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The Surtax Is An Ugly and Insufficient Way to Pay for Health Care Reform

July 21st, 2009 . by economistmom

The front page of today’s Washington Post reports on President Obama’s determination to forge ahead on his plans for health care reform, despite Republican attacks and a lack of consensus among even Democratic proponents as to how to pay for it:

Several House Democrats in the conservative Blue Dog Coalition have already said they will not vote for the current House bill, citing the risk of raising taxes in this economic climate. The House bill would expand insurance to 97 percent of Americans but would add a surtax of 1 to 5.4 percent for families earning more than $350,000 a year. Democrats are considering raising the surtax so that it applies only to individuals making at least $500,000 and families making $1 million a year or more, aides to Speaker Nancy Pelosi (D-Calif.) said Monday night.

In my mind the surtax–essentially an increase in income tax rates on the very rich (mostly millionaires)– is such a bad idea as a means of financing health care reform, for the following reasons:

  • Too tiny a base and thus tax rates that are too high. According to the Tax Policy Center (TPC), this is a tax increase limited to just 1.3 percent of households.  Limiting ourselves to such a narrow tax base while needing to raise a large amount of revenue (on the order of $600 billion over just the first ten years) means that tax rates have to be set quite high.  The TPC calculates that the effective marginal tax rate on millionaires would rise from 33.6 percent under current policy extended (Bush Administration tax rates) to 44.6 percent under the Administration’s budget proposals along with the health surtax.  The more-than-10-percentage-point increase in the marginal tax rate (an increase of about one-third) is significant and can be expected to have a disincentive effect on work and saving, even if not so large as to on net reduce revenues (I’m not talking Laffer Curve here…).
  • A very narrow distribution of taxpayers funding a program with broadly-distributed benefits. I see two problems in taxing only the very rich to pay for broader health care coverage:  (i) so few people “paying for” the new health benefits means so few people will feel they have a “stake” in it, and there will be so little pressure on the government to “get our money’s worth” out of the new health spending; and (ii) when it’s only the very rich that pay for benefits that are distributed progressively (disproportionately to lower-income households), it can create a perception that the funded program is a “welfare program”–which can undermine support for the program.  Or at least that’s the argument that many liberals make against raising the Social Security taxable maximum as a way of closing Social Security’s (relatively small) fiscal gap.  (What is the distinction here, anyway?)
  • A revenue base that can’t possibly keep up with the rapid growth in health care spending. As I (and Donald Marron) explained in an earlier post, health care spending is likely to keep rising considerably faster than the economy grows, even with considerable success in achieving cost containment via health care reform.  It’s really hard to imagine a revenue source that could rise as rapidly, unless what you tax happens to be well correlated with health care spending–such as is the case with taxing employer-provided health benefits (that idea that the Administration is reluctant to endorse).  Taxing the richest households only, at tax rates designed to offset the cost of health reform over the first ten years only (and when the expanded coverage only slowly phases in), means that revenues will fall increasingly short of the cost of expanded coverage over time.

The CBO’s most recent cost estimate of the House “tri-committee” bill is a tale of three trajectories.  It shows that the cost of expanded coverage doubles from 2014 to 2019.  It shows scorable savings from changes in Medicare and Medicaid payment policies growing at a much slower rate from 2014 to 2019 (by about a third).  And it shows the revenue from the surtax rising at a similar slower rate.  Put these together and you have a recipe for an unsustainable government program–just based on the sheer mathematics.  Add in the political challenges of the surtax looking like a “soak the rich,” anti-growth tax that will make health care reform seem like a new “welfare program,” and I just don’t see the current House proposal as a reliable route to achieving the reform.

Bruce Bartlett has the idea that this “Robin Hood” tax policy in the surtax will eventually get us to higher taxes on everybody:

I remain convinced that just down the road major tax increases will be needed to avoid national bankruptcy. When that day comes, it will be harder for Democrats to go back to the same well and demand that all the burden fall upon the wealthy, especially if it is clear by then that the surtax didn’t raise nearly as much revenue as expected. Congress will have no choice except to look for ways to tax people who have much more limited opportunities for tax avoidance: those who have only wage income, which means the middle class.

