The Great Tax Shift
The president says his cuts
are simply a way of "giving people their money back."
But the bill will come due one way or another-and lower- and middle-class
households will foot it.
by William G. Gale and Peter
The American Prospect magazine,
The Bush Administration claims that the
guiding principle for its fiscal policy has been "lower income
taxes for all, with the greatest help for those most in need,"
as the White House Web site puts it. The reality is starkly different.
The tax cuts enacted during George W. Bush's presidency shift
the burden of taxation away from upper-income, capital-owning
households and toward the wage-earning households of the lower
and middle classes. For all but the wealthy, this will ultimately
cause substantial harm. Shifting costs to future generations of
workers to finance tax boons for today's owners of capital is
unproductive, unfair, and unwise.
The Bush administration presided over
two major tax cuts, in 2001 and 2003, along with a smaller one
in 2002. Those cuts officially were going to cost the federal
government $1.7 trillion between 2001 and 2014, and to add nearly
$1 trillion in higher payments on the national debt over that
period. That may sound like a lot, but in fact the official estimates
are low, artificially held down by gimmicks, including the ostensible
sunsets of all the tax cuts in 2O10 or before. At least under
the administration's plans, these tax cuts would continue beyond
their official expiration dates. If they are extended, they would
reduce revenue by $3.6 trillion between 2001 and 2014 and cost
a whopping $4.8 trillion when the additional debt service is included.
Without a doubt, and despite White House
rhetoric to the contrary, the direct effect of the tax cuts is
to widen after-tax income inequality. If the tax cuts are extended
into 2011, after-tax incomes will increase by more than 9 percent
for households in the top 1 percent of the income distribution
in that year, by between 2 percent and 3 percent for households
in the middle 60 percent, and by only 0.1 percent for households
in the bottom 20 percent.
Most of the cost from the tax cuts reflects
highly regressive measures, including lower marginal tax rates
for high income households, reduced taxation on capital gains
and dividends, and elimination of the estate tax. These components
provide extremely large benefits to a very small number of households,
but they generate little if any benefit for most families. For
most of the population, wages and salaries represent the vast
majority of income. Capital income is much more significant the
more income one makes. The top 1 percent of the population earns
about one-tenth of the total wage and salary income but almost
half of all the capital income. Shifting away from a tax on all
income and toward a tax on just wages thus moves the tax burden
on to lower earning workers.
That means that the administration's claim-that
the cuts are progressive because high-income households will pay
a higher share of the income tax after the changes than before-is
misleading. It's true that high-income households will pay a higher
share of the income tax, at least in the short run. But changes
in tax shares are not an accurate way of measuring progressivity.
If we reduced everyone's income tax by 99.9 percent, for example,
the shares of income taxes paid would remain constant-but the
net result would be highly regressive.
Furthermore, the administration's argument
conveniently omits the estate tax (which is progressive and is
slated to be eliminated), the corporate tax (which is progressive
and was reduced in the tax cuts), and the payroll tax (which is
regressive and was not cut). When all federal taxes are considered,
the share paid by high-income households will decrease significantly
because of the tax cuts.
So how did the White House manage to convince
the public that Bush's tax cuts were in fact good for the middle
class? The cuts did have some provisions that were designed to
help the middle class, including a new 10-percent bracket (which
means that all households, including low and middle-income ones,
pay a l0-percent rate rather than a 15-percent one on their first
dollars of taxable income- $7,000 in taxable income for singles
and $14,000 for married couples); an expanded child credit; and
tax cuts for married couples. Yet these provisions account for
about one-third of the revenue loss from the tax cuts as a whole
over a 10-year period.
In other words, the middle-class elements
of the tax cuts were just a remarkably successful marketing ploy.
They allowed proponents to extol the benefits for carefully selected
Americans, disguising the much more regressive and expensive components
and confusing the debate.
The ultimate effect of the tax cuts depends
in part on how they are eventually financed. There are two options:
reductions in other government programs and increases in other
taxes. Borrowing indefinitely, the strategy preferred by many
policy-makers, is not a long-term solution. That's because the
longer policy-makers wait to pay for the tax cuts-or to give up
on the exercise and simply cancel them-the more harm is imposed
on the future economy from intervening budget deficits and the
more the nation risks a full-blown fiscal crisis.
