Higher Tax REVENUE is Not the Same as Higher TAXES

One point I'd like to recommend to McCain, and I wish that he'd used it last night -- is that a distinction can and needs be made between higher tax revenue and higher tax rates.

When John McCain says he wants to cut taxes, it rings hollow in the minds of undecided voters who realize that deficits are too high and that government has to do SOMETHING to reduce the delta.

McCain's theory, implicitly, is that cutting tax rates strengthens the economy, and the economy in turn grows, which in turn creates a net INCREASE in tax revenue/income. But McCain (unlike, say, Ronald Reagan) never makes that argument expressly -- and so it 'sounds' like he's merely pandering when he says that he'll cut taxes AND balance the budget.

Obama, on the other hand, thinks that raising taxes will raise tax revenue. That's intuitive but wrong. It reduces investment and reduces the economy's ability to produce new wealth, it increases government control over the economy, all of which leads to higher deficits. And all of that makes the NEXT big disaster -- the unfunded Social Security trust fund - more inevitable.

McCain had a chance to explain this last night to the American people. Too bad he wasn't up to the task.

Originally published in the WALL STREET JOURNAL

Monday, December 6, 1999

His opponents attack the plan. But Governor Bush puts the focus where it ought to be
- on cutting marginal rates.

Bush’s Tax Plan Makes Sense

Martin Feldstein

George W. Bush’s opponents took turns attacking his tax-reform proposal during last week’s New Hampshire debate. But Mr. Bush’s plan is a good one. Because it emphasizes cutting marginal tax rates, it would significantly improve the economy’s performance as well as increase after-tax incomes. And it’s not just the rich who would benefit.

High marginal tax rates are not reserved for those with high incomes. An unmarried taxpayer who earns $35,000 a year can face a marginal tax rate of more than 50%. An extra $100 of earnings means an extra $28 of personal income tax, $15 of employee-employer payroll tax, plus state income taxes that can take the total to over $50.

Because this marginal tax rate cuts in half the reward for extra personal productivity, it discourages the pursuit of skill-enhancing education and of on-the-job training. And why make extra effort or work longer hours or take additional responsibilities or assume increased risks if the government is going to take half the extra reward?

Marginal rates can be higher still for low-income families. A family of four with $25,000 of income faces an effective marginal tax rate of about 60% as a result of federal income and payroll taxes that total 30%, the loss of federal cash welfare benefits (the earned-income tax credit) at a rate of 21 cents for every extra dollar of earnings, state taxes and the loss of food stamps, housing subsidies and other benefits as income rises. A fiscal system in which the government takes nearly two-thirds of any extra income is a poverty trap. It is also a powerful temptation to shift to the underground economy, where work is often less productive and less well paid but more attractive because it is untaxed.

The Bush proposal to double the child credit would totally eliminate the income tax for millions of such low-income families, reducing their marginal tax rate by 15 percentage points. Reinstating the Reagan second-earner rule—a 1/10th reduction in the tax on the first $30,000 of wages earned by the married partner with the lower earnings—would further reduce the adverse effect of marginal tax rates on low- and moderate-income families.

The Bush emphasis on reducing marginal tax rates stands in sharp contrast to Al Gore’s defense of the status quo and Bill Bradley’s proposal for a health-insurance subsidy that would be phased out as income rises—which amounts to an increase in marginal rates on low- and middle-income people of 20 percentage points.

Like the Bradley proposal, the increased marginal tax rate that results from phasing out the earned income credit is just one example of the high marginal rates that are a byproduct of almost all government transfer programs. The Social Security earnings test reduces benefits by 33 cents for every extra dollar earned above a threshold amount by Social Security recipients in their 60s. Combining that with the income and payroll tax rates and with the state income and sales taxes produces a marginal tax rate for this group of more than 80%. It’s not surprising that many elderly people who would prefer to work choose instead to retire early. The Bush proposal to end the Social Security earnings test would cut their marginal tax rates by 33 percentage points.

When the resulting loss of individual productivity and individual income is added up over the 100 million taxpayers whose behavior is distorted by high marginal tax rates, the loss in national income is billions of dollars per year. And by discouraging saving and entrepreneurship, the high marginal tax rates lower our nation’s long-term rate of innovation and growth.

