Does the Budget Surplus Justify a Large-Scale Tax Cut?
Recent CBO estimates project large surpluses over the next 10 years in both the on- and off-budget portions of the federal budget. Although there is general agreement that the $1.8 trillion in accruing balances in the social security trust funds should be allocated to shoring up social security, there is significant disagreement about how to allocate the other $800 billion in surpluses, with the main candidates being debt reduction, government spending, and tax cuts.
We examine the appropriate use of the surplus, with particular focus on whether large-scale tax cuts would be appropriate, and reach several main conclusions. First, there is little in the short-term surplus estimates that justifies a tax cut. Over 50 percent of the projected on-budget surpluses are due to accumulations in government pension reserves and the medicare trust fund. These accumulations, like social security, represent resources owed to current workers when they retire, and so should not be spent on tax cuts. Over 75 percent of the on-budget surplus arises from projected cuts in real discretionary spending. These cuts are unlikely and may not be advisable either. The surplus forecasts also assume that almost all of the recent revenue surge will prove permanent, which may prove optimistic.
Second, the long-term fiscal situation provides even less justification for a tax cut. Over the next several decades, the government is projected to incur large fiscal deficits, not surpluses, due to the rising costs of social security, medicare and medicaid. The long-term fiscal gap is at least 1.5 percent of GDP, even if the entire surplus materializes and is saved over the next 10 years.
Third, the proposed 10 percent across-the-board cut in income tax rates would require using about $200 billion of the social security trust fund to finance general tax cuts, would provide large benefits to high-income households, but meager benefits to middle- and low-income households, and would require an ill-advised waiver of the budget rules.
Fourth, although aggregate federal revenues are near an all-time high relative to GDP, families at most points in the income distribution will pay a smaller share of their income in federal taxes in 1999 than in any year since at least the 1970s. The reconciliation of these two facts is that both tax rates and income have risen for high-income households.
We conclude that the combination of a short-term surplus, a sound economy, and the lowest tax rates for most households in decades provides a rare confluence of good fortune that should be used to address the nation’s pressing long-term fiscal problems related to social security and medicare, rather than being used to finance tax cuts.
Does the Budget Surplus Justify Large-Scale Tax Cuts?
In January of this year, the Congressional Budget Office (1999) announced projected federal budget surpluses of almost $2.6 trillion for fiscal years 2000 to 2009. Although budget forecasts have been improving rapidly over the last few years, the most recent forecast is notable for at least two reasons: the magnitude of the estimate surpassed by more than $1 trillion a similar estimate made last August, and, for the first time, the forecast contained a significant surplus in the non-social security portion of the budget.
This forecast, coupled with the release of the president’s long-awaited proposals for social security reform, have led to a veritable explosion of ideas about what to do with the surplus. While there is general agreement that the $1.8 trillion in surpluses accruing in the social security trust fund should be preserved for future social security obligations, views differ considerably about how to allocate the $800 billion in “on-budget” surpluses. Broadly speaking, there are three approaches: use the funds for saving, government spending, or tax cuts. The president has proposed a mixed set of uses that weighs heavily toward saving the surplus. He would allocate to the Social Security system that portion of the unified budget surplus that is attributable to it (although making use of an extremely confusing accounting mechanism to do so) and devote some of the remaining surplus to providing resources for Medicare and government-sponsored 401(k)-like saving plans. He also would allocate some of the surplus to increased defense and domestic discretionary spending.
In sharp contrast, leading Congressional Republicans, including House Budget Chair John Kasich (R-OH), Senate Finance Chair William Roth (R-DE), and Senate Budget Chair Pete Domenici (R-NM) weighed early in with proposals to use the entire on-budget surplus to finance 10 percent across-the-board cuts in income tax rates. Senate Majority Leader Trent Lott (R-MS) then announced a campaign of 150 Republican “town meetings” to popularize the idea (Edsall 1999). Shortly after the first meeting, and in the face of mutinies among fellow Republicans, Republican leaders backed down from advocating the across-the-board cuts (Stevenson 1999a, Pianin 1999).
Nevertheless, the prospect of a large-scale tax cut financed by the surplus is hardly a dead issue, for several reasons. First, tax cuts are a perennial topic, and the debate about the surplus is unlikely to disappear anytime soon. Just as the federal deficit dominated fiscal policy discussions in the 1980s and early 1990s, choices concerning how to allocate the emerging budget surpluses will be the centerpiece of tax and spending debates for the next several years. Second, despite the Republican Congressional leaders’ abandonment of across-the-board cuts, none of the Republican Presidential candidates have abandoned support for the proposition (Harwood 1999). Although George W. Bush has not advocated such a cut, his chief economic adviser, Larry Lindsey, is a strong proponent of across-the-board cuts (Novak 1999, Lindsey 1999). Finally, many of the issues that arise in financing across-the-board tax cuts also arise in the analysis of targeted tax cuts, which have been proposed on both sides of the aisle.
This paper examines the appropriate use of the projected on-budget surpluses, with a particular emphasis on whether the existence of the surplus justifies large-scale, across-the-board tax cuts. We draw several sets of conclusions:
First, the existence of the short-term surpluses provides little justification for across-the-board tax cuts. The case for tax cuts assumes that it is appropriate to use all of the (on-budget) surpluses for tax cuts and that the forecasted surpluses will actually be available for tax cuts. Both assumptions are questionable. For example, over 50 percent of the projected on-budget surpluses over the next 10 years is due to accumulations in the Medicare trust fund and in government pension reserves. The general agreement that the social security trust fund should not be squandered on new spending or tax cuts has implications for the use of the pension and Medicare trust funds. Like social security, pensions and Medicare balances represent resources owed to current workers when they retire. This implies that, like social security, these trust fund reserves should not be raided to finance tax cuts.
The on-budget surplus also depends critically on the assumption that discretionary spending will fall in nominal terms between 1999 and 2002, and will fall by 2009 by 25 percent of its current value relative to GDP. Under reasonable assumptions about the composition of the decline, domestic discretionary spending would fall to its lowest share of GDP since 1962 and defense to its lowest share since 1940. Such drastic cuts already seem unlikely to occur for political reasons (Stevenson 1999b) and may not be appropriate in any case. But even modest adjustments will cost plenty. Just holding discretionary spending constant in real terms—which would still reduce such spending by more than 20 percent relative to GDP—would cost over $600 billion between 2000 and 2009.
The on-budget surplus also depends on the apparent assumption that at least 84 percent of the recent surge in income tax revenues relative to GDP will prove permanent. This assumption may be too optimistic. Taking into account all of these factors suggests that there will be no surplus left over the next 10 years that would be appropriate to use for tax cuts.
Our second set of conclusions relates to the long-term fiscal situation. The short-term surpluses are a highly misleading indicator of the underlying fiscal position of the federal government. Current surpluses exist only because the government’s accounting methods ignore the enormous accruing liabilities of future entitlement benefits. In the long term, when these liabilities begin to mature, the government faces the prospect of sizable deficits as an aging population puts pressure on social security, Medicare, and Medicaid expenditures. The appropriate allocation of the short-term surplus hinges on whether the short-run surpluses outweigh the long-run deficits. Indeed, it is difficult to see how intelligent policy choices can be made at all in these circumstances without an understanding of the longer-run fiscal situation.
