following year only if paired with true comprehensive entitlement reform.
Both parties need to have skin in the game. Politically, the hardest thing to ask of the Republicans is that they propose an increase in tax rates. The hardest political feat for the Democrats is to propose entitlement reform. Employing only-Nixon-can-go-to-China logic, both must occur. Acknowledging their weak bargaining position, the Republicans should go first and unequivocally accept rate increases for the wealthiest two percent. Then the Republicans would have the credibility to argue that they have done their part, and demand that the Democrats put forward a serious plan for entitlement reform.
Imagine if the Republicans offered this deal. The dynamic of the debate could change completely.
Instead of all the attention being on the Republicans, their unwillingness to ask a bit more from the wealthiest among us, and the Norquist pledge, the spotlight would shine on the Democrats. Are they really willing to cut spending? Are they really willing to reform entitlements?
All of the sudden, the Democrats would lose their main talking point -- a talking point which they have been employing, successfully, for over a decade.
All of the sudden, the Republicans would look like the reasonable adults, putting country before politics -- which they would be doing. The onus would be on the Democrats to match their seriousness. If the Democrats fail, then we may fall over the cliff, but the country knows it was because the left couldn't agree to cut spending. If the Democrats succeed, then the country is better off because we've crafted sound, necessary policy.
Shouldn't the Republicans just pass an extension of the Bush tax cuts for families earning less than $250,000, avert the cliff, eat the tax increase on top earners to the full Clinton levels, and take up entitlement cuts when they have more leverage during the upcoming debt ceiling fight? No. Now is the time, because only now can the Republicans earn the political capital which comes from sacrificing a strong policy preference for the good of the country, and because it's very unlikely that the president will agree to lower top rates from their Clinton levels as part of a debt ceiling negotiation after he's just won the battle to raise them.
Plato tells us that prudence is the chief virtue of statesmen, and conservatism agrees. It is time for the Republican Party to reconnect with conservatism properly understood and to employ the politics of prudence, gaining as much political and policy ground as possible by unequivocally accepting higher tax rates.
Michael R. Strain is a research fellow at the American Enterprise Institute.