High marginal rates also waste income by distorting the form of compensation individuals and their employers choose. Instead of taking cash and spending it on what they want, employees are encouraged by the tax law to favor untaxed fringe benefits and other workplace amenities. If an individual faces a 45% marginal tax rate, he is better off if his employer spends a dollar providing fringe benefits that are only worth 60 cents to him rather than having the employer give him the dollar as taxable wages of which he sees only 55 cents. And for taxpayers who itemize their deductions, high marginal tax rates compound the distortion by encouraging spending on tax-deductible things like mortgage interest.

Taxes that induce individuals to produce less and to spend on things they value less cause a loss of real income that economists call the excess burden of the tax. My own research shows that every dollar of tax reduction that results from an across-the-board cut in income tax rates would also cause an additional benefit by reducing this burden by between 50 cents and $1.

It is strange, therefore, that much of the public debate is about “how much the tax cut costs.” From the nation’s point of view, cutting taxes produces a gain, not a cost. Instead of talking about the cost of the tax cut, it would make more sense to say that a reduction in tax revenue of $100 billion a year raises real national income by $50 billion to $100 billion, in addition to allowing taxpayers to keep $100 billion more of their money.

The revenue effect of specific tax changes is of course important if we are to avoid a return to budget deficits. Any sensible estimate of the effect of tax rate reductions on government revenue would take into account their favorable impact on work effort, skill development, risk-taking and other factors that increase taxable income. But the strange rules adopted by Washington’s official revenue estimators ignore these favorable effects, making tax-rate cuts look more expensive than they turn out to be in practice. I estimate that such favorable feedback effects would offset about one-third of the traditionally estimated revenue loss from cutting the top tax rate to 33% from 39.6% as Mr. Bush proposes. The governor nevertheless opted to use the traditional scorekeeping rules in order to avoid any challenges to his claim that the tax cut fits responsibly within the available budget surpluses.

The tax cuts of the 1980s provided a strong stimulus to individual initiative and economic growth. In the 1990s marginal tax rates rose sharply, and the percentage of income taken by the income tax jumped. Now we are at a point of national choice. The projected long-term budget surpluses present a remarkable opportunity to reduce marginal tax rates once again and to do so without creating budget deficits. It is an opportunity that should not be missed.

By Martin Feldstein, former chairman of President Reagan’s Council of Economic Advisers. He is a professor of economics at Harvard and an adviser to the Bush campaign

The Reagan Tax Cuts: Lessons for Tax Reform

During the summer of 1981 the central focus of policy debate was on the Economic Recovery Tax Act (ERTA) of 1981, the Reagan tax cuts. The core of this proposal was a version of the Kemp-Roth bill providing a 25 percent across-the-board cut in personal marginal tax rates. By reducing marginal tax rates and improving economic incentives, ERTA would increase the flow of resources into production, boosting economic growth. Opponents used static revenue projections to argue that ERTA would be a giveaway to the rich because their tax payments would fall.

The criticism that the tax payments of the rich would fall under ERTA was based on a static conception of human behavior. As a 1982 JEC study pointed out,[1] similar across-the-board tax cuts had been implemented in the 1920s as the Mellon tax cuts, and in the 1960s as the Kennedy tax cuts. In both cases the reduction of high marginal tax rates actually increased tax payments by “the rich,” also increasing their share of total individual income taxes paid. Unfortunately, estimates of ERTA by the Democrat-controlled CBO continued to show falling tax payment by upper income taxpayers, even after actual IRS data had become available showing a surge of income tax payments by affluent taxpayers.

Given the current interest in tax reform and tax relief, a review of the effects of the Reagan tax cuts on taxpayer behavior and tax burden provides useful information. During the 1980s ERTA had reduced personal tax rates by about 25 percent, while the Tax Reform Act of 1986 chopped them yet again.