Alan J. Auerbach
Robert D. Burch Professor of Economics and Law - Economics Department, UC-Berkeley
Director - Robert D. Burch Center for Tax Policy and Public Finance
William G. Gale
The Arjay and Frances Fearing Miller Chair in Federal Economic Policy
Senior Fellow - Economic Studies
Director - Retirement Security Project
Co-Director - Urban-Brookings Tax Policy Center
Over the next several decades, even if the entire 10-year surplus materializes and is saved (used for debt reduction), the federal government faces a large fiscal deficit. The Congressional Budget Office (1999) estimates that it would require an immediate and permanent increase in taxes or reduction in spending of about 0.6 percent of GDP, or roughly $50 billion in current terms, to maintain the same debt/GDP ratio in 2070 as currently exists. This “fiscal gap” rises to 2.2 percent of GDP if the on-budget surpluses over the next 10 years are returned to households via tax cuts or increases in spending. CBO’s estimates, however, understate the long-term problem because the government in 2070 would be running large deficits. Using a methodology developed by Auerbach (1994, 1997), we find that a permanent and immediate tax increase or spending cut of at least 1.5 percent of GDP is required to maintain fiscal balance in the long-run, even if the surpluses are used for debt reduction. Thus, the long-term fiscal situation provides no justification for a large-scale tax cut.
Our third set of conclusions results from direct examination of the proposed 10 percent rate reduction. We show that the tax cut would cost more than 100 percent of the projected on-budget surplus—that is, it would allocate about $200 billion from the social security trust funds for tax cuts. It would also provide very large benefits to the wealthiest households but very small benefits to low- and middle-income households, and would require what we view as an ill-advised waiver of the budget rules.
Finally, we show that recent claims that American taxpayers are laboring under heavier tax burdens than ever are not correct. While it is true that aggregate federal revenues are close to an all-time high relative to GDP, families at most points in the income distribution will have to forfeit a smaller share of their income in federal taxes in 1999 than at any time in the last 20 to 30 years. These two patterns are reconciled by the fact that burdens have risen among high-income households and, more importantly, that the share of aggregate income going to higher-income households facing higher tax rates has risen over time.
We conclude that the combination of a short-term budget surplus, a strong economy, and a tax system that is imposing the lowest rates for most households in more than two decades provides a rare confluence of good fortune that should be used to address the nation’s long-term fiscal problems, rather than being squandered on tax cuts financed by the on-budget surplus. Although we do not explicitly analyze the allocation of the off-budget surplus that is accruing in social security trust funds, the same line of reasoning as above suggests that tax cuts financed out of social security trust fund accumulations would be even less appropriate than cuts financed from the on-budget surplus.
Section I evaluates the projected surpluses over the next 10 years. Section II analyzes the long-term fiscal imbalance. Section III examines the effects of a large-scale tax cut. Section IV asks whether Americans are overtaxed and explores trends in aggregate and family tax burdens over time. Section V offers some concluding thoughts.
I. Surpluses over the next 10 years
A. CURRENT PROJECTIONS
Table 1 shows the CBO’s January 1999, baseline budget projections. Between 2000 and 2009, the unified budget is expected to accumulate $2.565 trillion in surpluses. The surplus is projected to double relative to GDP, from 1.4 percent in 2000 to 2.8 percent in 2009, and to average about 2.2 percent of GDP.
The off-budget surplus reflects the amount by which social security tax payments and interest earned by the social security trust fund on the Treasury bonds it holds exceeds social security benefit payments and administrative costs. Off-budget surpluses are estimated at $1.777 billion, rising from $127 billion in 2000 to $217 billion by 2009. As a proportion of GDP, the off-budget surplus is relatively constant, rising from 1.5 percent in 2000 to 1.6 percent in later years.
The rest of the budget is projected to run small deficits in 1999 and 2000 and to begin running significant surpluses in 2002. The on-budget surplus gradually rises from about $50 billion in 2002 and 2003 to $164 billion by 2009. As a share of GDP, the on-budget surplus rises from -0.1 percent in 2000 to 1.2 percent in 2009.
If the surplus is maintained, debt held by the public is projected to shrink by two-thirds in nominal terms, and from 41 percent of GDP in 1999 to 8.9 percent in 2009. Relative to GDP, this would be lowest level of public debt since before World War I.
B. RECENT IMPROVEMENTS
The turnaround in the budget forecasts has been nothing short of astounding. From 1981 to 1995, federal deficits averaged $193 billion per year, or 4.0 percent of GDP. Federal debt held by the public nearly tripled in real terms and nearly doubled relative to GDP. In 1995, the federal deficit stood at $164 billion and deficits stretched “as far as the eye can see.”
Since then, the budget forecasts have improved dramatically. For example, Figure 1 shows that, in March 1995, CBO forecasted a deficit of $472 billion for 2005. By January 1999, the forecast (corrected for policy changes) had changed to a surplus of $259 billion.
The cumulative estimates, shown in Figure 2, demonstrated similar changes. In January 1998, the CBO estimated a 10-year surplus of $660 billion. By July 1998, this was revised to $1.55 trillion, and by January 1999, the figure was revised to $2.565 billion.
In his January 1998, State of the Union address, President Clinton proposed to use the surplus to “save social security first.” At that point, the entire 10-year surplus resided in social security; the rest of the budget showed a substantial deficit over the 10-year horizon (Figure 3). It was not until the most recent forecast that there was a projected on-budget surplus. It is the emergence of the on-budget surplus that has energized the debate about how to use the surplus.
The recent improvements in fiscal position can be attributed to a strong economy, the deficit reduction packages in 1990 and 1993, rising revenues, and a decline in spending as a proportion of GDP. These sources, of course, are interrelated.
The economy Between 1992 and 1998, the economy grew continuously as unemployment, interest rates, and inflation all fell. The improvement in the economy had many sources, including sound monetary policy and some fortuitous events (such as very low energy prices).
Deficit Reduction Packages Some credit should also be given to the deficit reduction packages enacted in 1990 and 1993. George Bush’s willingness to abandon a poorly-conceived “no new taxes” pledge in 1990, and Bill Clinton’s 1993 tax increases, passed without any Republican support, greatly improved the fiscal status. Each of those budget and tax agreements were projected to reduced deficits by about $500 billion in the first five years after their enactment. The tax acts also raised the top income tax rate from 28 percent to 39.6 percent. Thus, when the income of higher-income households grew dramatically in subsequent years, tax revenues rose because of the higher marginal tax rate on those income gains as well as the increase in income itself.
Spending cutbacks Between 1992 and 1998, spending fell by 2.9 percentage points of GDP, from 22.5 percent to 19.6 percent. Defense spending accounted for much of the decline, falling by 1.7 percent of GDP. In addition, domestic discretionary spending fell by 0.3 percentage points of GDP, entitlements and other mandatory spending fell by 0.5 percentage points, and net interest fell by 0.3 percentage points. An important component of the decline in entitlement spending was lower-than-expected outlays for federal health care, mainly Medicare and Medicaid.