Historically, increases in the top rate have tended to pave the way for higher rates on the middle class…

But if we’re going to have to get to a broader-based but still-progressive tax base eventually, there’s a much easier way than leading off with that ugly and inefficient surtax.  Just let the Bush/Obama tax cuts expire.

3 Responses to “The Surtax Is An Ugly and Insufficient Way to Pay for Health Care Reform”

  1. comment number 1 by: Blue Dog Staffer

    Reason 4: In addition to a disinsentive toward work and savings, by raising the marginal income tax rate on the highest earners, the surcharge could have the perverse incentive for workers in this category to negotiate larger, tax excludeable health care benefit packages. These folks tend to already have the “Cadillac plans” that are a significant driver of health sector inflation.
    Though this will only be true of a very narrow distribution of taxpayers, for them it spells less out of pocket costs, exacerbated overutilization, and further bending the cost curve in the wrong direction.

  2. comment number 2 by: Sarah

    I think the idea that raising the marginal tax rate on the very rich to something close to what most people pay in Europe will act as a ‘disinsentive’ toward work is ludicrous. Did the top marginal rate of 77% discourage the rich from trying to become more wealthy under the Reagan administration, pray tell? And what of the ‘disinsentive’ to productive work on the other end? I personally know of half a dozen small businesses that were never started– or have been limping along on spare-time efforts — because their potential owners could not afford to leave jobs with health insurance and expose their families to the risk of being uncovered.

    In any case this notion that people in high-paying and prestigious jobs will work harder if paid more and less hard if they are paid less is absurd. People at the top of their games are already working as hard as they can– both because of the pull of doing what they love and are good at and the push from so many other talented people who would be happy to have their job. They might, indeed, become discouraged if their pay were suddenly cut by 20% relative to other people in their positions — that’s a matter of prestige– but if all of their peers are also earning a little less? That could only benefit us all by moving us back in the direction of a broadly middle-class society. And the evidence is strong that even the super-rich prefer to live in societies where few are either very wealthy or very poor– else why the preference among the rich for living in Switzerland over, say, Brazil?

  3. comment number 3 by: Jim Glass

    Did the top marginal rate of 77% discourage the rich from trying to become more wealthy under the Reagan administration, pray tell?

    The top marginal rate during the Reagan years was 50% and fell to 28%. There hasn’t been a 77% marginal rate in the US since the 1960s.

    In any case this notion that people in high-paying and prestigious jobs will work harder if paid more and less hard if they are paid less is absurd.

    I don’t how absurd it is — as a self-employed small-business owner, I surely vary my work hours by the reward they produce — but let’s take your caricature of all high earners as work addicts as being true for argument’s sake.

    Then consider three things, for starters….

    1) Their spouses. When a couple’s income piles up into a high tax bracket the documented effect on the work hours of second earner is very pronounced.

    For instance you are a wife and mother — if the government takes 77% of your pay, after adding to that the cost of the nanny, housekeeper, after-school programs and the psychic cost of having to jiuggle your time to be with your children, what’s the point of working? So you don’t.

    Now ProfessionalMom becomes StayAtHomeMom — a reduction of workplace equality that will be noticed and surely berated — and the nanny and housekeeper and everyone else who would’ve benefited from ProfessionalMom’s work income, including the US Treasury (via taxes) all lose.

    2) WorkAddictDad may indeed labor on just exactly as before under your 77% tax rate — but nothing says he’s going to report his income as before!

    You’ve created a situation where he can profit by paying up to 76% of every marginal hard-earned dollar he makes to devious accountants and tax lawyers (like me!) to whip up tax shelters, deferred pay arrangements, and a plethora of sophisticated tax avoidance (legal) and evasion (illegal — but good luck to the IRS in figuring them out) devices to keep his pay.

    Plus, of course, a lot of that 76% will go into politicians’ pockets via lobbying, to create new legal tax avoidance devices — which the politicians surely will provide to keep that money coming to them.

    Look at it this way: you’ve created a situation where WorkAddictMoms&Dads can more than quadruple their marginal take-home pay (from 0.23 to 1.00) by putting a little work into it. And they are work addicts. But hey, most average people would put some effort into quadrupling their marginal income, eh?