That danger exists because the deficit-financed
tax cuts are, overall, harmful to the country's economic growth.
Tax cuts themselves can have a positive direct effect on the economy;
for example, they can reduce marginal tax rates and encourage
people to work or save more. But tax cuts also increase the budget
deficit, which has an adverse effect on economic growth over the
long term because it reduces national savings, one of the key
determinants of long-term productivity. Given the structure of
the 2001 and 2003 tax cuts, various studies suggest that the net
effect of these cuts is likely to be negative in the long run.
In addition to the losses from reduced
economic growth, many families may suffer from increased interest
rates on mortgages, car loans, and credit cards, rates that go
up because higher budget deficits compete for the funds available
for such lending. Conventional estimates suggest that the deficits
associated with the Bush tax cuts could eventually raise long-term
interest rates by between 0.5 percent and 1.5 percent, which would
raise the annual payment on a $150,000 mortgage by between $500
and $2,000. Households that are net borrowers, which are more
likely to have modest incomes, suffer from the increase in interest
rates. Households that are net lenders, which tend to be higher
income, can benefit.
Ultimately, though, continuing to finance
the tax cuts by running up the budget deficit will be unsustainable
because even the federal government can't borrow an unlimited
amount. In the face of ongoing substantial deficits, financial
markets will eventually grow worried about whether the government
will be able to repay the borrowed funds. To avoid a fiscal crisis,
a permanent tax cut has to be financed either with lower spending
or higher revenues from other sources. Both options have problems.
Paying for the full tax cuts in 2014 by reducing government spending
would be catastrophic, both substantively and politically: It
would require a 48-percent cut in Social Security benefits, complete
elimination of the federal part of Medicaid, or an 80-percent
cut in all domestic discretionary spending (such as for environmental
protection, education, and health research). The overall effect
would be more harmful to lower- and middle-class Americans, who
depend on those programs, than the direct effect of the tax cuts
themselves. Alternatively, the tax cuts could be financed by a
34-percent increase in payroll taxes or by more than doubling
the tax on corporations.
If the Bush White House hadn't been ideologically
driven toward high-end tax cuts, it might have taken some important
steps with the money instead. Rather than cutting taxes primarily
for wealthy families, we could have financed substantial aid to
the states, which would have obviated the need for recession-driven
tuition increases and spending cutbacks. We could have invested
heavily in children, for example, by fully funding Head Start.
We could have provided more progressive tax cuts. Or we could
have done all three-and still had money left over to reduce the
We also could have averted the coming
crisis in Social Security. Over the next 75 years, the tax cuts
will cost about three times the projected 75-year actuarial deficit
in Social Security. |As a result, even if we had not enacted only
the most regressive components of the tax cuts, we would have
had more than enough revenue to eliminate the entire Social Security
deficit for the next 75 years. That wouldn't necessarily be the
best course, given the competing needs for revenue, but it does
dramatically illustrate the lost opportunities. It also underscores
why Alan Greenspan's proposal to pay for the tax cuts with reduced
Social Security benefits will never add up: Have you ever tried
to save $3 from $1?
The president likes to portray his tax
cuts as painless and simply "giving people their money back."
Tens of millions of people, however, gain little from the tax
cuts-and will eventually be hurt by the costs imposed on the budget
and the economy.
For now, too many policy-makers are pretending
that the tax cuts represent that ever-elusive free lunch. The
reality is that the bill from the tax cuts will come due one way
or another. And almost any way it plays out-other than simply
repealing the tax cuts or allowing them to expire as officially
scheduled-the vast majority of Americans will pay.
WILLIAM G. GALE is the Arjay and Frances
Fearing Miller Chair in Federal Economic Policy at the Brookings
Institution and co-director of the Tax Policy Center. PETER R.
ORSZAG is the Joseph A. Pechman Senior Fellow at Brookings and
co-director of the Tax Policy Center.