Tax hikes for the rich: Can the economy afford them?

NEW YORK (CNNMoney.com) -- Would making the rich pay higher taxes next year hurt the economy?

That question underlines one of the trickiest fiscal questions facing Washington policymakers: What to do about the 2001 and 2003 Bush tax cuts, which are set to expire at the end of the year.

President Obama wants to let the cuts lapse for joint tax filers who make at least $250,000 ($200,000 for individuals) but extend them for everyone else. That means the top two tax rates would revert to where they were in the late 1990s: The 35% rate would go to 39.6% and the 33% rate would go to 36%.

The highest-income filers would also see their tax rates on capital gains and dividends go up. And, if they're in line for an inheritance, they will see the reinstatement of the estate tax, although Obama's proposed estate tax is a less onerous version than the one scheduled to be in place under current law.

The debate over what Congress should do, which has been playing out for months in policy circles, is now receiving more prominent attention.

The stakes are high: On the one hand, there are fresh concerns that the economic recovery might be faltering; higher taxes on the rich could dampen spending and investment. At the same time, the nation's fiscal hole is deep, and the tax cuts cost the federal coffers badly needed revenue.

The deficit concerns were amplified last week by former Federal Reserve Chairman Alan Greenspan. Once a big supporter of the tax cuts, he now believes they should be allowed to expire not only for the rich but for everyone. He said the cost of extending them -- which could run as high as $3 trillion over 10 years -- will make the economy worse by adding to U.S. debt.

But few policymakers are talking about phasing out the tax cuts entirely. The debate is more focused on Obama's proposal to eliminate the cuts for high-earners.

And doing so won't harm the economy, says Treasury Secretary Timothy Geithner and many Democrats in Congress.

"What we're allowing to expire is the tax cuts that President Bush put in place for the most fortunate, the richest 2 to 3 percent of Americans," Geithner said last week on Charlie Rose. "And we think letting those expire is a prudent, sensible act because it allows us to make a contribution now to starting to reduce our long-term deficits."

Geithner added: "We don't want to solve those future deficit problems by raising the relative burden on working Americans, middle-class families."

Both Geithner and tax expert William Gale, co-director of the Tax Policy Center, note that the late 1990s were marked by a strong economy even though the top two rates at the time were 36% and 39.6%.

"If anything that shows that raising even the top rate is not utterly anathema to economic growth," Gale said at a Brookings Institution seminar last week.

On the other side are many Republicans -- and even a few Democrats on Capitol Hill -- who are concerned that higher taxes on the wealthiest Americans would hurt the economy at the present time.

Senate Budget Chairman Kent Conrad, D-N.D., who is a fierce deficit hawk, nevertheless allowed last week that he would be reluctant to let anyone's tax cuts expire just yet.

"In a perfect world, I would not be cutting spending or raising taxes for the next 18 months to two years" Conrad told reporters. "This downturn is still very much with us unfortunately."

Since households and governments are tapped out, nothing should be allowed to impede the chances for business spending, which is the best hope for generating future economic growth, according to Douglas Holtz-Eakin, a former Congressional Budget Office director who now runs a Republican think tank.

Holtz-Eakin believes that imposing higher taxes on those in the upper-income brackets would be bad for many job-creating small businesses, which often pay taxes under the individual income tax code.

He calculates that an increase in the top rate could reduce small business hiring by 18%.

Not everyone thinks small business would get hit so hard, however.

Tax expert Len Burman says that only 3% of small businesses are subject to the top two individual tax rates. He also notes that much of the income from those businesses comes from private partnerships such as law and accounting firms and investment firms, and not from traditional mom-and-pop ventures.

One option to mitigate the impact of allowing the top tax rates to go up: Phase in the increases over a few years.

"Allowing the tax cuts to expire for high-income filers all at once next year would be taking too large a risk with the fragile recovery," said economist Mark Zandi, who has served as a consultant to members of both parties. "At the very least, the tax increases for these groups should be phased in over two years -- half in 2011, the other half in 2012."