The New Political Frontier and U.S. Tax Policy

As Germany’s First Chancellor, Otto Von Bismarck, wisely observed, “To retain respect for sausages and laws, one must not watch them in the making.”  That certainly applies  to this historic post-election season as the U.S. heads into unfamiliar territory with three major political forces coming to a head:  the election of more than 100 new Members of Congress   an unsustainable and ever-growing deficit and debt; and an outdated, cumbersome, tax code that even our own Internal Revenue Service struggles to interpret.

Republicans now control the “People’s House” and have eaten into the Democratic majority in the Senate. “Washington, DC isn’t listening to us” isn’t just a Tea Party message but also one of frustrated Democratic progressives.  Many new Members of Congress come in on a wave of anti-spending public sentiment, deeply concerned about unfair taxes on hard work and saving, stifled economic growth and the fiscal nightmare bestowed on the next generation.

The new congress will soon be put to the test in deciding the fate of expiring Bush-era tax cuts, which could very well become a triggering event in 2011 for an historic debate over U.S. tax policy—not simply a reexamination of the level of taxation, but the principles of what we tax in the first place.  Economists agree that the U.S. focus on income tax penalizes saving and investment, economic growth and job creation. It is a system that can no longer sustain the political and economic demands on it such as the American “entitlement” explosion, which is on the same unsustainable path of the European welfare state.  Just like the Soviet Union gradually fell apart because it stopped working, our tax system may soon collapse for the same reasons.

Over three decades I have seen similar political and economic dynamics lead to two monumental shifts in US tax policy.  In 1978, bipartisan lawmakers weary from rising unemployment, a tenuous economy and a high tax/high spending government overturned President Carter’s effort to double the capital gains tax for many taxpayers.  These lawmakers understood that the capital gains tax was not just soaking the rich, but soaking middle class savings and investment as well. It was a shift in tax policy from income distribution to economic growth. It made possible the Economic Recovery Act of 1981, which substantially reduced the taxation of saving and investment and made us competitive with the tax polices of other growing economies.

That pendulum swung back with the Tax Reform Act of 1986, a last-ditch reform effort to “fix” the income tax system by closing loopholes and lowering marginal tax rates.  It failed. The system is now cratering and yet we still rely on it today.

The next chapter in tax policy remains to be written.  The message of November 2 is in the eyes of the beholder.  Yes, it was about job, jobs and jobs.  But it was also about “fairness,” government living beyond its means, reckless spending, the level of taxation and, I suggest, what is being taxed today.  A frustrated voter might say, “I don’t want my hard-earned money, savings for my children’s education and my nest egg taken from me and given to undeserving people or government programs. I’m not asking for special tax goodies, but get rid of loopholes for big corporations, unions or special interests. I’m honest, I want to pay my fair share but the IRS can’t even explain the tax rules to me.”

Will the new congress heed these demands?  Tax policy is a lever that can help reduce our deficit and debt.  It can encourage entrepreneurship, innovation and startups.  It can restore the American dream and make us more competitive in the world economy.

The clock is ticking.  If lawmakers do not act on expiring Bush tax cuts before December 31st, there will be a tremendous tax increase for all Americans.  Savings and investment, specifically on dividends and capital gains, will also be stifled under higher burdensome rates—the last thing one wants in a weak economy.

I predict the tax cuts will be extended for all Americans.  The question now is for how long..   The more provocative question is whether in the new Congress in 2011,  the stars will line up and the fate of the Bush tax cuts will trigger a broader debate on US tax policy as a policy lever to address the people’s concern about “fairness,” economic growth and  our crippling debt and deficit.

Obama is not Carter, 2010 is not 1978 but there are similarities. Just like the unexpected push back to President Carter’s attempt to increase the capital gains tax more than three decades ago set the stage for a fundamental shift in US tax policy, we could have a “replay of ‘78” when the new 112 Congress gathers in 2011.  To paraphrase a recent Economist essay; today damn it, it’s all about growth damn it.

One hopes that the future of the nation’s sausage-like tax code will reflect Winston Churchill’s optimism for its ally, “You can always count on Americans to do the right thing – after they’ve tried everything else.”