Why tax increases don't work
They don't raise enough revenue, and hurt small businesses.


U.S. President Barack Obama speaks at the Business Roundtable while Boeing Chief Executive Officer James McNerney (R) listens, in Washington December 5, 2012. Meeting with a business group on Wednesday, Obama renewed his call to include tax hikes on the wealthiest 2 percent of Americans as part of the final "fiscal cliff" resolution, and to call for including an increase in the nation's borrowing limit.

Article Highlights

  • Research, history, economics have demonstrated that raising taxes isn’t an effective pro-growth solution.

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  • Years of data show that when nations try to solve a fiscal crisis primarily by raising tax revenues, they tend to fail.

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  • Fiscal approaches based on entitlement reform and spending cuts tend to succeed in solving fiscal crises.

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  • Tax hikes aimed at small segments of the population wouldn’t raise much in revenues.

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  • Our problems today are manifest: Out of control entitlement spending; a lack of serious budgets; and a broken tax system.

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Congress and President Obama are in a stalemate in negotiations over the "fiscal cliff." If Congress fails to act, most Americans will pay higher taxes and the federal government will cut spending on Jan. 1. At the root of this impasse is the president's dogged insistence that raising marginal tax rates on the wealthy must be at the center of any solution.

Given the enormity of the budget gap, why would anyone object to this? Because research, history and economics have demonstrated that raising taxes isn't an effective pro-growth solution.

First, there is no evidence that tax increases will actually solve our troubles. On the contrary, years of data from around the world show that when nations try to solve a fiscal crisis primarily by raising tax revenues, they tend to fail. In contrast, fiscal approaches based on entitlement reform and spending cuts tend to succeed.

American Enterprise Institute economists Kevin Hassett, Andrew Biggs and Matthew Jensen examined the experiences of 21 Organization for Economic Cooperation and Development (OECD) countries between 1970 and 2007. They found that countries with successful fiscal reforms, on average, closed 85% of their budget gaps with spending cuts. The countries with failed reforms, on average, relied at least 50% on tax increases. President Obama's strategy falls firmly in the latter camp. After discounting the accounting tricks that create fictitious spending cuts, the president's plan would impose about $3 in tax hikes for every $1 in spending cuts.

That is, his approach would probably land America in the "failed attempt" column. Five years down the line, we would be in the same fiscal mess we are in today, just with higher taxes and a bigger government.

Second, tax hikes aimed at small segments of the population wouldn't raise much in revenues. Consider the "Buffett Rule" that the president spent many months promoting. According to the Joint Committee on Taxation, it would raise about $47 billion over a decade. The federal government currently spends about $4 billion more per day than it takes in. The Buffett Rule, then, would raise about enough next year to cover 28 hours of government overspending. Heritage Foundation economist Curtis Dubay finds that closing the deficit solely by raising the two highest tax brackets would require hiking them to 159% and 166%, respectively.

Third, as economists and business executives have noted repeatedly, raising taxes on families earning over $250,000 per year is effectively a massive tax hike on small businesses. Most small businesses today organize as S-corporations or other pass-through entities; their income is taxed as personal income. A study by Ernst and Young shows that Obama's proposed tax hike would force these small businesses to eliminate about 710,000 jobs. Moreover, these households already bear a great deal of tax liability. According to the most recent Internal Revenue Service data, those earning $250,000 and above -- roughly 2% of all taxpayers -- earn 22% of income, but pay 45% of all federal income taxes.

Simply put, increasing tax rates on the wealthy is not a serious approach to solving America's fiscal woes. The problem is purely one of excessive spending, not inadequate taxing. So what is the real motive here?

One answer comes from listening to Obama. As far back as the 2008 presidential primaries, Obama said he'd be willing to raise capital gains taxes -- even if it lost revenue -- in the interest of "fairness." In his famous speech in Osawatomie, Kan., last year, employed the term "fair" or "fairness" some 14 times in his arguments to raise taxes. He has spent months demanding that "millionaires and billionaires ... pay their fair share." Meanwhile, just a few days ago on the Today show, billionaire investor Buffett -- a major proponent of his namesake tax proposal --argued that tax hikes on the rich would "have a great effect in terms of the morale of the middle class."

In other words, taxes are an issue of "fairness," not economics, to these gentlemen. And they see raising taxes on the wealthy as a good in itself. President Obama's use of the term denotes equalizing economic outcomes more than at present -- that is the nature of defending redistributive taxation as fair, per se. But this is not in line with the way most Americans understand true fairness.

Most Americans understand that rewarding hard work and merit is both fair and critical to the opportunity that most of us see as key to the American dream. For four decades, the General Social Survey has asked Americans which is more important in determining success: "hard work" or "lucky breaks and help from people." And for four decades, between 60% and 70% of Americans say that "hard work" matters more. "Luck" has never topped 16%.

To make our country truly fair, we must work for greater opportunity for all. Tax increases to reduce income inequality won't do this, especially when Americans see the revenues blown on one government boondoggle after another, from subsidized green-tech firms to more than $800 billion in stimulus spending that most Americans say they believe was wasted.

We are not asserting that the president doesn't want greater opportunity for all -- of course, he does. But we are suggesting that his approach will not get us to that shared goal. To understand this, think of the American economy as an apartment building. We all agree that the folks in the penthouse are doing pretty well. We also agree that the basement is flooding and the people on the lower floors are suffering. We might even stipulate that the elevator doesn't work as well as it should.

So what is the solution? For the tax hikers, it appears to be, "Throw rocks at the top floor." That might feel satisfying, but it does nothing to help those who need relief and an opportunity to move higher, and nothing to improve the building.

In order to get serious about addressing America's deficits in both money and opportunity, we have to deal with our real problem: Our government is too big and it spends too much. It is wrecking our economy and mortgaging our future. Worst of all, we are spending lavishly on the wrong things, threatening the integrity of the social safety net for the poor and real public goods such as national defense.

Our problems today are manifest: Out of control entitlement spending leading to unsustainable deficits; a lack of serious budgets (annual or long term); and a broken, loophole-ridden tax system. Increasing tax rates cannot and will not solve these problems. It is only a class warfare diversion, and it wastes valuable time.

Arthur Brooks is president of the American Enterprise Institute. Edwin Feulner is president of the Heritage Foundation.

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