How High Could the U.S. Tax Rate Go?

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Viviane Moos / Corbis

A political billboard at New York City's Times Square asking Americans to reduce the deficit

Never mind about mortgaging the future. By running up a monster deficit as it struggles to keep the economy growing, the Obama Administration is setting the stage for sharply higher taxes down the road.

Of course, it's not an absolute certainty. The easier option is even more quantitative easing — a euphemism for printing money, which is a dirty phrase economists never like to use. This would devalue the country's currency and sovereign debt, triggering a cycle of hyperinflation of the likes the U.S. has never seen.

Hiking taxes is the less traumatic course, though it will only be accepted as the cost of inaction rises. "Congress only responds to financial crisis or some other external shock," says Bill Gale, co-director of the Tax Policy Center in Washington. "Nothing will be done in Obama's first term to substantially increase tax revenue."

Higher taxes are coming soon, however — and they will hurt. By some estimates, the tax burden on Americans could double before the end of this decade. The only question is: What form will these new taxes take?

Last year British Prime Minister Gordon Brown raised his country's top marginal rate for income tax to 50% from 40%. This came on the heels of a decision to borrow more than $1 trillion over the next five years, bringing his country's public debt to 79% of GDP by 2013. There has been the expected backlash from the superrich, but the majority of Brits don't seem to mind so much.

A similar strategy for managing a growing mountain of debt on this side of the Atlantic might work, with Washington increasing the top tax rate, say, from 35% to 45%. At the same time, rates could be increased by a smaller amount in lower brackets.

From a historical perspective this makes a great deal of sense. Consider that the top marginal rate peaked at 94% in the final years of World War II. It remained above 90% for most of the 1950s, and held steady at 70% during the 1970s. Republican Ronald Reagan emerged as the great tax buster, shaving the top bracket to a mere 28%. (During his presidency the rate in the bottom bracket increased by a point to 15%.)

Opinion is mixed about whether tax that primarily targets the rich would solve today's debt problems. "Once the marginal rate exceeds 40%, you get high levels of tax avoidance and evasion," says Daniel Feenberg, an associate with the National Bureau of Economic Research in Cambridge, Mass.

He prefers the idea of introducing a VAT, or value-added tax, and increasing payroll contributions for social programs such as retirement and disability insurance. Feenberg estimates that a 14% VAT on goods and services, similar to what exists in the E.U., would generate more revenue than the existing income tax.

He may be right, but selling a European-style VAT to Americans is a bit like selling snake poison and would likely mean political suicide for any of its supporters. That said, there's no hiding the fact that the ratio of public debt to GDP is expected to balloon from 60% to 82% by 2019.

Pacific Investment Management Co., based in Newport Beach, Calif., and manager of the world's biggest bond mutual fund, is warning investors that Britain's stratospheric debt load is resting on a bed of uncertainty comparable to "nitroglycerin." If Britain is receiving such harsh criticism from money managers, can the U.S. be far behind?

As Washington ponders its taxation options, it might also wish to cast its gaze toward the NYSE and Nasdaq, whose companies add very little to the public till. In fact, their contribution as a percentage of GDP ranks in the bottom quartile among OECD nations' figures.