The “fiscal cliff” is the single most important problem facing the House of Representatives. Most people considering the economic challenges facing America, believe that reduction of the deficit is critical to our future prosperity. In a recent CNN opinion poll two thirds of people agreed that reduction of the deficit should include a mix of spending cuts and tax increases. Even Republicans favor a mixed approach to reduction of the deficit, by an 8 point margin, 52% to 44%.

Warren Buffett, one of the wealthiest people in the United States, observes that he should pay a higher tax rate than his secretary, who makes a fraction of what he earns.

Buffett has suggested that there should be a minimum tax of 30% on incomes of 1-10 million, and a flat rate of 35% on any income above 35%.

While it is unclear exactly what plan may eventually be adopted by Congress, Republicans are starting to break ranks.  In the past they have declared that under no circumstances would they be in favor of raising taxes.  Now it appears that they may have been faced with some unforeseen circumstances.  Now some are indicating a willingness to consider raising taxes.   Republican Senator Saxby Chambliss of Georgia, Lindsey Graham of South Carolina, John McCain of Arizona, Tom Coburn of Oklahoma and Bob Corker of Tennessee  have joined Republican Representatives Peter King of New York, and Scott Rigell of Virginia, in suggesting that they are NOT bound to the Norquist pledge of never raising taxes.

The argument against raising taxes for the wealthy has been that it will thwart economic growth and result in job losses. The reality is that we can no longer afford to watch the deficit grow without attempting to address the amassing of debt. Under any policy proposed by Republicans or Democrats, the rate of capital gains taxes would remain lower than ordinary income tax for the wealthy. Capital gains taxes are those taxes on the sale of stock or assets sold after holding them for one year or longer. Thus there is a common sense argument that because invested income is taxed at a lower rate than ordinary income, people with money are more inclined to invest in stock of a company, than a money market or CD that would generate ordinary income.  Thus if a wealthy person had One Million dollars to invest, if it was put in a money market fund or taxable bond fund, it might return 2% on the investment, which would be taxed at ordinary income rates. The income earned on that One Million dollars would be $20,000. If it were taxed at a rate of 38%, the investor would have $12,400 in after-tax dollars to re-invest the following year. If instead that Million dollars was invested  in a new business, if that same Amount of revenue were generated as a result of appreciation of the stock after one year,  it would be taxed at the lower capital gain rate of 15% (rate if nothing changed) to 23% (the proposed new capital gains rate). In that same scenario the investor would have $17,000 to $15,700 to reinvest because his “gain” would be taxed at a lower rate.  Thus the investor would have thousands of dollars more to re-invest if he was taxed at the lower capital gains rate.  The higher the ordinary income rate, the greater the incentive of an investor to put his money into a company, instead of simply putting his money in the bank.

This “common sense” approach has been confirmed by sophisticated economists. In one study, economists confirmed that higher tax rates on the wealthy were associated with higher levels of growth.  As long as “ordinary income” rates for the wealthy stay low, the wealthy are well advised to opt for low risk investments that generate a steady stream of income. The higher the tax rates on ordinary income, the more likely that the investor will take his/her chances by investing in stock or a small business.

The argument could be made that raising taxes on the wealthy will result in less money to invest.  However we have tried lowering taxes with the Bush tax cuts, and we have seen major unemployment and an increasingly large deficit.  It is time to try something else.  A willingness of Congress to raise taxes, as unpopular as that may seem, will give markets a reason to believe again in the willingness of America to tackle its economic problems and will cause people to believe again in the U.S. market.  Investors need to have confidence in America,  or their investments will predictably go to foreign companies and markets.  If only to inspire confidence in the American markets we need a clear message from our Congress that they are willing to take the difficult steps necessary to deal with the fiscal cliff.  Raising taxes on the wealthy would send a message that we are willing to do the difficult work necessary to address the economic problems facing the country.  Restoring confidence in the American economy would undeniably be a first step on the road to recovery.

 

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