Revenue Growth The 1992-98 period also saw robust revenue growth. Revenues grew by 2.8 percentage points relative to GDP, from 17.7 percent to 20.5 percent. Federal revenue growth outpaced GDP growth in every year from 1994 to 1998. Most of the revenue gain was due to individual income taxes. After averaging 8.0 percent of GDP from 1950 to 1990, income tax revenues rose from 7.7 percent of GDP in 1992 to 9.9 percent in 1998. In 1993-5, income tax revenues grew by an average of over 7 percent per year, while nominal GDP grew by less than 5.5 percent per year. In the next three years, income tax revenues grew by more than 11 percent per year, while nominal GDP grew by about 5 percent annually.
While the 1993 tax package raised revenues relative to GDP in 1994, growth of tax revenues relative to GDP since then has been due to four factors, according to the CBO (1999, pp. 48-9). First, capital gains realizations increased by 150 percent between 1993 and 1997. Most of this increase mirrors the growth in the stock market and occurred before the 1997 tax act reduced capital gains taxes. Taxes on capital gains realizations accounted for nearly a third of the growth of tax liabilities relative to GDP from 1993 to 1997.
Second, taxable components of GDP—including wages, interest, dividends, rent, and proprietors’ income—rose relative to GDP. This accounted for about 10 percent or more of the increase. Third, other components of AGI that are not part of GDP also rose. In particular, a rise in retirement income, perhaps due in part to the stock market boom, accounted for about 15 percent of the increase.
Fourth, and most significantly, the effective income tax rate on income other than capital gains rose and accounted for about 40 percent of the increase in revenues relative to GDP growth. But there were no increases in statutory tax rates during this period, and the 1997 tax act actually reduced average tax rates for many taxpayers. Rather, the increase in effective tax rates occurred because, despite the income tax rate hikes on the top 2-3 percent of households in 1990 and 1993, higher-income households had proportional income gains that outpaced other groups.
C. Deconstructing the surplus
- The underlying economic forecast
One possible concern in any budget projection is the broad economic forecast that underlies the fiscal estimates. On the whole, however, CBO’s economic forecasts appear to be mid-range or conservative relative to other forecasts. For example, for 1999 and 2000, CBO forecasts real growth of 2.3 percent and 1.7 percent, respectively. The analogous Blue Chip consensus estimates are 2.4 percent and 2.3 percent, and the Blue Chip “Low 10” estimates are 1.9 percent and 1.8 percent, respectively.
- The underlying economic forecast
- Projected spending
Federal outlays were 19.6 percent of GDP in 1998, their lowest level relative to GDP since 1974. The budget forecast projects that federal spending will grow by 3.2 percent annually in real terms, but will decline relative to the rest of economy, falling to 17.3 percent of GDP in 2009 (Table 2). In only one year since 1958 has federal spending been a smaller share of GDP.
Components of spending are projected to grow in very different patterns from 1998 to 2009. Net interest payments are estimated to fall by almost two-thirds in nominal terms and from 2.9 percent of GDP to 0.6 percent of GDP. The decline is due to the vastly lower levels of public debt that would occur if the surpluses are maintained.
Social security, Medicare, and Medicaid are projected to grow from 8.1 percent of GDP to 9.6 percent. Although these levels are still manageable, they foreshadow larger increases that will occur when the baby boomers begin to retire en masse.
A key assumption is that discretionary spending will fall from 6.6 percent of GDP to 5.0 percent. The spending caps are assumed to be enforced between 1999 and 2002, and discretionary spending is assumed to stay constant in real terms from 2002 to 2009.
These assumptions may be unrealistic. For example, to comply with the spending caps in the Deficit Control Act, discretionary outlays would have to decline in nominal terms in each of the next three years, from $575 billion in 1999 to $568 billion in 2002. This implies that even if all of the “emergency spending” and IMF funds that were provided last year are discontinued, other discretionary appropriations will have to decline in nominal terms in 2000 by about $13 billion (CBO 1999, p. 64).
Even if the 1999-2002 spending levels comply with the caps, holding discretionary spending constant in real terms from 2002 to 2009 may prove difficult. Table 3 shows trends in the level and composition of discretionary spending between 1980 and 2009. Since 1980, discretionary spending has fallen from 10.2 percent of GDP to 6.6 percent. About half of the decline has occurred in defense, which has fallen from 5 percent to 3.2 percent of GDP. Domestic discretionary spending has fallen by almost as much, from 4.7 percent to 3.2 percent. International spending fell from 0.5 percent to 0.2 percent. Thus, relative to the size of the economy, discretionary spending has already sustained deep cuts over time.
However, virtually all of the reductions in real discretionary spending relative to GDP that have taken place since 1990 have occurred in defense spending (Table 3), where at least some downsizing was inevitable following the collapse of the Soviet Union. But large additional reductions there may prove difficult. If so, then a major portion of future cuts will have to come from domestic spending.
The implications of the budget’s forecasted decline in discretionary spending relative to GDP would be startling. Suppose that all international spending were eliminated, and the rest of the cut were divided equally between domestic and defense spending, so that each was allocated 2.5 percent of GDP in 2009. For domestic spending, this would be the lowest percentage since 1962 (CBO 1999, p. 135). For defense, it would be the lowest percentage since before World War II (OMB 1999, tables 1.2 and 3.1).
Changing the discretionary spending trajectory can have huge effects on future budget outcomes. Table 4 reports the results of various changes in discretionary spending, accounting for the interest costs of the change as well as the change in discretionary outlays. Holding discretionary spending at its current level of GDP would cost $1.4 trillion over the next 10 years. But even more modest changes in the spending trajectory would cut significantly into the surplus. For example, if discretionary spending were held constant in nominal terms from 1999 to 2002 and then held constant in real terms after that, the 10-year surplus would be reduced by $73 billion. If discretionary spending were held constant in real terms from 1999 to 2009, the 10-year on-budget surplus would be reduced by $609 billion. That is, more than three-quarters of the 10-year surplus is based on the assumption that real discretionary spending will fall.
- Projected spending
- Trust fund accumulations
More than 50 percent of the projected on-budget surpluses are due to accumulations in federal trust funds for pensions and Medicare. Table 5 shows that from 2000 to 2009, these funds are expected to grow by $363 billion and $55 billion, respectively. Together, accumulations in these two trust funds account for 53 percent of the projected 10-year on-budget surplus.
Analysts on all sides recognize that it is inappropriate to use social security trust funds to finance tax cuts or non-social security spending programs. The reason is that government budget accounting seriously misrepresents the long-term costs of the social security. But social security is only the tip of the iceberg when it comes to misleading government accounting. Like the social security trust fund, government pension reserves and the Medicare trust fund represent funds that are owed to current workers when they retire. Thus, it would be appropriate to save the surpluses generated in the trust funds by using the revenues to reduce the debt, rather than cutting taxes or increasing spending. Indeed, for similar reasons, many states already separate their pension reserves from funds available for tax cuts and other spending.
- Trust fund accumulations
- Will Medicare be allowed to go bankrupt?
Medicare’s long-term financial problems are more dire than social security’s. CBO projected last summer that the Medicare trust fund would be insolvent by 2012. A reasonable estimate is that the recent improvement in overall budget status pushed the date of insolvency back a few years. Nevertheless, the $800 billion on-budget surplus that is forecast for 2000-9 is predicated on the notion that nothing will be done to address Medicare’s problems. Clearly, any diversion of general revenues to Medicare would reduce the amount available for tax cuts.
