Costs of targeting the wealthy

By Brendan Miniter

President Obama's speech this month in Osawatomie, Kan., looked to be his administration's definitive statement on income inequality. Obama called this a "make-or-break" moment for the American middle class. And he made it clear his favored solution for inequality is higher taxes on the rich, calling the current tax rules on top earners "the height of unfairness."

This idea is picking up steam well beyond the Democratic caucus. Even Warren Buffet wants higher rates on the wealthy. In this push, however, tax activists are ignoring an inconvenient truth: A tax system heavily dependent on the wealthy is highly volatile and a breeding ground for bitter budget battles.

Consider three examples.

The first is California. The Golden State has been stumbling for years. We can blame its economic woes on a wide range of things, including environmental regulations, unstable electricity markets, and tax rates that have driven businesses to Colorado, Texas, and elsewhere. But we can also see that its budget deficits are, in large part, due to movement in one category of taxpayers.

From 2007 to 2008, California saw a sharp decline in taxes paid by those with incomes above $200,000 a year. After crunching the numbers, UCLA professors Andrew G. Atkeson and William E. Simon Jr. concluded in January that this decline accounted for "fully 93 percent of the decline in total tax revenues from 2007-08." A collapse in taxes paid by the wealthy put the state into the red.

The second example is New York. A full fifth of the Empire State's revenues come from taxes on financial companies. So the economic collapse of the past few years has led to plummeting revenues and a huge increase in public debt. In June 2007, the 16 highest taxed banks paid $173 million to the New York treasury. A year later, as the country was about to plunge into financial panic, those same firms paid just $5 million in state taxes - a 97 percent decrease.

For all the trouble they have had, at least California and New York have confronted their budget problems in real time - however misguided their tax-rate-raising approach.

Our third example - the federal government - shows us that putting off the day of reckoning doesn't make it easier to solve deficit problems.

According to data from the IRS, between 2007 and 2009, the number of tax filers with reported incomes of $1 million or more decreased from 390,000 to 237,000. As a result, the taxes paid by this group dropped 42 percent - from $309 billion to $178 billion. The dropoff in tax payments gets steeper the higher up the income ladder you go.

In the same period, the number of Americans with incomes of $10 million or more fell by 55 percent - from 18,394 to 8,274 - causing tax revenue from this category to drop by 51 percent. Falling tax revenue from the rich is a huge reason federal revenues are now just 15 percent of GDP, down from 18 percent or more in recent years.

Back in the early 2000s, when public officials thought tax revenues from the wealthy would remain robust, it looked like the feds might actually pay off the national debt. Today, with spending far outstripping revenues, total federal debt has climbed to $15 trillion.

This spike in national debt is precisely the danger of a tax system overly dependent the rich. And it's a very good reason to believe that hiking rates on the "one percent" won't solve our budget problems.

The truth is that the wealthy are unreliable taxpayers because their income is volatile. So a deadlocked supercommittee might have saved us from a Washington deal that would have left us more dependent an unstable tax source - the rich - and thereby has provided us with an opportunity to debate a reliable solution to our debt problems: economic growth.

Instead of seeking to tax the rich, we would do better to curb excessive spending and concentrate on enacting policies, such as tax simplification, aimed at sparking economic growth. With growth, all things are possible. We can lower unemployment, raise living standards, and pay down our national debts. What's more, in a booming economy, we'll also be likely to find that the wealthy are once again paying a bumper crop in taxes.