The Great Tax Shift

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

May 4, 2005

The Bush administration claims that the guiding principle for its fiscal policy has been “lower income taxes for all, with the greatest help for those most in need,” as the White House Web site puts it. The reality is starkly different. The tax cuts enacted during George W. Bush’s presidency shift the burden of taxation away from upper-income, capital-owning households and toward the wage-earning households of the lower and middle classes. For all but the wealthy, this will ultimately cause substantial harm. Shifting costs to future generations of workers to finance tax boons for today’s owners of capital is unproductive, unfair, and unwise.

The Bush administration presided over two major tax cuts, in 2001 and 2003, along with a smaller one in 2002. Those cuts officially were going to cost the federal government $1.7 trillion between 2001 and 2014, and to add nearly $1 trillion in higher payments on the national debt over that period. That may sound like a lot, but in fact the official estimates are low, artificially held down by gimmicks, including the ostensible sunsets of all the tax cuts in 2010 or before. At least under the administration’s plans, these tax cuts would continue beyond their official expiration dates. If they are extended, they would reduce revenue by $3.6 trillion between 2001 and 2014 and cost a whopping $4.8 trillion when the additional debt service is included.

Without a doubt, and despite White House rhetoric to the contrary, the direct effect of the tax cuts is to widen after-tax income inequality. If the tax cuts are extended into 2011, after-tax incomes will increase by more than 9 percent for households in the top 1 percent of the income distribution in that year, by between 2 percent and 3 percent for households in the middle 60 percent, and by only 0.1 percent for households in the bottom 20 percent.

Most of the cost from the tax cuts reflects highly regressive measures, including lower marginal tax rates for high-income households, reduced taxation on capital gains and dividends, and elimination of the estate tax. These components provide extremely large benefits to a very small number of households, but they generate little if any benefit for most families. For most of the population, wages and salaries represent the vast majority of income. Capital income is much more significant the more income one makes. The top 1 percent of the population earns about one-tenth of the total wage and salary income but almost half of all the capital income. Shifting away from a tax on all income and toward a tax on just wages thus moves the tax burden on to lower-earning workers.

That means that the administration’s claim — that the cuts are progressive because high-income households will pay a higher share of the income tax after the changes than before — is misleading. It’s true that high-income households will pay a higher share of the income tax, at least in the short run. But changes in tax shares are not an accurate way of measuring progressivity. If we reduced everyone’s income tax by 99.9 percent, for example, the shares of income taxes paid would remain constant — but the net result would be highly regressive.

Furthermore, the administration’s argument conveniently omits the estate tax (which is progressive and is slated to be eliminated), the corporate tax (which is progressive and was reduced in the tax cuts), and the payroll tax (which is regressive and was not cut). When all federal taxes are considered, the share paid by high-income households will decrease significantly because of the tax cuts.

So how did the White House manage to convince the public that Bush’s tax cuts were in fact good for the middle class? The cuts did have some provisions that were designed to help the middle class, including a new 10-percent bracket (which means that all households, including low- and middle-income ones, pay a 10-percent rate rather than a 15-percent one on their first dollars of taxable income — $7,000 in taxable income for singles and $14,000 for married couples); an expanded child credit; and tax cuts for married couples. Yet these provisions account for about one-third of the revenue loss from the tax cuts as a whole over a 10-year period.

In other words, the middle-class elements of the tax cuts were just a remarkably successful marketing ploy. They allowed proponents to extol the benefits for carefully selected Americans, disguising the much more regressive and expensive components and confusing the debate.

The ultimate effect of the tax cuts depends in part on how they are eventually financed. There are two options: reductions in other government programs and increases in other taxes. Borrowing indefinitely, the strategy preferred by many policy-makers, is not a long-term solution. That’s because the longer policy-makers wait to pay for the tax cuts — or to give up on the exercise and simply cancel them — the more harm is imposed on the future economy from intervening budget deficits and the more the nation risks a full-blown fiscal crisis.

That danger exists because the deficit-financed tax cuts are, overall, harmful to the country’s economic growth. Tax cuts themselves can have a positive direct effect on the economy; for example, they can reduce marginal tax rates and encourage people to work or save more. But tax cuts also increase the budget deficit, which has an adverse effect on economic growth over the long term because it reduces national savings, one of the key determinants of long-term productivity. Given the structure of the 2001 and 2003 tax cuts, various studies suggest that the net effect of these cuts is likely to be negative in the long run.

In addition to the losses from reduced economic growth, many families may suffer from increased interest rates on mortgages, car loans, and credit cards, rates that go up because higher budget deficits compete for the funds available for such lending. Conventional estimates suggest that the deficits associated with the Bush tax cuts could eventually raise long-term interest rates by between 0.5 percent and 1.5 percent, which would raise the annual payment on a $150,000 mortgage by between $500 and $2,000. Households that are net borrowers, which are more likely to have modest incomes, suffer from the increase in interest rates. Households that are net lenders, which tend to be higher income, can benefit.

Ultimately, though, continuing to finance the tax cuts by running up the budget deficit will be unsustainable because even the federal government can’t borrow an unlimited amount. In the face of ongoing substantial deficits, financial markets will eventually grow worried about whether the government will be able to repay the borrowed funds. To avoid a fiscal crisis, a permanent tax cut has to be financed either with lower spending or higher revenues from other sources. Both options have problems. Paying for the full tax cuts in 2014 by reducing government spending would be catastrophic, both substantively and politically: It would require a 48-percent cut in Social Security benefits, complete elimination of the federal part of Medicaid, or an 80-percent cut in all domestic discretionary spending (such as for environmental protection, education, and health research). The overall effect would be more harmful to lower- and middle-class Americans, who depend on those programs, than the direct effect of the tax cuts themselves. Alternatively, the tax cuts could be financed by a 34-percent increase in payroll taxes or by more than doubling the tax on corporations.

If the Bush White House hadn’t been ideologically driven toward high-end tax cuts, it might have taken some important steps with the money instead. Rather than cutting taxes primarily for wealthy families, we could have financed substantial aid to the states, which would have obviated the need for recession-driven tuition increases and spending cutbacks. We could have invested heavily in children, for example, by fully funding Head Start. We could have provided more progressive tax cuts. Or we could have done all three — and still had money left over to reduce the deficit.

We also could have averted the coming crisis in Social Security. Over the next 75 years, the tax cuts will cost about three times the projected 75-year actuarial deficit in Social Security. As a result, even if we had not enacted only the most regressive components of the tax cuts, we would have had more than enough revenue to eliminate the entire Social Security deficit for the next 75 years. That wouldn’t necessarily be the best course, given the competing needs for revenue, but it does dramatically illustrate the lost opportunities. It also underscores why Alan Greenspan’s proposal to pay for the tax cuts with reduced Social Security benefits will never add up: Have you ever tried to save $3 from $1?

The president likes to portray his tax cuts as painless and simply “giving people their money back.” Tens of millions of people, however, gain little from the tax cuts — and will eventually be hurt by the costs imposed on the budget and the economy.

For now, too many policy-makers are pretending that the tax cuts represent that ever-elusive free lunch. The reality is that the bill from the tax cuts will come due one way or another. And almost any way it plays out — other than simply repealing the tax cuts or allowing them to expire as officially scheduled — the vast majority of Americans will pay.