Tax Rates and Tax Revenues

High marginal tax rates discourage work effort, saving, and investment, and promote tax avoidance and tax evasion. A reduction in high marginal tax rates would boost long term economic growth, and reduce the attractiveness of tax shelters and other forms of tax avoidance. The economic benefits of ERTA were summarized by President Clinton’s Council of Economic Advisers in 1994: “It is undeniable that the sharp reduction in taxes in the early 1980s was a strong impetus to economic growth.” Unfortunately, the Council could not bring itself to acknowledge the counterproductive effects high marginal tax rates can have upon taxpayer behavior and tax avoidance activities.

Since 1984 the JEC has provided factual information about the impact of the tax cuts of the 1980s. For example, for many years the JEC has published IRS data on federal tax payments of the top 1 percent, top 5 percent, top 10 percent, and other taxpayers. These data show that after the high marginal tax rates of 1981 were cut, tax payments and the share of the tax burden borne by the top 1 percent climbed sharply. For example, in 1981 the top 1 percent paid 17.6 percent of all personal income taxes, but by 1988 their share had jumped to 27.5 percent, a 10 percentage point increase. The graph below illustrates changes in the tax burden during this period.

The share of the income tax burden borne by the top 10 percent of taxpayers increased from 48.0 percent in 1981 to 57.2 percent in 1988. Meanwhile, the share of income taxes paid by the bottom 50 percent of taxpayers dropped from 7.5 percent in 1981 to 5.7 percent in 1988.

A middle class of taxpayers can be defined as those between the 50th percentile and the 95th percentile (those earning between $18,367 and $72,735 in 1988). Between 1981 and 1988, the income tax burden of the middle class declined from 57.5 percent in 1981 to 48.7 percent in 1988. This 8.8 percentage point decline in middle class tax burden is entirely accounted for by the increase borne by the top one percent.

Several conclusions follow from these data. First of all, reduction in high marginal tax rates can induce taxpayers to lessen their reliance on tax shelters and tax avoidance, and expose more of their income to taxation. The result in this case was a 51 percent increase in real tax payments by the top one percent. Meanwhile, the tax rate reduction reduced the tax payments of middle class and poor taxpayers. The net effect was a marked shift in the tax burden toward the top 1 percent amounting to about 10 percentage points. Lower top marginal tax rates had encouraged these taxpayers to generate more taxable income.

The 1993 Clinton tax increase appears to having the opposite effect on the willingness of wealthy taxpayers to expose income to taxation. According to IRS data, the income generated by the top one percent of income earners actually declined in 1993. This decline is especially significant since the retroactivity of the Clinton tax increase in that year limited the ability of taxpayers to deploy tax avoidance strategies, temporarily resulting in an increase in their tax burden. Moreover, according to the FY 1997 Clinton budget submission, individual income tax revenues as a share of GDP will be lower during the first four years of the Clinton tax increase, which include the effects of the 1990 tax increase, than under the last four years of the Reagan tax changes (FY 1986-89). Furthermore, according to a study published by the National Bureau for Economic Research,[2] the Clinton tax hike is failing to collect over 40 percent of the projected revenue increases.

Incidentally, the claim that unrealistic supply side Reagan Administration revenue projections caused large budget deficits during the 1980s is false. Nonetheless, this false allegation is often used against current tax reform proposals. The official Reagan revenue projections immediately following enactment of ERTA did not assume huge revenue increases, and were actually quite close to the CBO revenue projections. Even the Democrat-controlled CBO projected that deficits would fall after the enactment of the Reagan tax cuts. The real problem was a recession that neither CBO nor OMB could foresee. Even so, individual income tax revenues rose from $244 billion in 1980 to $446 billion in 1989.

Conclusion

The Reagan tax cuts, like similar measures enacted in the 1920s and 1960s, showed that reducing excessive tax rates stimulates growth, reduces tax avoidance, and can increase the amount and share of tax payments generated by the rich. High top tax rates can induce counterproductive behavior and suppress revenues, factors that are usually missed or understated in government static revenue analysis. Furthermore, the key assumption of static revenue analysis that economic growth is not affected by tax changes is disproved by the experience of previous tax reduction programs. There is little reason to expect static revenue analysis to evaluate the economic or distributional effects of current tax reform proposals much better than it evaluated the Reagan tax program 15 years ago.

Christopher Frenze
Chief Economist to the Vice-Chairman

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