    (Minus fees, of course. As a lawyer who’d be collecting those fees I’m not entirely against high brackets and this is all pretty much an admission-against-interest for me, so consider it “fair warning”.).

    3) A third factor we should consider, especially those of us who want to stick-it-to-the-rich, is “progressive fairness”.

    High tax brackets greatly increase the returns to investment in tax planning, with the result being that the rich, who can afford it, pay lower actual rates of tax then the less rich.

    For instance, getting from my bookshelf IRS Statistics of Income data for 1965, the days of the good old 70% top tax bracket, we see effective tax rates by income level, tax actually paid/income (1965 dollars) of…

    >$1 million: 30.8%
    $500k to $1,000k: 32.8%
    $100k to $500k: 36.4%
    $50k to 100k: 31.2%

    So the people who had income of $50k to $100k paid a higher effective tax rate those who had twenty times more income.

    The great fallacy committed by those who push the idea: “just tax the richest with a 70% to 90% rate like in the good old days” is the naive belief that the richest will actually pay those rates. But they never did and never will. All the rules that go into those rates actually let them pay less than the less rich.

    (BTW, the exact same situation exists today with the estate tax, the richest pay significantly lower tax rates than the less rich — returns to investment in tax planning increase with scale.)

    Now all of this — second earners giving up work, those economically dependent on them losing work, incentives for tax avoidance & tax evasion, the purchasing of loopholes from politicians, inequities that let the richest pay less tax than the much less rich — starts well below the 77% tax bracket, of course. It starts at the very bottom tax bracket rates and increases as tax rates rise up, driven by the pressure of the deadweight cost of taxes that rises by the square of the rise in the tax rate.

    So doubling tax rates (from circa 35% to circa 70%) quadruples all this — and conversely, dropping tax rates in the other direction by the same amount reduces these distortions by a smashing 75%. Which is what happened in 1986.

    Before the bi-partisan (and it was) Tax Reform Act of 1986 dropped the top tax bracket rate from 50% to 28% there was a massive tax shelter industry in the US. (I know, I was there.)

    Part of the avowed purpose of the Act was to put that industry out of business. It worked. The 28% top rate pretty much wiped out the tax shelter industry. And it left the richest actually paying the highest effective tax rates!

    All this is why lower top tax rates were enacted not just in the US but across the entire world starting in the 1980s — for all OECD countries, the top individual tax rate, including their equivalent of state and local taxes, was reduced on average from 68% to 42% during 1980-2007. (Sweden dropped its top tax rate, including local taxes, from 87% to 50% in the years after 1980, since then back up to 55%). In Eastern Europe, after the fall of communism, the standard measure has been to adopt low flat-tax rates.

    Where I’m sitting in NYC, the top tax rate today is 35% federal, 9% state, 3.65% city, 4% unincorporated business tax (on the owner) & 2.9% medicare tax. That equals 54.55%. Assuming one is eligible to deduct maximum portions of the state, city and medicare taxes on the federal return, it nets to 48.2%. Add the “health reform” tax, we’re well up over 50% again. Which does nothing at all to close surging fiscal gap leading to the impending crushing of the USA’s credit rating in the 2020s.

    If Obama follows up on his promise to further tax “only the rich” to deal with that, by increasing top nominal tax rates, and then further increasing effective top tax rates by eliminating some itemized deductions and resurrecting the Pease phase-outs of all the rest, exemptions too, etc., then we’ll be solidly into 60+% top marginal rates here with well >50% rates across much of the US — while the rest of the OECD averages in the low 40%s. (Even with all their national health care costs.)

    And by “towering” our tax rates while continuing to narrow our tax base (47% of potential taxpayers now pay no income tax or receive refundable credits from the govt) — as the rest of the world continues to do the reverse — we’ll be heading right back toward the bad old days of the 70% tax brackets that the richest never paid, thanks to having their spouses not work and their massive investments in tax shelters and in purchasing loopholes from politicians, which left them paying lower tax rates than others.

    As a citizen of the US and taxpayer in NY this will be terrible for me.

    But professionally it will be great for my fee income, and I’ll know how to tax shelter it, so if you insist…