Will Raising Taxes on the Rich Lead to a Double Dip?

The wealthy might be able to afford to pay more taxes, but can a fragile U.S. economy afford to require them to do so? Although Washington isn't actively increasing taxes on the rich in 2011, their inaction will effectively do just that. President Obama's 2011 budget shows that he will allow the Bush tax cuts to expire for the top two income brackets. They will consequently jump from 33% and 35% to 36% and 39.5%, respectively. Will this harm the recovery, which will still likely be fragile in 2011?

A recent Rasmussen poll found that 52% of Americans agree that tax increases will hurt the economy. The only thing surprising about that poll is that this percentage is so low. Any time you're taking money out of the economy, it suffers. Even if only the wealthy are affected, that means they'll have less money in their pockets to either invest or spend -- both of which are important to stimulating the economy.

Earlier this month, Arthur Laffer argued that this tax increase will cause a double dip. He's best-known for the creation of his Laffer Curve -- a theoretical graph that purports higher taxes can sometimes lead to less government revenue. Here's his basic argument about why the 2011 tax increase is a problem:

Now, if people know tax rates will be higher next year than they are this year, what will those people do this year? They will shift production and income out of next year into this year to the extent possible. As a result, income this year has already been inflated above where it otherwise should be and next year, 2011, income will be lower than it otherwise should be.

His contention is that the improvement we've seen in 2010 is, in part, driven by wealthier Americans spending more and small businesses trying to pull as much profit into this year as possible. We've actually seen some evidence that the rich have, indeed, increased their spending a lot more than middle- and low-income Americans. Unfortunately, it's pretty hard to prove that small businesses that will be affected by the tax hikes -- like sole proprietorships -- are trying to inflate this year's earnings with revenue that would have hit in subsequent years. But the logic certainly makes sense.

If this theory holds, then we currently have an overly optimistic view of the economy. What's worse: it means that 2010's gain will be 2011's loss. Profits and spending will sink due to tax increases. This could cause consumer confidence to dip next year if Americans no longer believe the recovery will endure. This would effectively create a self-fulfilling prophecy.

As Laffer mentions in his column, this sort of behavior is precisely what we always see when people anticipate a change in government policy. With cash-for-clunkers, auto sales fell when the program ended. Similarly, after the home buyers' credit expired in April, house sales plummeted. His fear -- which seems plausible -- is that the same will happen with the spending of wealthy individuals and small businesses in 2011.

At this point, it seems quite unlikely that President Obama and Democrats in Congress will change their minds about allowing the tax cuts to expire. But extending them even a year or two would likely do the trick. While a double-dip will still be a threat in 2011, it's far less likely we would have to worry about one in 2012 or 2013. Even if the power in Washington wants to tax the rich at higher rates, the short-term benefit of doing so might not be worth the risk.