The Real Problem with Obama's Tax Plan

Although Senator Barack Obama promises a tax plan that will benefit the middle class, his new tax credits fail to provide adequate incentives for harnessing economic growth. High marginal tax rates, brought about by new tax credit phase-outs, will discourage work and saving activity and will lead to a less productive economy.

Research Fellow
Alex Brill
Visiting Scholar
Arthur C. Brooks
Resident Scholar
Alan D. Viard
We've heard a lot this month about how Senator Barack Obama's tax plans would affect Joe the Plumber--the Ohio man who recently asked the Democratic nominee whether Obama planned to raise his taxes. Opponents of Obama seized on the incident to argue that his middle-class tax cuts are a scam. Some have even claimed that he has proposed tax increases for people with incomes as low as $32,000. Obama's supporters responded that the tax cuts are real (and noted that Joe is not a licensed plumber). The entire episode has only added to the confusion over what Obama is proposing for middle-class taxes.

How should an honest fiscal conservative see the situation? For those making less than roughly $200,000 ($250,000 for couples), Obama would not only make President Bush's tax cuts permanent but would also offer an array of new tax credits. Nobody should deny this.

If rewards for America's entrepreneurs and firms are reduced through higher marginal tax rates, their incentives to earn, invest and create jobs will be diminished.

To be sure, these "tax cuts" contain some sleight of hand. More than $400 billion of the money over the next 10 years would take the form of refundable tax credits paid in cash to people who already pay no federal income tax. It would be more accurate to refer to these cash outlays as cuts in payroll tax or--even more accurately--as transfer payments. Regardless of what the credits are called, though, they would put more money in the pockets of some American families. That sounds great in these tough economic times. Who can be against a boost to spending power and consumption?

We can. While a few of Obama's proposals may be sensible, the overall package would be bad for the economy. Unlike rate cuts for high incomes or reductions in investment taxes, most of Obama's proposed tax cuts would do little to reduce the tax penalty on work and saving. For some households, the penalty on work and saving would even increase because the new tax credits would be phased out as income rises. These proposals wouldn't deliver the economic growth that incentive-based tax cuts would.

Furthermore, there is no free lunch. Obama's middle-class tax relief would have to be paid for, either now or later. Middle-class tax cuts might make sense if they were paid for by spending cuts, but that is not Obama's plan. Like his opponent, Obama points to vague savings from reducing waste, the kind of savings that never seem to materialize. He also hopes to reap savings by accelerating our redeployment from Iraq, a project with an uncertain fiscal impact. At the same time, he proposes a wave of new spending on health-care, education, energy and infrastructure programs and declares his opposition to reforms that would reduce the growth of Social Security and other entitlement benefits.

So where would the money come from for the tax cuts and new spending? Largely from raising other taxes: the ones that have the biggest impact on economic growth. Obama would let key parts of the Bush tax cuts expire, causing the top tax rate on ordinary income to go back to 39.6 percent, up from 35 percent today. The capital gains and dividend tax rates would rise to 20 percent from today's 15 percent. Obama might also impose Social Security tax at a rate of up to 4 percent on wages and self-employment income above $250,000, starting in 2019.

These tax increases are not as bad as some Obama statements during the Democratic primaries suggested they would be, and they fall well short of what some of his conservative critics claim. For example, Obama does not propose to tax dividends at 40 percent or to impose the full 12.4 percent Social Security tax on high earners.

His real proposals, however, would still be plenty damaging. If rewards for America's entrepreneurs and firms are reduced through higher marginal tax rates, their incentives to earn, invest and create jobs will be diminished. Americans will have less incentive to save, and firms will have less incentive to pay dividends. Tax avoidance will become more profitable. A smaller capital stock will mean a less productive economy and lower wages for middle-class and other workers. These disincentive effects also mean that the revenue gain is likely to be smaller than Obama envisions.

In sum, Obama may very well give Joe the Plumber a tax break, but only if Joe does not become too successful. Obama is offering real tax favors for the middle class, but not real benefits for the economy.

Alan D. Viard is a resident scholar at AEI. Alex Brill is a research fellow at the AEI. Arthur C. Brooks is a visiting scholar at AEI.

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