- Will Medicare be allowed to go bankrupt?
- Projected revenues
Federal revenues were 20.5 percent of GDP in 1998, the highest level since 1944, when they were 20.9 percent. They are projected to rise slightly relative to GDP in 1999 and then to decline by about 0.5 percentage points. From 2003-9, revenues are projected to be 20.2 percent, a larger share than in any year from 1945 to 1997. Revenues from corporate income taxes, payroll taxes, and other taxes are each expected to decline by about 0.2 percentage points of GDP (Table 6).
Income tax revenues are forecast to grow at 4.3 percent per year, roughly the same as the 4.4 percent growth of GDP from 1998 to 2009. After the explosive income tax growth of the past five years, the revenue forecast may seem relatively benign. But the forecast may be less conservative than it appears, because it seems to assumes that most of the recent surge of revenue relative to GDP will be permanent.
Estimating the proportion of the revenue surge that is assumed to be permanent is difficult to do in a precise way. In Table 7, we provide some rough measures of this proportion. For example, most of the revenue surge occurred in the individual income tax, which rose from 7.9 percent of GDP in 1994 (after OBRA 1993 had taken effect) to a projected 9.8 percent in 1999, only to fall to 9.6 percent in 2003-7, before rising to 9.8 percent in 2009. Using the estimated low of 9.6 percent of GDP suggests that 84 percent of the rise in income tax revenues relative to GDP from 1994 to 1999 is implicitly assumed to be permanent. Using all federal revenues suggests that 76 percent of the surge is assumed to be permanent in the forecast. The table shows that, depending on the tax measure and year used, the forecast assumes that somewhere between 76 and 97 percent of the revenue surge is assumed to be permanent.
Whether this assumption is reasonable depends on whether the sources of the gain are considered likely to continue. As noted above, about one-third of the revenue surge is due to higher capital gains realizations, which are in turn due to the surging stock market in the last few years. If half of the surge in realized capital gains continues in the future (as gains accrued in recent years are gradually realized) and all of the other components of the surge continue to hold, then roughly 83 percent of the revenue surge will prove permanent. However, if less than half of the capital gains surge continues and if any of the remaining two-thirds of the surge proves temporary, the permanent component of the revenue surge could fall well below 80 percent.
Small changes in the proportion that is assumed permanent can have large changes in the 10-year budget estimates. If the implicit assumption overstates the actual share of the revenue surge that is permanent by 10 percentage points, then future revenues would be lower by about 0.2-0.3 percent of GDP. Including the costs of added debt service, this would reduce the surplus by $300-450 billion over the 2000-9 period.
- Projected revenues
There are three generic reasons why surplus projections are difficult. First, the surplus is a residual, the difference between revenues and outlays. Roughly speaking, the surpluses over the next 10 years are projected to be about 10 percent of revenues or of outlays. Thus, relatively small changes in the economy, or in revenues or spending relative to the economy, can have large impacts on the surplus.
Second, changes in government’s fiscal position at one point tend to build on themselves over time. That is, short-run mis-estimates are typically amplified as the forecast horizon lengthens. For example, an increase in revenues reduces current deficits, but it also reduces interest costs, which reduces future debt and deficits.
Third, the economy is difficult to predict. CBO (1999, p. 85) reports the 10-year growth of real wages, salaries and corporate profits per member of the potential labor force, which is the labor force adjusted for cyclical variations in the economy. This figure was as high as 45 percent in the late 1960s, but then fell to negative 15 percent by 1982, and has since risen to over 10 percent. CBO (1999, p. 82) also reports that, in their 5-year forecasts from 1988 to 1998, the first projection of the surplus in a particular year was off by an average (absolute value) of 13 percent of outlays. Over 10 years, the variability would likely be larger. With projected outlays in 2009 of $2,346 trillion, or 17.3 percent of GDP, 13 percent would be $300 billion, or 2.25 percent of GDP, enough to wipe out most of the surplus in that year.
The range of uncertainty created by these factors is huge relative to the precision of the cumulative surplus estimates. For example, if revenues are mis-estimated by 1 percent, the surplus would be about $270 billion different over 10 years. If revenues were off by 0.5 percentage points of GDP, the surplus would be about $750 billion different. These hypothetical revenue changes, however, are only a tiny fraction of the large changes in real income per labor force member noted above.
In addition to these generic factors, there are a number of identifiable factors that create uncertainty about the surplus projections over the next 10 years. On the revenue side, these include whether the revenue surge will continue, how the stock market will evolve, and the growth in income among high-income households. On the spending side, the evolution of discretionary spending and of medical costs may have large effects on budget outcomes. External sources—for example, the international financial problems that have beset Asian countries and others—also increase uncertainty.
II. The long-term fiscal imbalance
As noted above, short-run budgetary outcomes can provide a highly misleading picture of the government’s fiscal status. In this section, we examine long-run projections of the federal government’s fiscal status.
Our analysis relies on the most recent long-term budget forecasts produced by CBO. This forecast begins with the assumptions embodied in CBO’s 10-year budget forecast. After the 10-year horizon, assumptions are shown in table 8. Social security and Medicare expenditures are assumed to follow the intermediate projections of the trustees, adjusted for differences between the economic forecasts of CBO and the Social Security Administration. Medicaid is projected using the same basic approach as that used for Medicare, incorporating a key—and perhaps overly optimistic—assumption that the growth rate of aggregate medical spending per enrollee slows gradually to match that of average wages by 2020. These assumptions imply that social security expenditures are projected to rise from about 4 percent of GDP in 1998 to 7 percent by 2050. Medicare and Medicaid are projected to rise from about 3 percent of GDP in 1998 to 9 percent in 2050.
Discretionary spending, federal consumption of goods and services, and all other government programs, with the exception of net interest, are assumed to grow with GDP. Net interest falls and actually turns negative, as debt held by the public is projected to fall below zero by 2012. Twenty years later, though, debt is projected to become positive and grow rapidly thereafter. Tax revenues are a constant share of GDP, except for supplementary medical insurance premiums collected for Medicare, which grow relative to GDP.
These assumptions, as shown in table 8, result in government non-interest expenditures rising steadily from about 17 percent of GDP in 1998, to 19 percent in 2010, 21 percent in 2020, and 23 percent in 2030. During this period, net interest expenses are projected to fall and eventually turn negative, as the debt is paid down. Starting around 2030, however, the pressure created by the higher level of government non-interest expenditures is projected to create deficits that become larger over time.
Using these assumptions, we update calculations based on a methodology developed in Auerbach (1994) and applied there and in Auerbach (1997). The technique solves for the “fiscal gap”—the size of the permanent increase in taxes or reductions in non-interest expenditures (as a constant share of GDP) that would be required to satisfy the constraint that the current national debt equal the present value of future primary surpluses. The primary surplus is revenues minus all expenditures other than net interest. The same result would follow from assuming that the debt/GDP ratio eventually returns to its current level.
