From the Wall Street Journal 07.02.2010

REVIEW & OUTLOOK
JULY 2, 2010




The Obama Tax Trap
How some Republicans are preparing to walk right into it.



"'Next year when I start presenting some very difficult choices to the country, I hope some of these folks who are hollering about deficits step up. Because I'm calling their bluff."

That was President Barack Obama, the heretofore unknown deficit hawk, all but announcing the other day the tax trap that he's been laying for Republicans. From what we hear about intra-GOP debates, more than a few will be happy to walk right into it.

You don't need a Mensa IQ to figure this one out. Mr. Obama's plan has been to increase spending to new, and what he hopes will be permanent, heights. Then as the public and financial markets begin to fret about deficits and debt, he'll claim that the debt is "unsustainable" and that the only "responsible" policy is to raise taxes.

White House officials even talk privately about the galvanizing political benefit of a bond market crisis, which would force panicked Members of Congress to accept a big new value-added tax. The President's two looming tax reports—one from his deficit commission and the other from Paul Volcker's economic advisory group—are intended to propose a VAT and other tax options. Whatever their initial reception, the proposals will be there to be pulled from the shelf when the political moment is right.

Voila, Mr. Obama will have established a new spend-and-tax policy architecture that has the feds taking from 25% to 30% of GDP, up from the roughly 21% modern average.

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This strategy explains why Mr. Obama is now starting to fret in public about deficits and debt. This week he even said reducing the debt will be "our project." Funny how debt seemed a lower priority when he was urging Congress to pass $862 billion in stimulus and $1 trillion in new health-care subsidies.

The Congressional Budget Office is contributing to this political drama by declaring this week that the "federal budget is on an unsustainable path." Of course, but why? The biggest reason is that Medicare and Medicaid keep rising at two to three times the rate of everything else in the economy and, as CBO explains, will eventually take up every dollar of tax revenues raised, leaving no money for anything else, including national defense.

"Slowing the growth rate of outlays for Medicare and Medicaid," advises CBO, "is the central long term challenge for federal fiscal policy." This is the same CBO that blessed ObamaCare's Medicaid expansion to 16 million more recipients.

What CBO's latest apocalyptic report doesn't stress is what we'd call the more important deficit in its forecast: the growth deficit. CBO predicts an annual rate of GDP growth of 2.2%. Yet since 1959 the U.S. economy has grown at an average rate of 3%, and during the 1980s and 1990s it was closer to 3.5%. The compounding effect of restoring this faster pace of growth would mean far more net national wealth and would certainly make debt repayment easier.

Even Mr. Obama's current spending level of 25% of GDP would be more manageable if the slow economic recovery weren't keeping tax revenue at unusual lows. In 2007, the economy threw off revenue of 18.5% of GDP. That fell to 14.8% in 2009 and may not be too much higher this year. The point is that there is no hope of balancing the federal budget without a return to higher levels of economic growth.

This is where Republicans need to maneuver around Mr. Obama's tax trap. He and his White House economists believe that taxes have little effect on growth so they can get revenues to 20% or 25% of GDP simply by raising tax rates or imposing a VAT. But if they're wrong about the impact of those taxes on a still-fragile economy recovery, they could keep the economy on a subpar growth path for years to come. We think the last thing the U.S. economy needs at the moment—and the worst policy for the deficit—is the big tax increase that will hit on January 1 with the expiration of the Bush tax cuts.

Yet we hear that even many Republicans are privately insisting that any extension of those Bush tax cuts must be "paid for" with other tax increases. Under Congress's perverse budget rules, extending those tax cuts will "cost" the Treasury revenue, even though extending those tax rates would only prevent a tax increase.

And because Congress still uses static revenue scoring—meaning no change in economic behavior from tax changes—the Joint Tax Committee thinks it will raise nearly $1 trillion over 10 years from the higher tax rates on incomes, dividends and capital gains. That's highly improbable. After those tax rates were cut in 2003, total federal tax revenue increased by 44%, or $743 billion, from 2003-2007.

In other words, Democrats have rigged the rules so that merely stopping a tax increase will be scored to increase the deficit. These are the same Democrats who haven't "paid for" trillions of spending in the last four years, but watch them soon denounce Republicans as fiscally irresponsible merely for trying to stop a tax increase. Orwell would love modern Washington.

If Republicans go along with this perverse pay-as-you-go logic, they will play into Mr. Obama's hands. He'll gladly offer to raise taxes on the wealthy in order to "pay for" extending the lower Bush rates on the middle class. Never mind that the tax increases on capital gains, dividends and income tax rates will do the most economic harm.

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Republicans need to break out of their rhetorical preoccupation with debt and deficits, focusing their political aim instead on spending and above all on reviving economic growth. They should hold the line against all tax increases and begin to consider a menu of tax cuts to make the U.S. more competitive, especially if the economy continues to underperform.

Mr. Obama's strategy of spending our way to prosperity clearly hasn't worked, as the voters are coming to understand. But if the GOP policy response is merely to bemoan deficits, they will soon find themselves back at their historic stand as tax collectors for the welfare state. To avoid Mr. Obama's tax trap, Republicans also need a growth agenda.