As negotiations continue in Washington over a plan to avoid the fiscal cliff — that combination of tax hikes and spending cuts scheduled for Jan. 1 — one big sticking point is whether to raise tax rates for high-income Americans.
Congress and the White House constructed the cliff last year, thinking it would force them to focus on solving the deficit problem. But they're still battling over what approach makes the most sense.
President Obama and other Democrats have been clear that they think raising tax rates for the wealthy is a sensible way to raise revenue and narrow the budget gap. The president says he wants to raise the top rates a few percentage points to 36 and 39.6 percent. That's where they were in the 1990s before the Bush tax cuts.
Sen. Charles Schumer of New York made the case for higher rates again Thursday.
"The election said raise the top rates on the highest-income people, and our democracy still works well enough that they're going to have no choice but to go along with that," he said.
But Republicans argue that raising tax rates for the wealthy would be counterproductive. House Speaker John Boehner repeated that view at a news conference Friday.
"Increasing tax rates draws money away from our economy that needs to be invested in our economy to put the American people back to work," he said. "It's the wrong approach."
According to the nonpartisan Congressional Budget Office, about 200,000 jobs would be lost next year if rates for the wealthy were increased. But the CBO also says the positive economic effects of deficit reduction would outweigh the potential dampening of job creation.
Glenn Hubbard, dean of the Columbia Business School at Columbia University, says raising rates is not the best approach.
"Just as an economist, it seems to me what you'd like to do is raise people's average tax rate — that is, their tax burden — but not their marginal tax rate, which is what affects decisions to start businesses, to hire people, to save, invest, to work," he says. "And it's pretty easy to do that by simply limiting deductions and exclusions for the well-to-do."
Economic theory says that when the government takes a bigger bite of your income as you move up the ladder into higher tax rates, you are less likely to work more, invest and build businesses. So economic growth and job creation suffer.
But William Gale, co-director of the Tax Policy Center, says evidence in the real world suggests the effects are small.
"A variety of things affect the growth rate of the economy, not just taxes," he says. "And I think to some extent the public discussion overemphasizes the role of taxes in generating economic expansion."
Gale says there are many studies that suggest that raising top tax rates a few percentage points is unlikely to have a big effect on growth. And he says that when tax rates were raised in 1993 to balance the budget, the economy grew dramatically for the rest of the decade.
"The point here is not that tax-rate increases cause economic expansion," he says, "but rather that they didn't get in the way of what was an extremely robust economic expansion."
But Columbia University's Hubbard, who was also Republican presidential candidate Mitt Romney's top economic adviser, says the goal should be finding the best tax system to support growth.
"I'd rather see us talk about tax reform," he says. "That is, have the Congress say, 'OK, here's the dollars that we need to raise in revenue. Now let's talk about a better tax system.' An example of that would be the Bowles-Simpson [plan]. It would get the revenue goal the president wants, but in a tax system that, frankly, would be healthier for our economy."
The Bowles-Simpson approach, proposed by the leaders of Obama's deficit-reduction commission, ended or capped virtually all deductions and tax breaks, like the mortgage interest and retirement savings deductions. The plan then used the added revenue to reduce the deficit and lower tax rates, not raise them.
Hubbard acknowledges that the details couldn't be worked out before Jan. 1. But he says the goals could be agreed upon and the details worked out next year.