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Congress Passes Fiscal Cliff Deal
We now see who are "millionaires and billionaires" in practice. They are individuals with income over $400,000 or married couples with income over $450,000. Their top tax bracket rises from 35% to 39.6%, an increase of 13%.
The capital gains tax rate goes from 15% to 20%, an increase of 33%.
The temporarily reduced payroll tax rate of 4.2% reverts back to 6.2%, an increase of 48% on all wages up to around $110,000.
The spending problem was not addressed.
There was one positive. The threshold to be forced into the "Alternative Minimum Tax" was set in 1993 and never adjusted for inflation. Incomes and prices have risen since then, so today much of the middle class would be ensnared in this regime that disallows most deductions including state income tax. Every year, Congress provided a temporary fix, and now they have finally made it permanent.
An increase in the tax on high incomes may not have a large immediate effect. Most high earners do not consume all of their income. They spend what they need to maintain their lifestyle and invest the remainder, though some may cut their consumption budget to keep a fixed ratio of their income. The damage done by this tax hike will be felt in future years, as it makes capital harder to accumulate. Our economy (and job creation) depends on capital accumulation. This tax hike in effect transfers capital out of the hands of those who may save it prudently into the hands of the government to be consumed.
Raising the capital gains tax rate strikes a blow directly at the entrepreneur and the investor. Fewer new businesses make sense to start or finance. Investments in new businesses are risky, and most are total losses to the investor. The few winners must earn enough to pay for all the losers. A higher tax on gains raises the bar that an investment must get over. There may be a long delay so that most will not see the connection. In addition, it is difficult to imagine the products that are not in the market but which would have been under a friendlier regime. One thing is clear, mature businesses are managed to reduce cost, which often means layoffs. Job creation is in new businesses. Higher taxes on capital gains may only hurt a few people directly. The indirect impact will be felt by everyone in the job market, along with every retail store, restaurant, and manufacturer of consumer goods.
The payroll tax affects the wage earner. I think it is safe to say that most of this reduction in take-home pay will translate into a reduction in consumer spending and the remainder will reduce the personal savings rate.
Taxes damage the economy in another way. They cause distortion. People are not stupid. They react to the incentives offered to them by the market or forced on them by the government. How much has demand increased for accountants and lawyers and decreased for fitness instructors? There is no way to calculate this, but we can say one thing with certainty. The distortion increases with the tax rate.
The problem is that the economy has become addicted to government spending. Withdrawal of this powerful drug will be painful. Right now there is approximately zero political will to make any cuts at all. For now, the government can get away with it. Just as in Greece, the government depends on the bond market. Whatever it cannot collect in taxes, it can make up by selling bonds, including the interest on outstanding bonds.
And just like Greece, the game ends when the bond market goes "no bid". This is not imminent in the US. But it is inevitable.