Truth In Taxes: A Voter’s Guide to Election-Year Tax Talk

Henry J. Aaron and
Henry J. Aaron The Bruce and Virginia MacLaury Chair, Senior Fellow Emeritus - Economic Studies

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

March 1, 2003

This brief guide to election-year tax policy debates is intended to help interested and skeptical readers make sense of the competing claims made by the candidates. Presidential elections always bring forth calls for changes in tax policy, and this one is no exception. Nevertheless, not every candidate has laid out a tax plan at the same level of detail.

George W. Bush has offered an ambitious tax plan that makes big cuts in marginal tax rates for most taxpayers, increases the child credit for middle-class and high-income taxpayers, abolishes the estate tax, expands IRAs for education, and introduces a charitable deduction for nonitemizers. John McCain has proposed widening the 15 percent tax bracket and creating Family Security Accounts that would provide tax preferences for saving held at least one year. Bill Bradley supports new tax subsidies to expand health insurance coverage. Al Gore supports Clinton administration proposals to spur retirement saving. Both Bradley and McCain favor closing various corporate tax loopholes.

How Big a Tax Cut?

Nearly everyone likes lower taxes, but cutting taxes as much as possible and for as many people as possible may not be a political plus this year.The reason is that many voters would like to allocate prospective budget surpluses to other purposes—strengthening Social Security or Medicare or paying down the federal debt. Furthermore, excessive revenue cuts can be fiscally irresponsible. One way to dress a large tax cut in the garb of fiscal responsibility is to phase it in gradually. A slow phase-in lowers costs during the early years used in computing “long-term” effects of budget changes—five years for the House of Representatives. Bush’s tax plan would cut revenues $483 billion over the first five years, according to his press releases (the campaign has not released revenue estimates beyond five years). But many provisions would not take full effect until after five years. The tax cut for the second five years would be more than $1 trillion.

Another way to appear to lower the cost of a proposed tax cut is to gloss over the fact that tax cuts mean higher federal debt and interest payments. The Bush proposal, for example, would raise federal interest payments at least $200 billion over the first 10 years, according to estimates by Brookings’s Charles Schultze and others. Taking this effect into account brings the 10-year cost of the Bush plan to more than $1.7 trillion, more than three times the 5-year cost reported by the Bush campaign. And the costs would continue to accelerate. In the 10th year alone the tax cut and the associated interest costs would equal $300 billion or more.

On the other hand, citizens may not receive the full benefits of a tax cut. For example, if the regular income tax were eliminated tomorrow, many people would still owe a lot under the “alternative minimum tax” (AMT). Congress enacted the AMT to prevent excessive use of tax avoidance techniques under the regular income tax. It applies to gross income less an exemption ($45,000 for married couples), but denies filers most deductions permitted under the regular income tax. The AMT liabilities of taxpayers with unusually large deductions may exceed their regular income tax liability, in which case they must pay AMT. Most proposed tax cuts reduce regular income taxes but not the AMT. Such cuts would expose many people to the AMT, denying them some or all of the promised cuts and complicating their taxes. Under the Bush plan, millions of taxpayers would be newly affected by the AMT because of the cut in income tax rates.

What Will the Tax Plan Accomplish?

One purported reason to cut taxes is to stimulate the economy. But the economy’s pace is already verging on the manic, a point Federal Reserve Chairman Alan Greenspan underscored in congressional testimony in February. Additional stimulation would tend to boost inflation rather than economic growth. To forestall such an outcome, the Federal Reserve, as inflation watchdog, would almost certainly react to a tax cut by boosting interest rates. When Republicans in Congress were voting for large-scale tax cuts in 1999, Greenspan opposed the cuts as irresponsible. A big tax cut could even slow growth if more government borrowing and higher interest rates choked off private investment.

One universally shared tax goal is simplicity. Unfortunately, lobbies abound for tax cuts for particular groups, but not for simplifying taxes. Every time the tax cut lobbies win, complexity grows, because each special provision requires a definition of who and what is eligible. That definition requires interpretation by the filer and the IRS, adds lines to the tax return, and leads to audits. Furthermore, one group’s win inevitably emboldens others to try their luck too. As concessions multiply, special rules proliferate. As tax collections from one group after another fall, the marginal tax rates needed to maintain government revenues increase, in turn creating more demand for special subsidies.