CBO undertakes a similar calculation by measuring the size of the immediate and permanent revenue increase or spending cut that would be necessary to result in a debt-to-GDP ratio in 2070 equal to today’s ratio. The cutoff at 2070 is arbitrary, however. Our estimates using a longer horizon will be larger than CBO’s since, as shown in table 8, the budget is projected to be substantially in deficit during the years approaching 2070 (and those that follow). That is, the picture between now and 2070 understates the magnitude of the long-term problem.
Table 9 reports various estimates of long-run fiscal gaps. Under the current budget projections, CBO estimates the fiscal gap is 0.6 percent of GDP. This compares to an estimate of 1.2 percent last August. The improvement is attributable primarily to two changes in long-term projections. First, the long-run GDP share of personal income taxes as a share of GDP has been adjusted upward, from 8.4 percent to 9.1 percent. Second, the growth rate of Medicare has been adjusted downward, leading to a reduction in the share of GDP absorbed by Medicare that rises over time, reaching .43 percent of GDP by 2030 and .80 percent of GDP by 2070. The long-term improvements mirror the short-term improvements in the forecast, indicating that the short-term improvements are, essentially, being assumed to be permanent.
Our estimate using the 2070 cutoff is a fiscal gap of 0.39 percent of GDP which is slightly lower than CBO’s estimate for reasons discussed below. Using the permanent horizon, the estimate is 1.53 percent, assuming that social security and Medicare maintain their 2070 shares of GDP in subsequent years. Even this estimate is likely to understate the magnitude of the problem, because the same forces driving social security, Medicare, and Medicaid spending to rise as a share of GDP until 2070 will be present thereafter. Thus, the assumption of constant GDP shares is almost certainly too optimistic. For example, the 1998 Social Security Trustees’ Report projects that the gap between OASDI benefits and payroll taxes will grow from 2.20 percent of GDP in 2070 to 2.26 percent GDP in 2075, the last year for which these projections are available.
It bears emphasis that all of these figures, and the underlying projections in table 8, presume that (a) current surpluses are used for debt reduction rather than on spending programs or tax cuts, and (b) the discretionary spending targets in the 10-year forecast are met.
Spending the on-budget surplus on tax cuts over the next 10 years would have severe effects on the long-term fiscal imbalance. CBO estimates that tax cuts would raise the fiscal gap to 2.2 percent.
Allowing all spending except Medicare, Medicaid, social security and net interest (essentially all discretionary spending) to remain constant as a share of GDP from 1999 on, rather than falling from 1999 to 2009 as projected in the budget forecast, would also have a large effect on the long-term fiscal imbalance. We forecast that the long-term fiscal gap through 2070 would rise from .39 percent of GDP to 2.12 percent of GDP, while the long-term gap would rise from 1.53 percent of GDP to 3.41 percent of GDP.
If the social security gap, as estimated in the most recent Trustees’ Report, were somehow magically eliminated—if revenue increases or benefit cuts were permanently put in place that closed the gap that Report identified—the permanent fiscal gap would fall to .69 percent of GDP. That is, fixing social security would solve just over half the long-run problem. Indeed, fixing social security in this manner would more than take care of the gap through 2070, leaving that gap at -.45 percent of GDP. But, in a sense, these estimates overstate the extent to which social security imbalances are the source of the long-term fiscal imbalance. If social security were fixed and discretionary spending held constant as a share of GDP starting in 1999, the long-term budget gap would fall from 3.41 percent of GDP to 2.57 percent of GDP. Thus, “fixing” social security closes about one-fourth of the long-term gap associated with current policies, before account is taken of projected cuts in discretionary spending relative to GDP. The remaining gap is primarily attributable to the projected growth in Medicare and Medicaid. Over the period until 2070, the corresponding gap would fall from 2.12 percent of GDP to 1.28 percent of GDP, representing a reduction of about 40 percent of the fiscal gap.
Delaying the necessary adjustments will only make the situation worse. If the surplus is saved, but no adjustment is made until 2014, the permanent fiscal gap would be 1.89 percent, and the gap through 2070 would be 1.02 percent of GDP. Finally, the situation will be worse still if delay is coupled with a short-run tax cut. Assuming that the 10% income tax cut is adopted for fiscal years 2000-2009 and that no subsequent fiscal action is taken until 2010, the permanent gap in that year (needed to reverse the tax cut and close the remaining gap) would be 2.54 percent of GDP. That is, enacting the proposed tax cut and waiting ten years to act again would raise the long-run gap by about 1 percent of GDP. For the 2070 horizon, the gap would rise from 0.39 to 1.68 percent of GDP, a larger increase because the shorter horizon allows fewer years to recover from delay.
A few cautionary notes about fiscal gaps are warranted. First, fiscal gap estimates are subject to large amounts of uncertainty. Nevertheless, it remains clear that the government faces a long-term financing problem. There is virtually unanimous agreement, for example, that social security and Medicare face long-term deficits. Indeed, the very existence of uncertainty makes the case for corrective action even stronger, for it means that very large future imbalances—which would be extremely costly to deal with—are possible.
Second, the estimated fiscal gaps are intended only to indicate the magnitude of the long-term budgetary imbalance. Our estimates, for example, do not take into account the macroeconomic effects of policy changes. One might expect that, by omitting feedback effects, we would overstate the needed policy changes, by ignoring the salutary impact of deficit reduction on the economy. However, this is not the case. Working in the opposite direction is the fact that we start from alternative initial baseline projections (provided by CBO) that do not incorporate the negative economic consequences of growing long-run deficits. Thus, our estimates of what it would take to close the long-run gap incorporate neither the macroeconomic effects of the projected rise in deficits nor those of adopting policies to undo this rise. In contrast, CBO’s estimate of the fiscal gap through 2070 incorporates both such feedback effects, which is the source of the small difference between our estimates and CBO’s over the period through 2070. The fact that our estimate is lower than CBO’s means that our omission of feedback effects (in both the baseline and in reaction to policy) leads to a small net understatement of the size of the long-run gap through 2070 and presumably, over the longer horizon as well.
Moreover, neither our calculations, nor those of CBO, take account of the negative macroeconomic consequences of labor supply and savings responses to the future marginal tax rate increases that may be needed to close the fiscal gap. As this gap and the associated future tax increases would be substantially increased by an immediate tax cut, any beneficial growth effects of these tax cuts would have to be measured against the offsetting negative growth effects of the tax increased needed in compensation.
Together, the two factors suggest that adding feedback effects is likely to make the net impact of tax cuts on fiscal balance look worse, not better.
Thus, the long-term fiscal situation provides no justification for a large-scale tax cut. The key point is that the emerging federal surpluses do not represent surpluses in an economic sense. Rather, they are largely an artifact of the peculiarities of federal government accounting. Specifically, the government keeps its books on a cash-flow basis. As a result, the official measure of the government deficit is a flawed and somewhat arbitrary measure of the burdens that fiscal policy places on future generations. Even though the government has more money coming in than going out over the next 10 years, this should not be confused with having an economic surplus.
III. Across-the-board tax cuts
Rep. Kasich (R-OH) and others members of Congress have introduced in H.R. 3 a proposal for an across-the-board 10 percent cut in regular income taxes. The tax cut would be effective January 1, 2000. A similar bill has been introduced in the Senate.
