Thinking Through the Tax Options

In January, President Bush proposed a set of tax cuts in his “Growth and Jobs” package that would reduce revenues by an estimated $726 billion over the next decade. On May 9, the House of Representatives passed a $550 billion version of the package and, on May 8, the Senate Finance Committee approved a package of tax cuts, expenditure increases, and offsetting revenue increases with a net cost of $350 billion. All three proposals would accelerate some provisions of the 2001 tax cut and—in different ways—reduce individual taxes on dividends. The first two proposals would also reduce taxes on capital gains. This column evaluates these proposals and considers alternatives.

Our overarching conclusion is that the Administration, House, and Senate Finance Committee proposals are seriously flawed and are strikingly removed from the economy’s current and long-term problems. Although each of the proposals would provide a short-term economic boost, almost any increase in government spending or cut in tax revenues would stimulate a sluggish economy (assuming the Federal Reserve cooperates). The three proposals on the table, though, would provide their stimulus at an unnecessarily high cost: they would reduce long-term growth, exacerbate looming budget problems, and impose significant burdens on future generations. In addition, they would be regressive and would not only fail to meet their ostensible goal of integrating the personal and corporate taxes, but could also open up new sheltering activity. Better alternatives would include substantial aid to the states, an extension of unemployment insurance benefits, and reform of the alternative minimum tax. Our specific findings include:

Revenue effects: Due to budget gimmicks, the official revenue estimates understate the likely costs. If the tax cuts in the House plan other than the acceleration of the 2001 tax cuts were made permanent, the 10-year cost would be about $1.6 trillion. The long-term costs would amount to about 0.5 percent of GDP, which is about two-thirds of the 75-year actuarial deficit in Social Security. The Senate Finance plan would create smaller long-term costs, especially if the offsets included in that plan were made permanent.

Short-term stimulus: In the short run, in an economy operating with excess capacity, increases in aggregate demand can raise output and income even without raising the capital stock. Each of the proposals would boost aggregate demand in the short term and thereby generate higher levels of income in classic Keynesian fashion, but the proposals would fail to stimulate the economy in the least expensive and most equitable manner. As shown below, the two principal components of the plans—acceleration of the 2001 tax cuts and dividend/capital gains tax cuts—would be regressive. This implies that they will be less effective in stimulating current activity, holding the size of the tax cut constant, than more progressive options, since high-income households are less likely to spend available resources immediately than would low- or moderate-income households. Alternatively, it would cost less to generate the same stimulus from a more progressive plan. It is ironic that tax cut advocates are selling dividend and capital gains tax cuts, which are traditionally associated with long-term supply-side goals, as short-term stimulus for aggregate demand.

Long-term growth: In the long run, economic growth reflects expansions in the capacity to produce goods and services. Such expansions, in turn, reflect increases in labor supply and capital, as well as technological advances. Tax cuts can increase growth by providing incentives to raise the level, and improve the allocation of, labor supply, saving, and investment. But tax cuts can reduce long-term growth by raising after-tax income (which discourages work), by providing windfall gains (which encourages consumption rather than saving), and by reducing public and national saving. Although the three proposals are called “Growth and Jobs” packages, this moniker is misleading. A new study by the Joint Committee on Taxation estimates the macroeconomic effects of the House plan. Using a variety of models and assumptions, the JCT shows that the House plan would reduce the size of the economy in the second half of the decade, and by implication would reduce the size of the economy by increasing amounts after that. Analysis by the Congressional Budget Office leads to similar conclusions about the Administration’s budget.

Distributional effects: All three plans would make the distribution of after-tax income less equal. In the Administration plan, the percentage increase in after-tax income rises as income rises, reaching a whopping 4.2 percent for households with income above $1 million. The House plan is even more regressive. Although the Senate Finance plan is less skewed, it is still regressive. Although the average tax cut in the House plan would be $731 in 2003, more than one-third of tax filing units would receive no benefits and another sixth would receive less than $100. The notion that the tax cut would provide significant help for the elderly is misguided: under the House plan, for example, more than half of all elderly tax filing units would receive no tax cut and the average tax cut among the bottom 80 percent of elderly households would be just $70.

Accelerating EGTRRA: Accelerating the scheduled marginal tax reductions from the 2001 tax cut (the Economic Growth and Tax Relief Reconciliation Act, or EGTRRA) would be expensive and regressive. The 10-year budget cost, including interest payments, would be about $117 billion. More than half of the benefits would go to households with incomes above $100,000 and after-tax income would rise by 3.0 percent for households with incomes above $1 million, compared to between zero and 1.1 percent for the 85 percent of households with incomes below $75,000. The distribution of benefits is important not only on equity grounds, but also because it reduces the short-term boost to aggregate demand from the proposal, as noted above. The acceleration would reduce marginal tax rates for fewer than one-third of all tax-filing units and so is unlikely to have substantial supply-side benefits. Despite claims suggesting sizeable benefits for small business, only about one-third of small business returns would receive marginal tax rate cuts and only 2 percent of all small business returns would benefit from the reduction in the top tax rate.

Dividend and capital gains tax cuts: Taxing all corporate income once is a sound idea, other things equal. But it requires not only eliminating tax on the doubly taxed portion of corporate income under current law but also taxing the sizable untaxed portion of corporate income. None of the dividend and capital gains tax cut proposals under consideration accomplishes the latter objective. While the Administration’s and Finance Committee’s proposals have some features that would discourage corporate tax shelters, the House plan would probably increase both corporate and individual sheltering. The common feature of the dividend and capital gains proposals is that they would represent large, regressive tax cuts.

Better alternatives: Substantial aid to the states would be a more effective short-term stimulus than the Administration, House, or Senate Finance approaches. It would be more equitable, helping support education, homeland security, and health care. It would be less damaging to the long-term budget outlook. In addition, a very high proportion of any funds spent on extending unemployment benefits would translate into immediate increases in spending. If policy-makers feel the need to enact long-term tax cuts, reform of the alternative minimum tax, a problem that was made far worse by the 2001 tax cut, would simplify taxes, reduce marginal tax rates, and help resolve fiscal uncertainty.

We begin by describing the three proposals and examining their effects on revenue, growth, and income distribution. Following that, we explore the two most prominent components of the plans: acceleration of marginal tax rate cuts from the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 and tax cuts for dividends and capital gains. The last section discusses alternatives for reform.