The Cost of Tax Cuts

Peter R. Orszag and
Peter R. Orszag Vice Chairman of Investment Banking, Managing Director, and Global Co-Head of Healthcare - Lazard
William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

September 19, 2004

The large tax cuts passed by Congress in 2001, 2002 and 2003 were signature items in President Bush’s fiscal policy. All provisions of those tax cuts, however, expire by the end of 2010 and some expire earlier. A prominent feature of the president’s campaign is to make almost all the tax cuts permanent.

We have analyzed that proposal and reached the following conclusions:

· Making the tax cuts permanent would generate large, backloaded revenue losses over the next 10 years. Combined with a minimal but necessary fix to the government’s Alternative Minimum Tax, making the tax cuts permanent would reduce federal revenues by almost $1.8 trillion over 10 years — and that’s in addition to the $1.7 trillion of revenue losses already locked into law. By 2014, the annual revenue loss would amount to $400 billion, or 2 percent of gross domestic product — almost the size of this year’s federal budget deficit.

· Paying for the tax cuts would require monumental reductions in spending or increases in other taxes. To offset the revenue losses in 2014 would require, for example, a 48 percent reduction in Social Security benefits, a 57 percent cut in Medicare benefits, or a 117 percent increase in corporate taxes.

· Over the long run, making the tax cuts permanent would cost as much as repairing the shortfalls in the Social Security and Medicare Hospital Insurance trust funds. Thus, to the extent that Social Security and Medicare are considered major long-term fiscal problems, making the tax cuts permanent should be seen as creating a fiscal problem of equivalent magnitude.

· Making the tax cuts permanent would be regressive; that is, it would confer by far the biggest benefits on high-income taxpayers. After-tax income would increase by more than 6 percent for households in the top 1 percent of the nation’s income distribution, 2 percent for households in the middle 60 percent, and only 0.3 percent for households in the bottom 20 percent. The share of the tax cut accruing to high-income taxpayers would exceed their share of federal tax payments today, so their share of the federal tax burden would decline. The tax cuts will ultimately have to be financed with other tax increases or spending cuts. Once plausible methods of financing the tax cuts are taken into account, more than three-quarters of households are likely to end up worse off than they would have been if the tax cuts had never taken effect.

· Making the tax cuts permanent is likely to reduce long-term economic growth, not increase it. Studies by the Federal Reserve, the Congressional Budget Office and the Joint Committee on Taxation, as well as our own research, indicate that making the tax cuts permanent would increase the size of the economy slightly and temporarily but would reduce growth in the long term, in part because higher federal deficits will have a negative effect on long-term saving, investment and capital accumulation.

· It has often been argued that Congress needs to make the tax cuts permanent to reduce uncertainty for taxpayers. Indeed, the 2001 tax cut represented an explosive increase in the use of temporary and expiring tax provisions, chiefly because the administration gambled that Congress would pass larger annual tax cuts if they were initially temporary and then made permanent at a future date. But making the tax cuts permanent now would actually increase economic uncertainty. It would increase the nation’s underlying fiscal gap — the difference between projected revenues and spending — and hence raise uncertainty about how the government will eventually close the gap.

So far we have not discussed another thorny problem facing the president and Congress. This is the Alternative Minimum Tax, a parallel set of tax rules designed to make sure that higher-income taxpayers do not make excessive use of tax breaks. Under the administration’s budget, which does not address the long-term AMT problem, 30 million households will face the AMT by 2009, up from 3 million today. Fixing the AMT is necessary to avoid further complexity in the tax code, but it would also raise the cost of making the administration’s tax cuts permanent by hundreds of billions of additional dollars.

The 2001 tax cut was a centerpiece of President Bush’s electoral campaign in 2000, and much of the 2003 tax cut was a partial acceleration of the 2001 tax cut. Now the administration proposes making these tax cuts permanent.

It is astonishing that, more than four years after the proposal was first made public, the administration has still not released an analysis of the plan’s long-term economic effects, or even a statement of how it intends to pay for the tax cuts. Even supporters of the tax cut would presumably like to know the answers to those questions.