Expiring tax provisions (or "sunsets") have long been a feature of the tax code, but they have traditionally involved minor provisions. The 2001 tax cut departed dramatically from this pattern: All of its provisions sunset by the end of 2010 and many expire sooner. The 2002 and 2003 tax cuts continued the aggressive use of sunsets to hold down official budget costs. Last night, in his State of the Union address, President Bush once more called for making the tax cuts permanent. This note provides information on the effects of doing so.
For details, see "Sunsets in the Tax Code
, June 9, 2003 and "The Budget Outlook: Analysis and Implications
, October 6, 2003.
A. Making the tax cuts permanent, assuming that the AMT follows current law
Making the 2001, 2002, and 2003 tax cuts permanent would reduce revenues by $1.7 trillion through 2014. Including the added interest payments on the debt, the total increase in budget deficits would be $2.0 trillion.
The 10-year estimate implicitly understates the long-term cost, since repealing the sunsets is a back-loaded tax cut. For example, in 2014 alone, the revenue loss from repealing the expirations would be $330 billion, or about 1.8 percent of GDP.
Under these estimates, 44 million people would face the alternative minimum tax in 2014.
B. Making the tax cuts permanent, with AMT reform
To avoid having the AMT take over the tax system, legislators will need to fix the AMT in one way or another. The President did not address AMT reform in his State of the Union, even though failing to reform the AMT would over time "take back" the tax cuts he is proposing to make permanent. Not fixing the AMT also reduces the apparent cost (in the budget) of making the tax cuts permanent.
A natural AMT reform to consider is to extend expiring AMT provisions, index the AMT for inflation, and allow dependent exemptions to be counted against the AMT, moving all but 5 million households off the AMT by 2014 (compared to 3 million AMT payers today). This policy alone would reduce revenues by $452 billion over the next decade, and raise the deficit (including interest payments) by $572 billion. In 2014, it would reduce revenues by $52 billion, assuming the Bush tax cuts were not extended.
If this AMT policy were followed, making the 2001, 2002, and 2003 tax cuts permanent would reduce revenues by $2.0 trillion through 2014. That is, cutting the AMT raises the costs of making the Bush tax cuts permanent. Including the added interest payments on the debt, the total increase in budget deficits would be $2.4 trillion. In 2014 alone, the revenue loss from repealing the expirations would be $435 billion, or about 2.3 percent of GDP.
Including both the cost of the AMT reform and the extension of all of the expiring Bush tax cut provisions, the revenue loss would be $2.5 trillion over the next decade and the total increase in the deficit (counting interest payments) would be $3.0 trillion. In 2014 alone, the revenue loss would be $487 billion, or 2.6 percent of GDP.
C. Long-term effects, compared to Social Security and Medicare Trust Fund shortfalls
Assuming a sensible AMT reform, the cost of extending the tax cuts over a 75 year period would exceed 2 percent of GDP—which is more than the actuarial deficits in the Social Security and Medicare Hospital Insurance Trust Funds over the same period. Over the next 75 years, the actuarial shortfall in the Social Security Trust Fund is 0.7 percent of GDP; the shortfall in the Medicare Hospital Insurance Trust Fund is 1.1 percent of GDP.
These estimates take into account a wide range of microeconomic behavioral responses. They do not take into account macroeconomic growth effects of the tax cuts. However, recent work by JCT, CBO, and others suggests that any positive growth effects from the tax cuts by themselves will be small and that, including the adverse impact of the tax cuts on the budget deficit, the effect is likely to be negative.
For details on the Alternative Minimum Tax, see "Key Thoughts on the AMT" or "The AMT: Projections and Problems," Tax Notes, July 7, 2003.
The expiring tax cuts are regressive—they provide a larger percentage cut in after-tax income for high-income households than for low-income households. If the tax cuts were made permanent, filers with income above $1 million would see a 5.7 percent increase in their after-tax income, whereas filers with income below $50,000 would see just a 2.2 percent average increase in their after-tax income. (These figures do not include the estate tax repeal, which is also quite regressive.)
The percentage changes in after-tax income are the most theoretically preferred method of examining the progressivity of tax changes, but attention also naturally focuses on other measures. For example, the top 1 percent would receive 27 percent of the tax cuts provided by making the expiring provisions permanent, even though that group pays only 21 percent of federal taxes. As a second example, taxpayers with income above $1 million would receive average annual tax cuts of $107,000 (again, this does not include the estate tax). This is higher than the income of about 86 percent of tax filing units.
These distributional estimates assume that the AMT exemption remains at $58,000 and the nonrefundable credits are allowed against the AMT.
Is allowing the tax cuts to expire equivalent to a legislated tax increase, as the President and others have claimed? Whatever it is called, it should be noted that this is what supporters of the 2001, 2002, and 2003 tax cuts voted for. In each case, tax cutters could have obtained smaller immediate cuts that would have been made permanent, but in each case they chose larger short-term cuts that expire.
Is extension of the expiring provisions necessary to ensure economic prosperity? In the short run, the answer is clearly no. Reducing taxes in 2014 can actually hurt the economy today because financial markets are forward-looking; larger projected deficits in 2014 can therefore raise interest rates today. In the long run, the answer is also clearly no. The tax cuts themselves may have a modest positive effect on the economy, but they also increase the budget deficit, which has a negative effect on the economy. The net effect, according to a variety of estimates noted above, is likely to be negative, not positive, in the long run.
The Administration has also claimed that the tax cuts need to be made permanent to reduce the uncertainty that taxpayers face. This argument is misleading. Making the tax cuts permanent would not help resolve the fundamental uncertainty about future tax rates or future policy. The reason is that the true underlying source of uncertainty in fiscal policy is how the fiscal gap is going to be closed—what combination of revenue increases and spending cuts will be used. Enacting another fiscally unsustainable policy (making the tax cuts permanent) on top of the already unsustainable fiscal situation does not make the situation more stable, only less so.
In principle, sunsets might be justifiable for policies that should temporary, may provide flexibility in policymaking, and may be useful in focusing policymakers' attention on fiscal issues. In practice, however, recent sunsets have been motivated by the desire to manipulate budget rules and hide the likely costs of new tax cuts. That is, in practice, the sunsets are being used to fit a larger annual tax cut within a given multi-year budget total.
Sunsets that are used to increase the underlying annual size of a tax cut put fiscal policy on an increasingly unsustainable course, and leave policymakers in the future with less flexibility than they would otherwise have, since allowing sunsets to take effect is likely more difficult than forgoing new tax cuts in the future. In addition, as sunsets have come to dominate the tax code, the official budget projections have become increasingly divorced from reality.
The single most useful policy change to prevent the removal of existing sunsets and the creation of new sunsets would be to re-instate permanently the pay-as-you-go rules that required that mandatory spending increases or tax cuts be financed by other changes in taxes or spending, while creating new budget rules to "score" proposals at their long-term cost regardless of whether the proposals officially sunset.