Raising Taxes on the Rich: The Right Policy, but Not a Solution

Democrats should win the "rate debate." But their victory will do little for the jobless, the housing market, our clogged credit pipes, our sagging infrastructure, our higher education system ...

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Reuters

I remember a divorcing couple who had a huge argument about who should end up with a pillow case - a pillow case! These friends believed at the time that they were fighting over a single item of what was a sizeable joint estate. In fact, there were much deeper matters in play. And, absent a rationality time out, both lost big as the damaging argument ended up increasing the lawyers' billable hours.

This is similar to the current argument between Democrats and Republicans over the tax rates for top earners. It has emerged as the dominating issue in a much larger debate on how to deal with America's debt and deficit challenges. But by obsessing on this one single issue, important insights are being crowded out. Indeed, if current trends continue, whoever wins the argument could feel they won a battle at the expense of losing the war. In this eventuality the victims would be average Americans who are yet to recover properly from the Great Recession.

Virtually all, Democrats and Republicans speak to the importance of medium-term fiscal reforms. And most agree that over the next few weeks it would be idiotic to allow the fiscal cliff, a major self-inflicted disruptor, to push the country back into recession in 2013. But when it comes to the details, they disagree loudly on whether to allow the marginal tax rates on the rich to go back up.

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On the surface, the debating points seem simple enough.

Democrats argue that what has gotten us to this point - namely, rate reductions for the rich introduced under President Bush 12 years ago - were meant to be temporary and reversible. Meanwhile, well-off Americans have done extremely well over this period, both in absolute terms and relative to other Americans. And they now need to be an integral part of improved fiscal responsibility.

Republicans stress different points. They feel that increasing the rates on high earners would dis-incentivize innovation, entrepreneurship and risk taking. They argue that this would undermine the country's already sluggish growth and employment engines. And this would endanger the quest for medium-term fiscal sustainability.

Both parties are sticking to their views with utter conviction - and in a manner that, to a rational outsider, would seem excessive given the foundations of the arguments. These are simply not solid enough to make the top rates the overriding single issue of the fiscal cliff debate and, more broadly, the country's fiscal challenges. Yet it is, and for understandable reasons.

For Democrats, this issue captures well much deeper (and wider) concerns about inequality of income, wealth and opportunities. Fairer burden sharing and proper collective responsibilities are the topics du jour.

For Republicans, it speaks to limiting the size and scope of government. They see an urgent need to counter what some have even gone as far as to label "creeping socialism." And there is nothing like the S word to mobilize the Republican base.

Presented by

Mohamed A. El-Erian is CEO and co-chief investment officer of Pimco, the world's largest bond investor, and author of When Markets Collide.

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