Time to Pay the Price

In 2002 the inimitably audacious editorial writers at the Wall Street Journal brought to the nation’s attention the existence of a vast and allegedly pernicious class of “lucky duckies” who pay no federal income tax because their incomes are in sub-$40,000 territory and they qualify for one or more of the many credits added to the tax code in recent decades.

Since then, thanks to tax changes proposed and signed into law by President Bush, this impoverished yet fortunate class has only grown–to 45.6 million households, or one-third of all income tax filers, according to the Tax Foundation, a right-leaning think tank with a reputation for getting its numbers right. If the various tax cuts and credits Barack Obama has proposed on the campaign trail are enacted, the group estimates, that figure will rise to 63 million, while John McCain’s tax plans would bring the tally to 62 million. Either way, more than 40% of the population would stand to come out even or ahead on April 15.

What are we to make of this development? Some conservatives say it endangers the underpinnings of American democracy, echoing the 2002 Journal editorial: “Workers who pay little or no taxes can hardly be expected to care about tax relief for everybody else. They are also that much more detached from recognizing the costs of government.” This argument is historically obtuse, considering that the federal income tax was initially designed to hit only a tiny minority of high earners and exempt the other 99% (it first became a mass tax during World War II). It’s also misleading, in that lucky duckies still get hit with payroll taxes for Social Security and Medicare, federal excise taxes, state and local sales taxes and so on.

But the growth in the ranks of those who pay no income tax does raise an important question that both Obama and McCain failed to fully answer during the current campaign: How the heck are we going to finance our government? The question has been looming for a while because of the chronic deficits of the Bush years and the soon-to-escalate demands on Social Security and Medicare. It has gained urgency lately, with Washington committing vast sums to fighting financial panic and with more deficit-financed emergency aid surely on the way.

Obama’s partial answer is that he will raise taxes on those making more than $200,000 a year ($250,000 for two-earner households) by returning their tax rates to the levels that prevailed before 2001. McCain’s partial answer is that he will cut government spending. But both are also pledging big tax cuts. The Tax Policy Center, a joint venture of the left-leaning Urban Institute and Brookings Institution that also has a reputation for getting its numbers right, estimates that Obama’s tax proposals would increase the deficit by up to $3.5 trillion over the next decade, while McCain’s would increase it by up to $8.6 trillion. That doesn’t count possible spending cuts, but even McCain’s proposed “freeze” wouldn’t come anywhere near to closing that hole.

The upshot is that you can probably throw out the window most of the tax proposals Obama and McCain have been talking about on the campaign trail. The demands on government are growing, and investors around the world won’t finance huge U.S. deficits forever. Four or eight years down the road, the likeliest scenario is that the overall tax burden will be higher, not lower.

So who will pay those taxes? Obama’s plan to target the highest earners has merit, given that almost all income gains in recent years have gone to the top 1%. But because the rich can afford good tax lawyers, there are diminishing returns to increasing their tax rates. Returning to the pre-2001 top rate of 39.6% (from 35% now) would surely bring in more money, but going much higher might not. Also, the bulk of the recent gains at the top of the income spectrum has come from huge paychecks in the financial sector–paychecks that are almost sure to shrink in coming years.

That brings us back to the lucky duckies. Trouble is, they’re an even less promising target. The share of pretax income going to the bottom 40% of households dropped from 20% in 1980 to 15.9% in 2005, according to the Congressional Budget Office, and that decline has been counteracted only modestly by tax credits. There’s simply not enough money there to close any budget gaps.

So where is the dough going to come from? In 2007, 56% of pretax income went to households making between $70,000 and $250,000 a year, estimates the Census Bureau. That’s the upper middle class, broadly defined. If we need more money to keep the country running, here’s betting that is where it’s going to be found.

Extra Money To read Justin Fox’s daily take on business and the economy, go to time.com/curiouscapitalist