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

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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.

PILLOW TALK

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.

With these types of considerations anchoring the two extremes of the debate, timely and proper resolution becomes a tricky proposition. You see, for all the rancor and tangents, what we are witnessing on Capitol Hill is essentially quite a balanced debate. Or so it seems... However, this is the case if, and only if, the two views are considered in strict isolation of a much larger macro framework.

WHY DEMOCRATS WILL WIN

When placed into the larger context of America's challenges, the Democratic view prevails. But before they celebrate what is likely to end up going their way, they should realize that this would prove a shallow victory if it is not followed up by a more holistic approach to re-invigorating the U.S. economy.

Republicans' dis-incentive arguments about taxing the rich would apply if the country was starting from much higher tax rates. It is not. Similarly for the rate on dividend income and for how carried interest is treated. Moreover, most in the party have already yielded on the need to raise additional tax revenue from the richest Americans by signaling that they would agree to limits on deductions (that, currently, disproportionately benefit this fortunate group).

Then there is the Republicans' broader argument about the size of government. It is true that large governments become extremely inefficient - directly, and by stifling a much more productive private sector. A government that is always subject to some type of capture by special interests (as ours has proven over the prior decade), becomes much more vulnerable to widespread corruption. But, again, this is not America's starting point.

Our challenge as a society is to re-orient government activities rather than shrink them - away from supporting the few to acting as a proper enabler for the many, and as an efficient provider of better safety nets for the most vulnerable segments of society. And this medium-term priority needs to be implemented in the context of measured and sustained deficit reduction.

WHY IT WON'T BE ENOUGH

Given the math, none of this would realistically happen without higher tax rates on the rich. This is why the Democrats will end up by prevailing on this issue. But their victory will be short-lived if they do not rapidly place it in the context of a much deeper and wider economic initiative - one that accompanies comprehensive reform of fiscal revenue and spending with efforts to improve the functioning of the labor market, improve housing and housing finance, unblock clogged credit pipes, and properly invest in people, education and infrastructure.

Today, Democrats and Republicans resemble the divorcing couple mentioned at the outset. They are using a highly visible single issue to fight over deeper and more consequential matters. And like the divorcing couple, one of them will end up by winning. But the similarities end here.

Neither Democrats nor Republicans will be able to go their own way thereafter. And, as elected representatives of some 315 million Americans, all will be worse off unless this single issue debate gives way to them cooperating on the much bigger challenges facing the country

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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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