Many politicians claim their tax cuts help the poor. But few tax cuts do, for a simple reason: the poor pay little or no income tax. Reporting the percentage change in income taxes can make a cut of even a few dollars sound like a big break for low-income workers. Bush and his advisers, for example, note that his proposed cut reduces income taxes for households making less than $20,000 a year by 100 percent. That sure sounds compassionate—a lot more compassionate than saying that poor households get cuts averaging less than $125 while wealthy households’ cuts average more than $20,000.

McCain’s proposal to help “lower- and middle-class taxpayers [who] are hardest hit by the current system” by widening the 15 percent bracket also makes use of distributional doublespeak. Three-quarters of tax filing units are already in the 15 percent bracket or the zero bracket. Extending the 15 percent bracket can’t help them. It only helps the top 25 percent of filers.

When there is no way short of misrepresentation to portray a tax cut as pro-poor, tax cut advocates often revert to plan B: an income tax cut has to help the rich because the rich pay most of the taxes. To be sure, high-income households do pay most of the income tax, but people must pay other taxes too. For 74 percent of American families, the payroll tax is a larger burden than the income tax. Cutting the payroll tax itself is not the answer: every penny of these revenues is needed to cover current and future costs of Social Security and Medicare. But other tax measures could help these low earners. The income tax code contains many credits designed to help people meet onerous expenses, such as child care. But low-income workers with little or no tax liability derive negligible benefits from these credits because almost all are limited to the amount of tax due. Only the earned income credit is refundable. Making the child care credit refundable or adding a refundable credit for payroll taxes would ease considerably the burden on low-income households.

All four presidential candidates have proposed to encourage various worthy public policy goals—education, retirement saving, investment—through tax breaks. But that strategy is often inefficient, yielding small incentive effects per dollar of revenue reduction. For example, universal tax credits to encourage people to buy health insurance would go not only to the 16 percent of nonelderly adults who now lack insurance, but also to the 84 percent who already have it. If half the uninsured use the credit to buy insurance and all who are insured simply use the credit to reduce their tax bill, $84 will go to the “already-insured” for every $8 that goes to the uninsured. Now, health insurance coverage may be a good thing. But whether it is worth spending $92 to direct $8 to health insurance is far from clear. As a result, Bradley, Gore, and others have proposed targeting the tax cut to lower-income households. That reduces the revenue cost and may well improve the cost efficiency of the proposal, but it also requires phase-out rules that can become quite complex and that act as implicit high marginal tax rates on households in the phase-out range.

Odds and Ends

Two tax issues long under discussion are the estate tax and the marriage penalty. Proposals to abolish the former have increased of late. The estate tax is doubtlessly complex, but it is a subject of much misinformation. Many politicians claim, erroneously, that we need to abolish the estate tax because it destroys small businesses and forces sales of family farms. But farmers and small businesses already have double the normal estate tax exemption, and their heirs have 10 years to pay any tax that is due. With even a modicum of planning, they can buy life insurance to cover estate tax liabilities. The vast majority of farms and small businesses are not subject to estate taxes when the owner dies. Farms account for less than 0.5 percent of taxable estates, and small business wealth accounts for less than 10 percent. The typical dollar in estate tax revenue comes from a taxpayer who looks more like Steve Forbes than the owner of the corner grocery or the tiller of 600 acres.

The marriage tax is also controversial and widely misunderstood. About 42 percent of married couples pay more tax than they would if they were single and their income and deductions were the same. But an even greater share of married couples—51 percent—receive marriage bonuses: they pay less in taxes than they would if they were single. Marriage penalties tend to arise when husbands and wives have relatively equal income, bonuses when they have unequal incomes or when one spouse does not work. Although most people think that taxes should be neutral with respect to marriage, the goal is unachievable as long as tax rates are progressive and couples whose total income is equal are taxed equally. Under the current system, eliminating all marriage penalties is possible only by penalizing single filers.

The marriage penalty can be addressed in many ways. Some focus on low-income filers, others on high-income filers. Some reduce revenue more than others. Bush’s plan looks promising. It would allow married couples to deduct 10 percent of up to $30,000 of earnings of the lower-earning spouse. The deduction would reduce the marriage penalty while largely avoiding raising the marriage subsidy.

Where Do We Go from Here?

Many of the plans above pursue worthy causes, but they will ultimately intensify citizens’ frustrations because they make taxes more complicated. While Americans argue endlessly about how high taxes should be and who should pay them, there is universal agreement that taxes should be simplified. A politician who took simplification seriously might find a wide and enthusiastic following. Instead, it seems to be a safe bet that, whoever is elected president, taxes are going to become more complex.