A. REVENUE EFFECTS
The Joint Committee on Taxation has estimated that the bill would reduce tax revenues by $776 billion over the next 10 years. This is significantly less than 10 percent of income tax revenues over the period, which would be $1,079 billion. The reason why a 10 percent rate cut does not cut revenues by 10 percent is that the reduction only applies to regular income taxes, not to the alternative minimum tax or capital gains. The tax cut will in all likelihood push more people onto the AMT, since it reduces conventional tax liability, but not AMT liabilities.
The tax revenue loss, however, is not the total cost to the government, since reduced revenues in each year would raise the national debt and hence raise net interest payments. In table 10, we calculate the added interest costs and estimate that the total revenue costs over the 10-year period would be about $984 billion. This figure exceeds the total projected 10-year, on-budget surplus by about $200 billion. That is, the proposed 10 percent across-the-board income tax rate cut would implicitly use about $200 billion of revenues from the social security trust fund over the next 10 years.
Figure 4 plots the implied cost of the tax bill and the projected on-budget surpluses on a year-by-year basis through 2009. The figure shows that from 2000 to 2006, the estimated costs of the tax cut exceed the projected on-budget surplus.
B. DISTRIBUTIONAL EFFECTS
Table 11 provides Joint Committee on Taxation estimates of the distributional impact in 2001 of the proposed tax cut. We explore a variety of measures of the distributional impact, all of which suggest that the tax cut would imply disproportionately large benefits to higher-income households. These effects are presumably much less progressive than allowing the surplus to be used to lessen the needed restructuring of Medicare and social security.
- Distribution of tax burdens and tax cuts by income class
About 70 percent of tax filers are projected to have income below $50,000 in 2001 and, under current law, they would be expected to pay about 22 percent of all federal taxes. The top 1.8 percent of taxpayers, with income above $200,000, will pay 25 percent of all federal taxes; the top 15 percent of taxpayers have income above $75,000 and will pay about 60 percent of all federal taxes.
The 10 percent income tax rate cut would provide benefits to the highest income taxpayers in excess of the proportion of federal taxes they pay. The top 1.8 percent would receive 31 percent of the cut, and the top 15 percent would receive two-thirds of the reduction. The bottom 70 percent would receive only 16.6 percent of the tax cut.
- Distribution of tax burdens and tax cuts by income class
- Percent changes in tax payments and in after-tax income
The percentage change in federal taxes would also be largest for the highest income groups. Federal taxes would fall by over 6 percent for taxpayers with income over $200,000, by 3-4 percent for households with income between $10,000 and $50,000, and by only 0.5 percent for households with income below $10,000.
Several factors that determine the pattern of tax cuts by income class. First, tax burdens do not fall by anywhere near 10 percent, for the simple reason that income taxes constitute less than half of federal revenues. For the vast majority of households, combined employer and employee payroll taxes are larger than income tax payments. Second, tax burdens fall by a greater percentage for high-income households, because income taxes are a larger share of their total tax burden. According to the CBO (1998), payroll taxes exceed income taxes for 74 percent of all households, including about 80 percent of households in the third and fourth income quintiles, and over 90 percent in the bottom two income quintiles. Third, as shown in the table, about one-third of all tax filers, including over 90 percent of those with income below $10,000, and 64 percent of those with income between $10,000 and $20,000 would receive no tax cut at all. These taxpayers, although they currently pay no income tax, may well have to pay payroll taxes and excise taxes. Fourth, the proportional cut in income tax liabilities is greater than 10 percent for some low- or middle- income households. For example, consider a household that currently owes $1,000 in taxes before credits, receives a $500 credit, and thus pays $500 in taxes. If rates were cut by 10 percent, the household would owe $900 before credits, or $400 after credits are applied. Thus, the 10 percent income tax rate cut would reduce the household’s net tax payment by 20 percent, from $500 to $400.
Because of differences in pre-existing tax levels across income classes, the percentage change in after-tax income can provide additional information. The table shows the uniform result that the higher the income group, the larger is the percentage increase in income after federal taxes.
- Percent changes in tax payments and in after-tax income
- Tax cut in dollars
Because income levels and tax payments vary extensively across the population, examination of the actual tax cuts received by income class can provide useful information in addition to the percentage changes noted above. The top 1.8 percent of taxpayers, those with incomes over $200,000, would receive an average tax cut of $9,221. For the 6.1 percent of households with income between $100,000 and $200,000, the tax cut would average $1,855. In contrast, for the bottom 70 percent of taxpayers, with income below $50,000, the average tax cut would be $128. The bottom 50 percent of households would receive almost nothing. The 33 percent of households with income between $10,000 and $30,000 would receive an average of $77 per year. For the 15 percent of households with income below $10,000, the average tax cut is $1.
C. ECONOMIC IMPACT
Tax cut advocates claim that an across-the-board tax cuts would have beneficial economic effects by boosting consumption spending, personal saving and labor supply. As discussed above, any such effects, operating in reverse, would accompany the future tax increases necessitated by short-run tax cuts. However, even the short-run effects may not be that large; they may not be desirable, either. For example, with the economy running at full employment and low inflation, the traditional rationale for a government-induced increase in personal consumption spending is lacking.
Moreover, the effects on saving and labor supply are likely to be small, since both the change in the after-tax return to those activities, and the underlying behavioral elasticities are small. For example, for a household that pays 15 percent on the margin in federal income taxes, a 10 percent rate cut raises the after-tax return to saving from 0.85 to 0.865 times the interest rate, an increase of 1.8 percent. Applying a saving elasticity of 0.4, which could well be too high, would imply an increase in personal saving of less than 1 percent. For households in the 28 and 39.6 percent brackets, the implied saving increases would be 1.6 and 2.6 percent, respectively. These increases would be too small to have any noticeable impact on economic growth.
The labor supply response would depend in part on the presence of payroll taxes as well as income taxes, but the same general finding of a relatively small change in after-tax returns would still apply. Estimated labor supply for males, who account for the vast majority of hours of labor supplied in the U.S. economy, are typically close to zero. For married women, an elasticity closer to 1 is more reasonable, but even an elasticity this high would imply only about a 2-4 percent increase in their labor supply.
A third channel for tax cuts is their impact on taxable income, which may have a higher elasticity than labor supply. But in light of the conflicting evidence on this topic, it is difficult to reach a firm conclusion about the magnitude of the effect.
D. TAX CUTS AND THE BUDGET RULES
Large-scale tax cuts would require a waiver of the budget rules, which currently require that tax cuts be offset by other tax increases or mandatory spending cuts. Though imperfect, and sometimes avoided, the budget rules have helped to constrain spending and especially to minimize fiscally irresponsible tax cuts. The budget rules were put in place in 1990 in part to avoid tax reductions that increased future deficits. But reducing the surplus has exactly the same economic effects as raising the deficit—lower national saving, higher government debt and interest costs, and increased financial burdens placed on future generations—so there is little justification for removing the rules, especially when the “surplus” is an artifact of arcane and internally inconsistent accounting procedures.
