Knowledge@Wharton Law and Public Policy Research Article

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This is the first in a series of articles examining the various economic and fiscal proposals of the two candidates for president: Democratic Sen. Barack Obama and Republican Sen. John McCain. The articles will appear in each issue of Knowledge@Wharton running up to the November election.

They may paint themselves as agents for a new, more bipartisan attitude in Washington, but John McCain and Barack Obama both tend to adhere to their parties' usual approaches to tax policy.

McCain would cut overall income taxes for the top 1% of American earners, according to recent data from the Tax Policy Center, a non-partisan joint venture of the Urban Institute and the Brookings Institution. Obama would raise taxes on those in the highest tax bracket, while reducing them for low- and moderate-income families.

The TPC study says both candidates' tax plans would substantially increase the national debt over the next decade, though the candidates themselves have made general promises to reduce the deficit and eventually balance the federal budget. The study also says that neither candidate articulates how they will do this. As for the tax cuts, McCain says he would renew the package of cuts initiated by President Bush (due to expire in 2011), while Obama says he will keep only some of those cuts.

"In deciding how much we're going to tax and spend now, we're implicitly deciding how much we're going to tax and spend in the future," says Wharton finance professor Nicholas Souleles. "Given our debt, if we increase our deficit spending now, we're going to either have to cut spending or raise taxes in the future.... You do have to remember that eventually you'll have to pay back your debt. So it's really about transferring resources over time, and that's a choice that policy makers have to [face]."

Souleles says it's useful for voters to think about where some of the bigger numbers are, such as the Bush tax cuts, new spending, and incentives to improve Americans' savings rate and address the credit crunch, to name a few. Proposals, such as McCain's to extend the Bush tax cuts and Obama's to roll them back for taxpayers in the highest brackets, offer a clear contrast between the candidates, Souleles says, but actual implementation of policy -- Congress must eventually approve the changes and is likely to tinker with key details -- is another matter.

Kent Smetters, a Wharton professor of insurance and risk management, agrees, and he worries about the combination of a Democratic president and a Democratic-controlled Congress. "Spending tends to go up dramatically when the president and Congress are of the same party, so that alone suggests that an Obama presidency would be more inclined to inflate the debt," Smetters says. "Senator McCain has made stopping wasteful spending and earmarks his signature cause in the U.S. Senate... despite solid Democratic majorities." But he also says that a single party's control over the White House and Congress is more likely to bring at least some action on such issues as the future of Medicare and the Alternative Minimum Tax.

Congress and Voters Hold Sway

A President McCain and his tax policies would face a formidable hurdle in Congress with both houses controlled by Democrats, notes Wharton finance professor Richard Marston. "It's basically a moot question on what his tax stances are," Marston says. "The state of the economy is the number-one determinant of elections, and McCain has been dealt a bad hand by the bust in real estate and the subsequent financial crisis. If McCain is elected, he will have to deal with an overwhelmingly Democratic Congress. So he won't be able to implement his tax agenda, anyway."

Either candidate "will be faced with budget realities that look a little different once they are in office," says Eric Toder, taxation and fiscal policy analyst at the Urban Institute, a Washington, D.C., economic and social policy research group. "But there is a history of enacting different policies [from their immediate predecessors], particularly at the beginning of an administration." Toder was an assistant secretary for tax analysis in the U.S. Treasury Department for several years during the Clinton administration, served in the Office of Research at the Internal Revenue Service and was a tax analyst at the Congressional Budget Office.

"The specific proposals are much more important at the beginning of an administration than at the end," Toder says. "General financial market activity takes time to adjust to policy changes." This happens even with two-term presidents: Ronald Reagan's tax plans in 1981 were entirely different from those of his second term, Toder adds. The same was true for Bill Clinton; middle class tax cuts became more possible in his second term when the economy was robust.

Janet Rothenberg Pack, a Wharton business and public policy professor, finds fault with both candidates' proposals. "McCain's saying he will not reverse the Bush tax cuts is a big mistake -- this economy is in enough trouble, and the budget deficit is really out of control," Pack says. "And the analysis of Obama's tax proposals seems like more of a welfare program."

According to Smetters, "Tax policy should ultimately be about collecting revenue in such a way so as to minimize its effect on economic growth. The tax code has gotten far away from this ... and it's clear that Senator Obama's plans go even farther away from this, as it uses tax credits to encourage a myriad of activities."

But all tax policy is intertwined with social programs, Pack says. For example, any solutions proposed for Social Security and Medicare -- which were formed to be all-inclusive -- will impact taxes directly. "There are so many interlocking [elements at work] here," she states, citing Social Security, pensions that can be revoked or frozen at any time, the availability of employee-sponsored 401(k) retirement funds, and an aging population as some of the issues that have to be factored into long-range taxation policies and income classifications.

The most radical change in taxes proposed by Obama concerns Social Security, Marston suggests. One advisor to the campaign told him the proposal would raise the Social Security tax rate by 4% on all income above $250,000, Marston notes. "An individual in the top tax bracket would pay 39.6% [the permanent tax rate that would prevail starting again in 2011] plus a 2.9% Medicare tax [which has no income limit] plus the 4% Social Security tax. The campaign is vague about when [any new taxes] would be imposed, but it is quite a departure from previous practice."

