Yes, We Can Afford Higher Taxes—Here's Why

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Neither Obama nor Romney is offering a perfectly plausible vision of America: A stronger safety net and better security paid for with higher taxes on more than the top 2%.

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Barack Obama and Mitt Romney both agree that this is a crucial election. A pivotal one. A battle for the future of America. It isn't true.

I agree that this is an important election. There are profound differences between the candidates (despite what Adam Davidson says), and which one is elected will have a major impact on issues ranging from economic growth to the social safety net to abortion rights to maintaining a sane foreign policy that reduces the risk of war. But on the central economic questions -- the role and "size" of government, the tax system, social insurance and health care, etc. -- this is just the latest stop in a long, strange road trip that conservative Republicans have been taking us on for forty years. The question is whether we pause for a few years or keep on driving.

Since the 1970s, conservative groups and later the entire Republican Party have mounted a sustained campaign to reduce the role and size of government in American society. You may think that's good or bad. The story has been told many times, including in chapter 3 of White House Burning, so I'll just point out a few key elements of that campaign. They include intellectual attacks on Keynesianism, welfare programs, regulation, and affirmative action (among other things); rhetorical demonization of government, when conservatives are in power ("government is the problem") but particularly when they are out of power (recall the frenzy provoked by the elections of Presidents Clinton and Obama); and, perhaps most importantly, the most successful tax revolt in American history.

The huge tax cuts passed under Presidents Reagan and Bush II (surrounding smaller tax increases under Bush I and Clinton), in the short term, contributed to the largest budget deficits in peacetime U.S. history. In the long term, they undermined the federal government's ability to pay for the social insurance programs that make up the largest part of the federal budget: Social Security, Medicare, and Medicaid. But the most remarkable victory of the conservative revolution has been taking tax increases off the policy table, to the point where even letting tax cuts for the very rich expire as scheduled is a non-starter in Washington. Instead, Mitt Romney and Paul Ryan can claim with a straight face that the solution to our long-term national debt problem is to lower taxes.

While next month's presidential election will have a major impact on the lives of hundreds of millions of Americans, it is unlikely to change our long-term political direction. Mitt Romney does not represent anything particularly new -- just another step down in tax rates and another reduction in government programs for the poor and the middle class. Barack Obama represents a pause in the long march, not a reversal of direction; he has largely bought into where we are today. His proposed tax increases would leave the vast majority of the Bush II tax cuts in place, he agrees with the idea that entitlement programs need structural change to reduce spending, and, despite his inaugural address, he cannot bring himself to say much that is good about government.

It doesn't have to be this way. We can continue to pay for our modest social insurance programs, so people who are laid off have time to look for good jobs, poor people can get health care, and the elderly can retire with a minimum of security. It's just a matter of choice.

But, the Serious People and the self-appointed centrists say, that would require raising taxes to unprecedented levels (as a share of the economy), which is Bad Bad Bad, because then people wouldn't work as hard.

There are at least two major problems with this argument. One is the principle of Baumol's cost disease. As technology increases productivity in some industries (manufacturing, telecommunications, etc.), relative prices must go up in industries that are less amenable to automation (health care, education). As a result, the latter get shifted to the public sector (because it's harder to make a profit), and government spending necessarily goes up. If you want health care and education, that's the way it has to be.

The other is that the argument about the incentive effects of tax increases is wrong. The usual argument is that if you raise taxes from 35% to 39.6%, that reduces after-tax wages, so people will work fewer hours and consume more leisure instead, since the value of leisure remains constant. (This is the substitution effect; the income effect actually says that some people, particularly low-income workers, will work more because they need the money.)

In the short term, that may be true, although the empirical evidence for the impact of tax rates on labor supply is weak. (See Piketty et al., for example.) But in the long term, there is another factor at work. Over the decades, average productivity goes up, so real pre-tax wages go up. If you keep tax rates constant, real after-tax wages go up, while the value of leisure remains constant, so people should be working more. That means that you can increase tax rates and people's real after-tax wages can still go up.

Since 1981, for example, real wages have gone up by about 11 percent. (Nominal data here, deflated by the CPI-U.) That means that over that time period, you could have increased tax rates by about 6-8 percentage points* and left workers' real after-tax wages constant; so, in theory, the higher tax rates would have had no impact on people's labor-leisure decisions, and no impact on labor supply.

I'm not saying this would necessarily happen. I am saying that if you think higher tax rates reduce labor supply because of the substitution effect, then you have to take higher real pre-tax wages into account. The result you get then is that increasing tax rates over the long term is no problem at all.

In other words, there's nothing wrong with a society and an economy where we vote ourselves increasing levels of security and we pay for it with higher tax rates. Rising productivity means that our real after-tax wages will still go up and the incentive to work will remain at least as strong. It's a choice we can make. It's just not a choice we have in this election.

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*The new tax rate T1 that leaves the same after-tax wage as the old tax rate T0 is given by T1 = (T0 + 0.11) / 1.11. So if T0 = 15%, T1 = 23.4%; if T1 = 35%, T1 = 41.4%.

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    James Kwak, an associate professor at the University of Connecticut School of Law, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.
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    James Kwak is an associate professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. He blogs at The Baseline Scenario and tweets at @JamesYKwak.
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