The Case For An Across The Board Tax Rate Reduction

Policy Backgrounders | Taxes

No. 140
Wednesday, September 25, 1996
by Bruce Bartlett

Reasons for a Tax Rate Cut

Figure III - Average Weekly Hours Worked%2C All Private-Sector Workers

"Historically, tax levels even close to these have triggered major tax cuts."

Historically, tax levels even close to these have triggered major tax cuts. Now Republican presidential candidate Bob Dole has proposed an across-the-board reduction of 15 percent in the individual income tax, as well as a cut in the capital gains tax from 28 percent to 14 percent. The purpose, Dole said, is to "repeal the Clinton tax hike on the middle class" and to "return total taxes to where they were when Ronald Reagan left office."

Although President Clinton proclaimed in his State of the Union address that the nation's economy is in the best condition in the last 30 years, overall economic growth has in fact been weak. Further, incomes today, whether measured by weekly earnings or by median family income, are lower than they were in the 1980s.

Stimulating the Economy. The main goal of the Dole economic plan is to increase the anemic rate of growth of the U.S. economy. From the fourth quarter of 1992 through the second quarter of 1996, real GDP has increased by an average of just 2.4 percent per year. Even the growth rate for 1996, now estimated to reach 2.6 percent to 3 percent, is still well below the economy's historic growth rate of 3.1 percent.

Dole has not released estimates of what effect his plan - which also includes cutting the capital gains tax rate in half - would have on economic growth. However, based on the published revenue estimates, the Tax Foundation has estimated that the impact of the plan would be an increase in GDP of 0.1 percent the first year, rising to 0.8 percent in the third year as the tax cut is phased in, and then falling to 0.3 percent in the sixth year.3

Some critics have attacked as implausible the very idea that growth can be raised at all. For example, an article in the August 12 issue of the New Yorker maintained that the economy cannot grow more than 2.5 percent per year without reigniting inflation. Faster growth, the article said, would lower unemployment, and with the economy already at full employment, the added demand for labor would only increase wages and prices.4

"We are nowhere near full employment, even with an August unemployment rate of 5.1 percent."

This analysis is faulty on several counts. First, we are nowhere near full employment, even with an August unemployment rate of 5.1 percent. In recent years, some economists have insisted that the "natural" rate of unemployment is 6 percent, and that a drop below that rate will trigger inflation. Historically, however, 4 percent unemployment has been considered "full employment" and in the 1950s this rate was achieved without inflation.

Figure IV - Real Median Family Income

Second, the unemployment rate does not fully take into account part-time workers who would prefer to work full-time, and it does not count those who have given up hope of finding a job. In July, according to the Bureau of Labor Statistics, there were 9.6 million people in the two categories.

  • 4.4 million held part-time jobs due to lack of full-time work.
  • 5.2 million had dropped out of the labor force altogether.

Further, there is vast room for expansion of the labor supply through increased hours. As Figure III illustrates, average weekly hours for all private-sector workers have fallen sharply over the last 30 years. This is partly due to the rise of part-time employment, but also due to fewer work hours for those nominally employed full-time. In July, for example, 9.7 million full-time employees worked fewer than 35 hours per week.

In short, there is good reason to believe that the labor supply could easily expand enough to raise the growth rate well above current levels.

Increasing Incomes. The Clinton administration maintains that a 2.2 percent growth rate is the best we can do at present.5 Further, it says that with unemployment now in the low 5 percent range, any increase in growth would push up wages and thus trigger inflation and an increase in interest rates by the Federal Reserve.

"Incomes today are lower than they were in the 1980s."

It is true that faster growth would raise wages. But in 1995, according to the Bureau of Labor Statistics:

  • Real average weekly wages were just 75 cents higher than in 1992.
  • Real average earnings were $255.29 per week, or 5.5 percent lower than during the Reagan administration, when they averaged more than $270 per week.

Declining real wages, in turn, have led to a decline in living standards. According to the Census Bureau, real median family income has fallen from $40,890 in 1989 to $38,782 in 1994, the latest year available. [See Figure IV.] By contrast, during the Reagan administration, real median family income rose every year after the end of the recession.6

The Senate Budget Committee reports, as shown in Figure V, that the median family now pays 25 percent of its income in federal taxes, compared to 12 to 13 percent in the early 1960s. With this increased tax burden, many families are having trouble making ends meet, saving for college and retirement and living as well as their parents did.

Figure V - Average Federal Tax Rate on the Median Family

"Real median family income has fallen from $40,890 in 1989 to $38,782 in 1994."

In short, workers need a pay raise, and increasing the demand for labor is one way to provide it. Of course, keeping inflation under control is also an essential goal. But nothing in economic theory or economic experience demonstrates that rising real incomes are inconsistent with price stability. Moreover, Federal Reserve Chairman Alan Greenspan and other Fed officials have repeatedly stated that monetary policy would not stand in the way of balanced higher growth.

"The median family now pays 25 percent of its income in federal taxes."

The American Bankers Association recently reported that 3.66 percent of all credit card holders were behind in their payments in the second quarter of 1996. This is the highest figure in 22 years and well above the level during the 1990-91 recession. At the same time, consumer debt has hit an all-time high - over $1 trillion - a 44 percent increase during the Clinton administration. With debt at such a high level, even a small rise in short-term interest rates could depress consumer spending very quickly.

While household assets also have risen due to the run-up in the stock market, much of the gain is locked into retirement accounts such as 401(k) plans and is difficult to tap in a crunch. Generally, Federal law requires financial institutions to withhold 20 percent of assets withdrawn from a retirement account.

Yet for many consumers the crunch is already here. According to the American Bankruptcy Institute, personal bankruptcies hit an all-time high in 1995 at 874,642 filings. And the trend suggests that this year's figure will be even higher. In just the first quarter, another 252,761 individuals filed for bankruptcy. If this trend continues for the rest of the year, more than one million people will go bankrupt in 1996.

While a 15 percent tax rate reduction may not be enough to solve the problems of declining real incomes, stagnant wages and soaring debt burdens, it will put more money into people's pockets. Therefore it will unambiguously raise disposable incomes and give people more resources with which to service their debts and avoid bankruptcy.

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