IV. Are Americans Overtaxed?
It is often claimed that Americans are overtaxed and therefore deserve a tax break. Note that this claim is not particularly related to whether a surplus exists. Moreover, the assertion is subjective to a large extent. One’s views on whether Americans are overtaxed depend in part on how one values government spending. Nevertheless, there are some relevant facts to consider.
A. AGGREGATE TAX REVENUES
- Historical Comparisons
- From 1950 to 1995, federal revenues fluctuated between 17 percent and 19 percent of GDP (Figure 5). There was a general decline in the importance of the corporate income tax and excise taxes with a commensurate increase in payroll taxes. Individual income taxes averaged 8.25 percent of GDP, and ranged from 7.6 percent to 9.4 percent.
Starting in recent years, though, overall tax revenues and income tax revenues have increased. Total revenues were 17.7 percent of GDP in 1992, rising to 20.5 percent of GDP in 1998. Other than one year during World War II, federal taxes claim a higher share of GDP today than any time in U.S. history.
The rising share of taxes in the economy is the natural result of the tax increases in 1990 and 1993, the long economic expansion of the 1990s, the rise in capital gains realizations, rapid income growth among high-income households, and other factors, as noted above.
- Cross-country Comparisons
Relative to other countries, U.S. tax burdens are fairly low. Of the 29 OECD countries in 1996, the United States had the 25th lowest ratio of taxes to GDP. Japan’s ratio was 0.1 percentage point of GDP lower than the U.S. ratio, and only Mexico, Turkey, and Korea had lower ratios (OECD 1998).
B. Tax burdens for typical households
Perhaps surprisingly, however, the increase in the tax share of GDP is not associated with rising tax burdens for most families. There are many measures of how large the tax burden is for typical families. They vary according to the year, the taxes included, assumptions about who bears the burden of particular taxes, the components of income included, and the income level examined. By and large, however, the estimates suggest that most families at fixed points in the income distribution have been paying less in federal taxes over time.
- Treasury estimates
Using a long-standing methodology, the Department of the Treasury (1998) estimates income and payroll tax burdens for families of four with all income from wages, and with income at different points of the distribution of income for families of four (Table 12 and Figures 6 and 7). For four-person families with the median income of $55,000 for four-person families, the income tax burden in 1999 is projected to be 7.5 percent, the lowest level since 1966. For families with half-median income, the 1999 income tax burden is projected to be -1.2 percent. This is the lowest level since 1955, when the estimates begin. These figures show that median and low-income households are decidedly not paying more in income taxes. Much of these reductions are due to the child credits passed in 1997, but even without those credits, average income tax burdens are well below their peaks in the 1980s.
For families with double the median income, the income tax burden in 1999 is projected to be 14.1 percent of income, the lowest income tax burden since 1972. This family, however, would be firmly ensconced in the top 10 percent of the income distribution. Thus, for families in a very broad range of the income distribution, federal income taxes are lower in 1999 than in the last 20-30 years or more.
The last three columns of Table 12 show the combined burden of federal income and employer and employee payroll (social security and Medicare) taxes. These rates are higher, of course, since they include payroll taxes. However, despite the secular rise in payroll taxes, these rates are remarkably low compared to their historical counterparts. For median income families, the 1999 tax rate will be lower than any since 1978, while for half-median income families, the 1999 tax rate will be lower than any since 1968. For families with double the median income, the 1999 tax rate is the lowest since 1990 and is approximately the same as it has been since 1980.
One caveat for the Treasury estimates is that, in the data for 1997-9, the income levels associated with each typical family are adjusted only for inflation. Real income growth is assumed to be zero. This implies that the 1999 tax burdens are understated, since real income growth has in fact been positive. Nevertheless, other estimates of tax burdens give results and time patterns very similar to Treasury’s.
- Treasury estimates
- Congressional Budget Office estimates
Estimates by the Congressional Budget Office (reported in CBO 1998 and Committee on Ways and Means 1991, 1993) of total effective federal taxes as a percentage of adjusted family income are presented in Table 13 and Figures 8 and 9. Tax rates for the bottom three quintiles will be lower in 1999 than in any measured year in the table, dating back to 1977. Average tax rates in the fourth quintile have held fairly constant over the last twenty years.
Only in the top quintile has there been an increase in federal tax burdens. For the top 1 percent of families, average tax burdens fell by 11 percentage points, or by one-third from 1977 to 1985. This fall is larger than it may seem at first because, as table 14 shows, real pre-tax income rose by 41 percent for this group between 1977 and 1985. From 1985 to 1999, the average tax rate rose by 10 percentage points, almost reaching the 1977 value. However, in 1999, the top 1 percent had average income more than twice as high as their 1977 counterparts, so the tax schedule that they faced was significantly reduced compared to the one faced by the top 1 percent in 1977.
Households in the rest of the top quintile experienced smaller reductions in tax burdens from 1977 to 1985, and much smaller increases from 1985 to 1999. Their 1999 tax rates were about two percentage points higher than their 1977 counterparts. Their real income, however, was also higher, by between 18 and 40 percent.
Table 15 shows that even with higher tax rates in 1999 than in 1977, the top quntile obtained a higher rate of growth of after-tax income than did households in the other income groups.
Thus, the CBO data provide a clear reconciliation of the seemingly contradictory trends that most families are paying less in taxes, but aggregate tax burdens are rising. The reconciliation is that average tax rates grew for the top income groups and their income grew much faster than the rest of the population as well.
Note also that the CBO may overstate the degree of tax burden increase among high-income households. This is because the adjusted family income measure is based on cash income, and hence realized capital gains. In the past few years, accrued gains have far exceeded realized gains (Gale and Sabelhaus 1999), so that a broader measure of income that included accrued gains and excluded realizations would presumably show even higher income growth at the top end, and therefore a smaller increase in the average tax rate.
- Congressional Budget Office estimates
- Joint Committee on Taxation estimates
Table 16 shows estimates of federal tax burdens by income class generated by the Joint Committee on Taxation, for 2001. The overall average federal tax burden is just over 22 percent, and for households in the 50th to 60th percentile, the burden is 19.4 percent. These figures are slightly below CBO’s, which estimated that for the 40th to 60th percentile the average tax burden is 19.8 percent in 1999, because the JCT uses a broader definition of income.
- Joint Committee on Taxation estimates
- Tax Foundation estimates
The Tax Foundation (1998) publishes estimates of the burden of all taxes—federal, state and local. They apply the taxes to two different families: a family with the median income of all one-earner families, and a family with the median income of all two-earner families. Their estimates are shown in table 17 for selected years since 1955. For 1997, the median one-earner family pays an estimated 35.6 percent of income in taxes, while the median two-earner family pays an estimated 38.2 percent of income in taxes. These estimates have increased only slightly over time, and are within one percentage point of the average tax burdens in 1985 and 1995.
These estimates are much higher than the estimates by Treasury and CBO, and several issues arise in interpretation. First, the estimates do not apply to the median family or household. Rather, the estimates are based on median income among families with one or two earners. Thus, the tax rates do not apply to retirees, students, or the unemployed. The median income among two-earner families, for example, is at the 67th percentile of all families (Lav 1998). Since taxes tend to rise with income, one reason the Tax Foundation finds a higher tax rate is that it examines families that are at higher places in the income distribution.
