Still smarting from their defeat in the 1995 budget battles with President Bill Clinton, congressional Republicans entered the 105th Congress in January 1997 determined to avoid another such confrontation. Having retained control of Congress in the 1996 elections, they hoped to make a deal with the president to both cut taxes and achieve their goal of a balanced federal budget in 2002. In May 1997, Republican congressional leaders signed off on a budget agreement negotiated with the Clinton administration. The agreement broadly outlined the features to be included in budget legislation, providing for a net tax cut of $85 billion between 1998 and 2002.¹ Gross revenues would be cut by $135 billion, offset by $50 billion in revenue increases, most of it ($33 billion between 1997 and 2002) from an extension of the airline ticket tax.

A major factor allowing the agreement was the Congressional Budget Office (CBO) decision to sharply revise upward its estimate of the federal government's future income absent any budget deal. In a May 2, 1997, letter to the chairmen of the House and Senate Budget Committees, CBO Director June O'Neill estimated that revenues for 1997 would be $45 billion higher than the CBO had forecast in January. (The CBO never explained the exact source of the additional revenue.) Dr. O'Neill also said revenues would be higher by "similar amounts" in the years 1998 through 2002.² Both Congress and the White House took this to mean that projected deficits would be lower by $225 billion between 1998 and 2002. This anticipated revenue "windfall," gained by multiplying $45 billion by five years, made the budget deal possible. ³

Significantly, the details of the tax legislation were not spelled out in the budget agreement. But Republicans received the cuts in capital gains and estate tax rates they wanted, along with a $500 per child tax credit. President Clinton came away with a commitment reserving $35 billion for education tax initiatives. Both sides agreed to extend the Airport and Highway Trust Fund excise taxes, due to expire on September 30, 1997. Beyond these specifics, the chairmen of the tax-writing committees, Bill Roth (R-Del.) of the Senate Finance Committee and Bill Archer (R-Texas) of the House Ways and Means Committee, reserved the right to draft their own bills.

The lack of clear understanding about key details led to considerable wrangling between the White House and congressional tax-writers throughout the summer of 1997. The Clinton administration and congressional Republicans had sharp differences of opinion and so did the Senate Finance Committee and the House Ways and Means Committee. Eventually, however, the details were worked out. The Taxpayer Relief Act of 1997 was approved by overwhelming majorities in both the House and Senate. President Clinton signed it into law on August 5. ⁴

A CBO report after passage concluded that on balance the deal reduces the budget deficit. However, its impact is far more modest than its supporters would have us believe. The economy rather than the budget deal deserves most of the credit for reducing the deficit. As Figure I shows, revised economic assumptions and technical adjustments would have reduced the deficit in 2002 to just $63 billion if there had been no budget deal at all. Indeed, the budget deal actually increases the deficit by more than $20 billion in 1998.

It is not entirely clear where the idea for the child credit originated, and there is no economic rationale for it. Conservative groups had complained for several years about the "anti-family bias" in the tax code. However, this concern mainly centered on the erosion of the real value of the personal exemption. ⁵ Unlike a tax credit, the personal exemption - which may be taken for each dependent - reduces taxable income by the amount of the exemption, rather than directly reducing one's tax liability. The value of the dependent personal exemption has declined in real terms by more than one-third over the last 50 years. ⁶

In 1991 the National Commission on Children proposed a $1,000 refundable tax credit for all children. ⁷ This was intended as a modified negative income tax that would replace other parts of the tax and welfare systems. Economists Eugene Steuerle and Jason Juffras, authors of the $1,000 credit proposal, explained its need as follows: ⁸

• Households with children have borne more than their share of tax increases in the past decade.
  
• Children with equal needs do not receive equal treatment in the welfare system, violating a basic principle of fairness.
  
• The welfare and tax systems together create strong disincentives for low-income parents to work, marry or move to find a job.

Shortly thereafter, conservatives began turning away from personal exemption increases, adopting the tax credit approach instead. ⁹ Subsequently, the tax credit became a top legislative priority for Christian and pro-family groups that are important to the Republican Party. These groups saw the child credit as a means of allowing working mothers and fathers to spend less time at work and more time with their children. ¹⁰ Eventually, congressional Republicans officially adopted a $500 child credit as part of their "Contract With America."

When Republicans took control of Congress, enactment of the child credit became a high priority. On March 21, 1995, early in the 104th Congress, the House Ways and Means Committee reported a bill embodying provisions of the contract. The child credit provision would have allowed a $500 credit for taxpayers with incomes up to $200,000.

It is still not clear why the child credit, rather than an increase in the personal exemption, became official Republican tax policy. In previous years, Republicans had opposed tax credits on principle in favor of deductions and exemptions.

Tax exemptions and tax credits have very different effects; the value of the former depends on marginal tax rates, while the value of the latter does not. When one receives an exemption, taxable income is reduced by that amount. Thus the tax saving is a function of one's marginal tax rate - and the higher the marginal tax rate, the greater the value of the exemption. In the case of a tax credit, taxable income is unchanged but one's tax liability is reduced by the amount of the credit. Marginal tax rates do not affect its value.

Furthermore, for taxpayers at the income threshold for a higher tax bracket, an exemption or deduction might result in a lower marginal tax rate by reducing taxable income below the threshold, but a tax credit will not. The tax credit is phased out for higher-income taxpayers, in a way that increases marginal tax rates for single taxpayers with AGIs above $75,000 and joint-filers earning more than $110,000.

The child credit was sold primarily as an issue of social policy. Its primary economic effect was to use up three-fifths of all the revenue allocated for the entire tax package, which foreclosed the possibility of other broad-based tax cuts in 1997.