NCPA - National Center for Policy Analysis

Tax Rate Cuts Increase Incentives

February 16, 2001

The $1.6 trillion cost of the Bush tax plan is only about half of the $3 trillion surplus remaining after projected Social Security surpluses are set aside, according to official estimates. However, the cost will actually be less, says economist Martin Feldstein.

Reducing marginal tax rates reduces the distorting and disincentive effects of high marginal rates, which economists call the deadweight loss of taxes.

  • For instance, someone who earns $50,000 now faces a 50 percent overall marginal tax rate -- a 28 percent federal income tax rate, a 15 percent payroll tax rate and additional state and city taxes.
  • Thus each extra dollar of taxable earning produces only 50 cents of extra spendable cash.
  • By cutting marginal rates, the Bush tax plan would cut the deadweight loss by more than $600 billion over 10 years -- making taxpayers better off by as much as an additional $600 billion of spendable cash.

Taxpayers will respond to the lower marginal tax rates by working and/or saving more, increasing taxable income and therefore tax payments substantially.

  • That means the net revenue loss would be only about 65 percent of the official estimate, or about $1.2 trillion instead of $1.6 trillion.
  • And the share of taxes paid by taxpayers with incomes over $400,000 will actually increase to 28.8 percent of the total, from 27.2 percent today.
  • Meanwhile, the share of taxes paid by those with incomes between $20,000 and $50,000 would be cut to 10.7 percent of total taxes, from 11.6 percent today.

In fact, says Feldstein, the top tax rate could be cut back to 28 percent -- where it stood after the 1986 Tax Reform Act -- at a cost of only about $4 billion in 2010 and less than $30 billion over 10 years.

Source: Martin Feldstein (National Bureau of Economic Research), "The 28% Solution," Wall Street Journal, February 16, 2001.

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