The Case For The Tax Cut

Studies | Taxes

No. 226
Sunday, August 01, 1999
by Bruce Bartlett


Executive Summary

Congress has passed a 10-year $792 billion tax cut bill that President Clinton has criticized as "gargantuan" and has vowed to veto. Put in perspective, however, the tax cut is small, and is justified. It does not even offset the projected growth in federal taxes over the next decade, or use any of the $2 trillion of excess Social Security tax revenue to finance the cut. It is, in short, a very modest effort to give something back to those who are mainly responsible for the surplus: the taxpayers.

  • The tax cut phases in very slowly and will not have any significant effect on revenues before 2002.
  • It averages just 0.6 percent of Gross Domestic Product (GDP) over the 1999-2009 period, with a peak impact of 1.3 percent in 2008.
  • In 2008, revenues will still be far above their postwar average at 19.8 percent of GDP.
  • It will be at least 2003 before the 1999 tax cut and the tax cut of 1997 together offset the impact of the 1993 increase rammed through a Democratic Congress as Clinton's first major act in office.

In 1998 the federal government took more than 21.7 percent of the nation's entire output of goods and service - the highest percentage in history.

  • The highest year ever previously recorded was 20.8 percent in 1981.
  • The World War II peak was 19.9 percent in 1943.

Even with the tax cut, receipts will average 20.7 percent of GDP between 1999 and 2009 - higher than any single year in American history before this administration save one.

The tax cut bill remedies a number of existing inequities in the Tax Code.

Estate Tax. This bill would phase out the U.S. estate tax. The Treasury Department argues that the tax is necessary to maintain the overall progressivity of the Tax Code. But in reality, even liberal economists agree that it does nothing to break up large fortunes and promote a more egalitarian distribution of wealth. Careful estate planning is so effective at avoiding estate taxes that the effective tax rate on estates over $20 million is actually lower than on those between $2.5 million and $5 million. Those paying the highest effective estate tax rates are often family farms and businesses that must be sold to pay the tax collector.

The estate tax actually costs the government revenue because it reduces economic growth, investment, new business formations and employment. For example:

  • A new survey of 365 family-owned businesses in New York found that they spent an average of $125,000 each on estate planning costs, reducing employment by more than 5,000 jobs.
  • In those 365 companies alone, the estate tax itself is expected to destroy another 15,000 jobs over the next five years.

Capital Gains Indexing. The bill provides for indexing, another provision opposed by the Clinton Administration. The tax law has traditionally taxed nominal, or money, income. But for economists the concept of income has always meant real income; that is, nominal or money income adjusted for changes in the general price level by means of some appropriate index such as the Consumer Price Index.

In 1980 economist Robert Eisner looked at aggregate capital gains from 1946 through 1977 and found no real capital gains whatsoever over this entire period. Instead, households suffered a real loss of $231 billion on nominal gains of almost $3 trillion. Ironically, the main burden of the excess taxes actually falls more on those with low incomes than the wealthy. Consequently, indexing does more to help the middle class than the rich.

Marriage Penalty Relief. A marriage penalty exists when a two-earner couple pays more federal taxes than they would pay if each spouse could be taxed as a single. The tax tends to be greatest where each spouse has roughly the same income. The tax bill helps alleviate this problem by widening the 15 percent bracket and increasing the standard deduction for married couples.

According to the Treasury Department, this year alone couples will pay $28.3 billion more in federal taxes than if there were no marriage penalty. The Treasury study also found that increasing the standard deduction for couples would reduce the marriage penalty for three million of the 25 million couples affected, with the benefits mainly accruing to couples making between $15,000 and $30,000 per year.

Saving and Investment. One of the most remarkable economic developments during the Clinton Administration has been the virtual collapse of saving. The savings rate has fallen from 5.7 percent in 1992 to just 0.5 percent last year - in tandem with the rise in personal taxes.

  • If Americans had saved in 1998 at their 1992 rate, saving would have been $277 billion higher.
  • If they had been taxed at the 1992 rate, their taxes would have been $215 billion lower.
  • Assuming they saved these taxes, the saving rate would have been a healthy 4.5 percent.

The tax bill proposes to encourage additional saving. In particular, individual retirement account limits would rise from $2,000 per year to $5,000.

Alternative Minimum Tax. Basically, taxpayers take taxable income from their 1040 form, figure their taxes, then add back a long list of so-called tax preferences, including deductions for state and local taxes, charitable contributions and the standard deduction, and use a new set of exemptions and tax rates to figure their taxes again, paying whichever tax is higher. The problem is that the personal exemption, standard deduction and individual income tax brackets are indexed to inflation, whereas the AMT exemption is not. It is estimated that unless action is taken, the number of individual tax returns required to pay the AMT will rise from about 800,000 this year to over nine million by 2009. The congressional tax bill phases out the AMT for individuals and abolishes it in 2008. The bill also reforms the AMT for corporations.

Research and Development Credit. In 1981 Congress enacted a tax provision designed to stimulate private research and development. A 1995 report from Congress's Office of Technology Assessment found that the credit stimulated $1 of new R&D for every $1 of revenue loss. A Commerce Department study that same year found an even higher response: $2 of R&D for every $1 of revenue loss. Unfortunately, Congress has been unwilling to make a long-term commitment to the R&D credit. The tax bill extends the credit for five years, less than optimum but better than the year-to-year extensions of the past.

In the end, the main justification for a tax cut is that the money belongs to the people and not the government. Experience shows that only when the government's allowance is cut off will it make a serious effort to restrain its profligacy. Throughout history, governments have taken taxpayers for granted, only to be shocked when they rise up in revolt. Although taxpayers today may not yet be in a revolutionary mood, it should be remembered that in the past, tax burdens far below those we have today have triggered tax revolts.


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