Second, several factors lead to overstatements of the tax rate. The study omits a number of deductions like child credits. It does not consider the use of flexible spending accounts. Pension contributions and health insurance are not considered as part of income. The study assumes that the typical household pays estate taxes, even though only 1.5 percent of people do. The study counts corporate taxes, but does not count corporate income; it counts property taxes but does not count the imputed income from housing. For all of these reasons, the study overstates taxes, understates income, and is not a reliable guide to tax policy choices.
Third, the Tax Foundation estimates include state and local taxes as well as federal burdens. This difference, however, cannot explain why the Tax Foundation estimates differ so significantly from the others. The average federal tax rate for families in the middle quintile is just under 19 percent in 1999, according to CBO. Lav (1998), using the CBO’s figures, suggests that a reasonable estimate is that all federal, state, and local taxes account for about 26 to 30 percent of income for families in the middle fifth of the income distribution. This figure is still significantly lower than the Tax Foundation estimate. Using the JCT estimates of federal tax burdens would generate an even lower overall tax burden estimate.
- Tax Foundation estimates
- Additional comments
Several other facts suggest that the tax burden on American households is not as crushing as tax cut advocates sometimes claim. First, because of personal exemptions, standard deductions, the earned income credit, and the child credit, a family of four will not owe any net income tax in 1999 until it earns around $28,000. A significant portion of families fall into this income group. Second, approximately 75 percent of more of tax-paying units are in either the zero or the 15 percent marginal tax bracket (Burman, Gale and Weiner 1998).
Third, to the extent that taxes impose burdens on low- and middle-income families, it is the payroll tax and not the income tax that is the source of the problem. Payroll taxes account for about two-fifths of the 26-30 percent of income that a typical family is estimated to pay in all federal, state, and local taxes, and about 55 percent of its payments of federal taxes (CBO, 1998, table A-3). Since payroll taxes are associated with future social security benefits, all of the burden measures reported above overstate the true costs of taxation for most households.
Fourth, the estimates do not include the burdens imposed by state and local taxes, but incorporating these taxes would not affect the conclusions significantly. State and local receipts were about 10 percent of GDP in the 1970s, fell just below 10 percent in 1979-81, then rose gradually to 10.8 percent in 1991, and have stayed flat since then (Council of Economic Advisers (1999), Table B-85, p. 426).
C. THE MORAL DIMENSION
Some tax cut advocates have argued that tax revenues “belong” to the American people and so any excess funds should be returned to them. This view is correct as far as it goes, but does not go far enough. The problem is that the future liabilities of government also “belong” to the American people. The question in each case is, which American people, current or future. It would be irresponsible for taxpayers, or government, simply to ignore the impending retirement of the baby boomers and the obligations that the elected representatives of America’s people have made.
The emerging federal surpluses are no minor achievement, but are only a first step toward long-run fiscal sustainability. The short-term surpluses are an accounting illusion, and the long-term forecast shows a significant fiscal deficit.
These may seem like unfair criticisms; that is, it may seem like the goalposts have been moved back, now that we have reached a balanced budget in the short term. In a way, they have, but there is a good reason why. U.S. fiscal policy and the economy have benefitted from a demographic holiday during the last 15-20 years. Although we can generate budget surpluses while the baby boomers are in their peak taxpaying years, our fiscal problems will be massive if they cannot be resolved by the time the boomers retire and start receiving benefits. Tax cuts not only do not solve this problem, they make it worse.
The fiscal 1999 federal budget provides a rare opportunity to address the nation’s long-term fiscal problems from the vantage point of a short-term surplus, a strong economy, and the lowest tax burdens for most families in decades. Under these circumstances, focusing on long-term problems now, while they are still manageable, is an offer we cannot afford to refuse.
Auerbach, Alan J. (1994), “The U.S. Fiscal Problem: Where We Are, How We Got Here, and Where We’re Going,” in NBER Macroeconomics Annual, edited by Stanley Fischer and Julio Rotemberg, 141-75, Cambridge, MA: NBER.
Auerbach, Alan J. (1997), “Quantifying the Current U.S. Fiscal Imbalance,” National Tax Journal, 50:3, September, 387-98.
Burman, Leonard E., William G. Gale and David Weiner (1998), “Six Tax Laws Later: How Individuals’ Marginal Federal Income Tax Rates Changed Between 1980 and 1995,”, National Tax Journal, 51:3, September, 637-52.
Council of Economic Advisers (1999), Economic Report of the President, Washington: U.S. Government Printing Office.
Democratic Staff, Committee on Ways and Means (1999), “Federal Budget Surplus Priorities: Comparison of Democratic and Republican Initiatives,” February.
Edsall, Thomas B. (1999), “Lott Takes GOP Tax-Cut Show on the Road,” Washington Post, February 16.
Gale, William G. and John Sabelhaus (1999), “Measures of the household saving rate,” Brookings Papers on Economic Activity, volume 1, forthcoming.
Harwood, John, 1999, “GOP Presidential Field Makes One Thing Clear: Party’s Nominee Will Campaign on a Tax Cut,” Wall Street Journal, February 24.
Lav, Iris (1998), “The Debate Over Tax Levels: How Much Does a Typical Family Pay?,” Center for Budget and Policy Priorities, Revised March 16, Washington, DC.
Lindsey, Lawrence (1999), “The Surplus: Give it Back to Taxpayers,” Brookings Quarterly Newsletter, 9:1, Spring.
Novak, Robert (1999), “Bush’s Budding Brain Trust,” Washington Post, February xx.
Organization for Economic Co-operation and Development (1998), Revenue Statistics, 1965-1997, OECD Paris.
Pianin, Eric (1999), “GOP May Give Up Tax Cut Plan,” Washington Post, February 23.
Stevenson, Richard W. (1999a), “GOP’s Moderates Test Power in House with New Tax Plan,” New York Times, February 10.
Stevenson, Richard W. (1999b), “Congress on Path to Approve a Rise in Spending Caps,” New York Times, February 28.
Tax Foundation (1998), “Family Tax Burdens 20 Years Later, Revisited,” February 5, Washington, DC.
U.S. Congressional Budget Office (1998), “Estimates of Federal Tax Liabilities for Individuals and Families by Income Category and Family Type for 1995 and 1999,” http://www.cbo.gov.
U.S. Congressional Budget Office (1999), The Economic and Budget Outlook: Fiscal Years 2000-2009, January, USGPO.
U.S. Department of the Treasury (1998), “Average and Marginal Federal Income, Social Security and Medicare, and Combined Tax Rates for Four-Person Families at the Same Relative Positions in the Income Distribution, 1955-1999,” Office of Tax Analysis, January 15.
U.S. House of Representatives, Committee on Ways and Means (1991), Overview of Entitlement Programs: Background Material and Data on Programs within the Jurisdiction of the Committee on Ways and Means, U.S. Government Printing Office, Washington, DC.
U.S. House of Representatives, Committee on Ways and Means (1993), Overview of Entitlement Programs: Background Material and Data on Programs within the Jurisdiction of the Committee on Ways and Means, U.S. Government Printing Office, Washington, DC.
U.S. Office of Management and Budget (1999), Budget for Fiscal Year 2000, Historical Tables, U. S. Government Printing Office, Washington, DC.