How The Income Tax System Really Works...

...Or How Obama's Foolish Tax The Rich Plan Won't

The fiscal cliff standoff pits Barack Obama's social-justice symbolism against a Republican approach that actually would raise money and help close the deficit.

How do you get the rich to pay their "fair share"? The president and his party have an answer for you, assuming that you regard the question as legitimate:

Just raise their marginal tax rates. Instead of telling them to send 35 of the next 100 dollars they make to Uncle Sam, tell them to send, say, 40 or so. They can afford it, and middle-income voters don't have to pay a cent.

Barack Obama has the rules of propaganda on his side here: The simple beats the complex, and social-justice symbolism packs an emotional punch that economics can't match. But the reality is clear: You can jack up rates on the rich all you want, but that doesn't mean you'll get more tax revenue out of them.

History shows this. Top income-tax rates have been very high — up to 94% during World War II — and very low — down to 28% after Ronald Reagan's tax reform of 1986. It's striking how little their movements affect personal income tax revenues.

That revenue has varied, mostly in a range between 6% and 10% of GDP, but its postwar ups and downs show no relation to changes in the top rate.

Revenue sank to a low of 5.7% in 1949 with the top rate at 91%; it reached as high as 10.2% in 2000 with the top rate at 39.6%. Seven years before that, in 1993, it only reached 7.7% with the same top rate. Going back a few more years to 1989, it was 8.3% of GDP at a top rate of only 28%.

The lesson is that income-tax revenues are driven by swings in the economy and stock market. Rates are a political sideshow.

Americans of a certain age can remember when rates were much higher than they are now — the 1950s. Some of them, like Warren Buffett, remember it to be a good time to get rich, despite a 91% top rate.

One fact conveniently ignored about this era, however, was that few Americans paid the top rate or anything close to it. The Tax Code was quite different from the one we've lived with since the 1986 reform. It was full of perfectly legal dodges for those who could hire a decent tax adviser.

Until 1986, for instance, you could write off paper depreciation losses in real-estate holdings you didn't actually manage — so-called "passive losses" — against ordinary income. Interest of any kind, not just mortgages, was an itemized deduction.

Paying taxes was as much a game as a chore, with the government giving you lots of ways to make it profitable.

It was a great system for sellers of tax shelters, but not for the economy in general. It stifled growth by warping decisions on investment and spending, luring people to put their money into products or investments that made little economic sense.

The insight of tax reformers — whose work started in the 1980s and still isn't finished — was that cutting rates and closing loopholes would free the economy from Tax Code distortions.

Ultimately it's a matter of mindshare. The less you think about how much you'll be taxed on what you make, the more you'll focus on making money rather than, say, booking paper losses.

When people work and invest in this way, they put their money and effort where they'll get the highest return. The economy grows, and the government gets the revenue it needs.

Right now, to judge from news reports, the GOP offers to raise some $800 billion over 10 years by trimming deductions but not raising marginal rates. Obama wants to raise rates and says he can get $1.6 trillion that way.

It's only a guess, but to judge from the history of the income tax, we'd say the Republican plan is more likely than Obama's to meet its goal.

In fact, we doubt that Obama's plan could even meet the Republicans' goal. It's a little complicated to explain, but this is how an economy actually works.

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