Opinion: Daily Journal

We‘re Already Over the Fiscal Cliff

Don’t count me among those who think President Obama and Congress will spend the next month locked in a death struggle over marginal income tax rates.

I think they will make a deal. I think the outline of the deal is already discernible. Because the Bush-era cuts in marginal income tax rates will expire at the end of the year, any subsequent tax legislation coming out of Congress will be a tax cut – a reduction in what would be much-higher income and payroll tax rates for everyone starting on January 1. Do you really think that Congressional Republicans will vote against a 2013 tax cut for virtually all federal taxpayers? Me neither.

So on the tax side of the fiscal negotiations, the focus will be how much to trade off marginal rates and tax breaks for upper-income households. Republicans are arguing, properly, that it would be better to cap or eliminate biases in the tax base than to leave the top two income-tax rates significantly above their 2012 levels of 35 percent and 33 percent. The Obama administration is now signaling some flexibility on that score.

The truly unresolved issues involve the tax treatment of investment income and the seriousness of entitlement reform. I’ll focus on the former today.

While there would be sizable economic damage from allowing the top marginal tax rate to return to nearly 40 percent from its current 35 percent, the consequences of allowing the Bush-era tax rates on investment income to soar would be far more serious. As we speak, the federal tax rate on income from dividends and capital gains is 15 percent. On January 1, the tax rate on dividends will rise to above 43 percent, including the surtax imposed by Obamacare, while capital-gains rate will rise to nearly 24 percent.

Keep in mind that most of the dividend tax and a large share of the capital-gains tax is already a kind of surtax – imposed on a stream of income to investors that has already been taxed at the federal corporate tax rate, which currently tops out at 35 percent. The same is not true for wage income, which is deductible to companies. In most American states, including North Carolina, you must then add another layer of surtax in the form of state taxes on personal and corporate income.

Right now, under the Bush-era tax rates, America already has the highest corporate tax in the developed world and among the most anti-investment tax systems on the planet. Several months ago, I computed the state and federal tax treatment of investment here in North Carolina. If we were a separate country, our investment taxation would rank 4th highest in the developed world.

In other words, when it comes to taxing the investment that makes future economic growth and job creation possible, the American economy is not poised on the edge of the cliff. It fell over the cliff a long time ago, and is currently clinging to a narrow ledge several feet below, injured and reeling.

Those who want to see the federal tax rate on dividends rise from 15 percent to 43 percent actually think it would be good for us to lose our precarious hold on the ledge and plummet. If nothing is done, America’s combined tax rate on corporate investment will on January 1 rise to 69 percent for returns received as dividends (highest in the world) and 57 percent for returns received as capital gains (second-highest in the world).

Some on the Left live in a fantasy world in which prices (including tax rates) don’t affect behavior and investment is defined as the equivalent of taxpayer-subsidized windmills, not the formation of truly valuable physical, financial, and human capital used to make things consumers willingly buy.

For everyone else, including Democrats who reside in the real world, the treatment of investment is the key tax issue to be resolved in the coming weeks and months. To judge whether Washington gets it right or wrong, watch Wall Street.

Hood is president of the John Locke Foundation and author of Our Best Foot Forward: An Investment Plan for North Carolina’s Economic Recovery.