That's because Social Security was set up as an insurance system, "and every president since FDR has maintained the principle that Social Security taxes are like insurance payments in that they fund your future retirement," Marston says. "It's true that there is substantial redistribution within the system. An individual contributing the maximum amount to Social Security, currently those with an income of about $100,000, earns less Social Security income relative to contributions than an individual contributing with an income of only $30,000."

But anyone earning more than the maximum income "no longer has to contribute extra, because that person will not receive extra benefits as a result of the Social Security taxes," Marston adds. "The Obama proposal is to abandon the principle because it will raise Social Security taxes on higher-income individuals without any change in future benefits. The proposal is clever in exempting most of the middle class. Taxpayers making more than $100,000 would be exempt from extra taxes as long as their income was below $250,000."

The TPC broke down the candidates' proposals and found that both plans would result in cuts for most American families. However, of those in the much-discussed "top tenth of 1%" (incomes of $2.87 million or more), the Center found a difference of almost 16 percentage points: McCain's plan would decrease those top earners' taxes by 4.4%, while Obama's would increase them by 11.5%.

On the bottom of the scale, Obama's tax decreases are larger than McCain's, but for the middle ground of American families (three income categories that range from $66,000 to $227,000), the candidates' proposed tax cuts are similar, ranging from 1.4% to 3%.

Those similarities for the middle to upper-middle class are not very surprising, says Ben Harris, a senior research associate at the Washington, D.C.-based Brookings Institution. "That group tends to have a fair amount of capital gains, which would be lower under McCain than Obama. Obama wants to tax capital gains and dividends at 20% while McCain wants to continue the 15% rate. But then Obama also has a lot of targeted tax provisions that tend to affect this group."

Before the Bush tax cuts, dividends were taxed at the ordinary income tax (for the top bracket) of 39.6%. Capital gains taxes were lowered from 28% to 20% by President Clinton. "Bush then lowered both tax rates to 15% for the top bracket," Marston notes. "The Obama campaign has been a little vague about how much it will raise these two taxes. But they talk of rates between 20% and 28%."

Key Tax Is Unaddressed

Neither candidate will immediately address one of the toughest tax issues -- the Alternative Minimum Tax. The tax, once aimed at the very highest incomes, has gradually come to include some middle-income taxpayers, mostly because of inflation. Congress has been limiting the AMT's reach by enacting temporary "patches," and both presidential candidates propose more such patches until they can come up with a long-term solution.

The AMT is no small source of revenue for the government, Souleles says. "We're talking about on the order of a trillion dollars over 10 years. Both candidates have discussed trying a permanent fix, such as indexing it to inflation, but that would be a very expensive proposition." For starters, it would significantly reduce tax revenues, because millions of taxpayers would no longer be obliged to pay it. That makes cutting taxes, or extending the Bush cuts, even more difficult.

Harris agrees with Souleles' concerns about repealing the AMT -- doing it would be costly, but it should be done. "The problem is that it raises a lot of revenue by placing a fairly high tax burden on upper middle income families who weren't intended to be the target of the tax in the first place," Harris says. The AMT differs from the regular tax code in that it has one big exemption. "After that, it's essentially a flat tax. With the regular tax code, there's a smaller exemption, but the tax rates go up as income goes up. So this big exemption you have with the AMT matters a lot."

Obama's vice presidential running mate, Delaware Sen. Joseph Biden, said during his bid for the White House in late 2007 that he, too, would like to "reform" the AMT. By allowing the Bush tax cuts for the top 1% of earners to expire, he would use the money -- up to $50 billion over five years -- to invest in social and homeland security programs.

"There were 4.1 million taxpayers on the AMT in 2007," Harris says. "If the Bush tax cuts are extended, and the AMT is not patched, this number will jump to 38.8 million in 2012. If the Bush tax cuts are not extended, this number falls to 22.7 million. That is because the Bush tax cuts actually push people onto the AMT, a side effect of the administration's tax policy that is not well-known."

All the more reason to roll them back, Pack says. "It's tough to figure out if these really are solutions for more than a short period of time. Neither [candidate] is giving us a very satisfying set of proposals. The worst thing for McCain is that he would not reverse the tax cuts, even though he initially voted against them. You simply don't go to war and have a tax cut -- that's just unheard of."

Likewise, economists have stated that Obama, since he adopted a policy of keeping some of the Bush tax cuts while eliminating others, leaves a gaping hole in his numbers and undermines fellow Democrats who insist on "pay-as-you-go budgeting," a belief that new policies should be paid for upfront, not loaded on to the national debt.

"Obama has criticized Bush for his fiscal irresponsibility, and now he's using Bush's baseline as a yardstick by which to measure fiscal responsibility," Leonard Burman, co-director of the Tax Policy Center, told The Washington Post in August. "Congress hasn't agreed to extend the Bush tax cuts because they don't have the money to pay for [them]."

Some of Obama's maneuvering on the issue could be interpreted simply as election year politics, since allowing the cuts to expire means raising taxes -- something most candidates are loath to talk about on the stump. However, Souleles says there is a distinction to be made between getting through economic bad times with a short-term stimulus and making a tax cut permanent, or only for another 10 years. "They should be distinct decisions. If your goal really was to get through a recession, you could extend the tax cuts for one or two years. It's about distinguishing short-term motivations from long-term motivations, and thinking explicitly about the merits."

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