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Can we Balance the Budget by Taxing the Rich?

144,000 people in the State of California pay half of all of the income taxes collected in a state with 38M people. That is a startling statistic. .37% of the population paying 50% of income taxes. And income taxes are almost half of California’s revenue.  Underlying that statistic is the unspoken “problem” which is behind the California budget deficit (besides out of control spending of course).

That same unspoken “problem” has also not been honestly discussed on Capital Hill where we hear of all of the policies to add surtaxes of up to 5% to the “rich” (and you are rich if your family makes more than $250,000) to pay for healthcare. To extend the 1.45% medicare tax to capital gains. To pay for the trillion dollar over ten years energy tax hidden in the Waxman bill. To roll back the Bush tax cuts. To increase the capital gains rate.

What is that vexing “problem?” Simply put – the rich make most of their income through their investments. Not through their salaries. And while salary income may be somewhat predictable, investment income is not at all predictable. In fact it is quite volatile.

Investment income depends on a rising stock market. A rising real estate market. True appreciation in every variety of asset classes. So raising tax rates on the “rich” won’t solve the deficit problem, at the State or the Federal level, unless the economy improves fundamentally and real asset values begin to rise again.

California has one of the worst current deficit problems. Ignoring the self-inflicted spending wounds by California’s elected officials, the current problem is a precipitous drop in tax revenue. Why? A stock market collapse in 2008. A real estate market collapse. Very little investment income. Very little capital gains. California built up its bloated budget riding the wave of entrepreneurial wealth creation in the 1990s. Yet the NASDAQ collapse in 2000 didn’t slow the state’s spending binge. As a result, for the last 10 years California has struggled to balance the budget. The capital gains taxes just were not there.

So why do we think, at the Federal level, that new higher tax rates on the “rich” will solve all of our budget woes? They won’t. The only way out of the deficit mess on the revenue side (and of course there are many ways to cut costs as well) is to grow our economy. To re-invigorate the IPO market. To provide a business framework where american companies can compete globally and as a result help to revive the stock market. Only then will we be able to see rising tax receipts at the state or federal level. To think that higher tax rates on a few (less than 1% of the population) will solve all of America’s ills is fools gold.

I worry that our economy will be de-leveraging its debt binge for quite some time. Perhaps 3-5 years or beyond. If this is the case, given that consumer spending accounts for 70% of our GDP, we are likely to see less than stellar stock market numbers, poor appreciation in home values, and continued tax receipts that come short of expectations.