Are U.S. income tax rates too high or too low? How do we decide?

When I graduated from law school and started practicing tax law in Philadelphia back in 1975, the top rate on both federal income and estate tax was 70%. And there were taxpayers, who actually paid that rate. Fifteen years before that, the top rates were over 90%.

When Ronald Reagan ran for President in 1980, his revolutionary idea was that no taxpayer should have to pay more than 50 cents out of an earned dollar to the federal government as income tax, and no dollar in a decedent’s estate should be subject to federal estate tax of more than 50 cents. Those ideas were achieved in the Economic Recovery Tax Act of 1981.

President Reagan was subsequently able to negotiate the top income tax rate down to 28% in 1986, but only by agreeing to tax capital gains at the same rate. Previously long-term capital gains had been taxed at a preferential rate of about half that on ordinary income. As part of the Tax Reform Act of 1986, many popular deductions were reduced or restricted.

That bi-partisan compromise unraveled under President George H.W. Bush when he broke his “read my lips: no new taxes” promise in an effort to reduce the federal deficit. President Clinton was able to eliminate the federal deficit by raising the top income tax rate to 39.6%.

The so-called “Bush tax cuts” were enacted in the first term of President George W. Bush, and lowered the top tax rate on ordinary income to 35%, and the top rate on most long-term capital gains and dividends from stock to 15%. These were enacted as temporary tax cuts in response first to the bursting of the internet stock bubble, and then to economic fears after the 9/11 terrorist attacks.

Originally scheduled to expire at the end of 2010, they were extended for two more years under President Obama, and are now scheduled to expire at the end of 2012. Unless Congress and the President can agree on a modification, tax rates for all taxpayers will increase in 2013 back to the level in effect under President Clinton when the budget was balanced and the economy was strong.

Why did the Republican Congress which enacted the Bush tax cuts make them temporary instead of permanent? Clearly that Congress concluded that the country could not operate permanently at the low levels of taxation specified by the temporary Bush tax cuts.

So we are headed for a great debate over the appropriate level of taxation, as well as the appropriate level of government spending, over the course of the 2012 election cycle. How do we decide who’s right and who’s wrong on taxes? Do we just go with our gut feelings about taxes? Few of us are anxious to pay more taxes, and all of us can point to something we think our government is doing wrong with our money.

I think we need to recognize and acknowledge that the overall rate of federal income taxation, looking at both ordinary and capital gains income, is currently at historically low rates enacted as temporary measures by Congress, despite now three on-going wars. We also need to acknowledge that the federal deficit, the excess of what the government spends over what it takes in, has grown to unprecedented levels.

Neither political party is proposing enough spending cuts to bring the federal budget into balance, though each claims to have a plan to reduce the size of the deficit. Each year’s deficit adds to the growing national debt.

Something has to be done, and something will be done. 2012 will be our year of decision on taxes.