Emerging federal budget surpluses have sparked calls for large-scale tax cuts that would be irresponsible and counterproductive. Surpluses over the next ten years are based on optimistic assumptions regarding revenues and spending. Even if they do materialize, the surpluses will exist only because government accounting obscures the growing cost of future liabilities. The government faces a large, long-term deficit, and tax cuts would make this problem worse. The proposed 10-percent income tax rate cut would provide disproportionately large benefits to wealthy households and little to lower income households. It would have little effect on economic growth, but would impose higher burdens on future generations, and would reduce future budget discipline by violating the budget rules. Moreover, for most families, tax burdens are already at their lowest level in twenty years. Saving the surplus, by paying down public debt, would help the economy much more than would tax cuts.
POLICY BRIEF #46
This past January, the Congressional Budget Office projected federal surpluses totaling nearly $2.6 trillion between 2000 and 2009. The forecast is notable because the estimate surpassed by more than $1 trillion a similar estimate made last August, and for the first time in decades, the forecast projected a significant surplus independent of Social Security revenues.
This forecast, coupled with the release of the president’s long-awaited Social Security reform proposals, has led to an explosion of ideas about how to use 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 fund obligations, views differ considerably about how to allocate the remaining $800 billion in on-budget surpluses among debt repayments, government spending and tax cuts. Roughly speaking, the president has proposed to use the on-budget surplus to shore up Medicare, create a government-sponsored 401(k)-like saving plan, and expand discretionary spending.
In sharp contrast, leading congressional Republicans, including House Budget Chairman John Kasich (R-OH), Senate Finance Chairman William Roth (R-DE), and Senate Budget Chairman Pete Domenici (R-NM) proposed using the on-budget surplus to finance a 10-percent, across-the-board cut in income tax rates. Senate Majority Leader Trent Lott (R-MS) recently convened the first of 150 town meetings to popularize the idea, but the proposal was quickly withdrawn amid complaints by moderate Republicans.
Nevertheless, the prospect of a large-scale tax cut financed by the surplus is hardly a dead issue. Just as the federal deficit dominated fiscal policy discussions in the 1980s and early 1990s, the emerging budget surpluses will be the centerpieces of tax and spending debates for the next several years.
Large-scale, across-the-board tax cuts would be unjustified, counterproductive, and irresponsible, for several reasons. It is unclear how much of the projected on-budget surplus will materialize. More than 75 percent of the surplus arises from projected cuts in real discretionary spending, which seem unlikely for political reasons. The forecasts also assume that almost all of the recent revenue increases will prove permanent, which is unlikely unless the economy continues to grow rapidly.
The surpluses that do materialize will occur only because government accounting procedures obscure enormous accruing future government liabilities. For example, more than 45 percent of the projected on-budget surpluses are due to accumulations in government pension reserves. These accumulations, like Social Security, represent resources owed workers at retirement, and should not be spent on tax cuts. More importantly, during the next several decades, the rising costs of Social Security, Medicare, and Medicaid will create large fiscal deficits that need to be addressed sooner rather than later.
Direct examination of the proposed 10-percent cut reveals additional problems. The tax cut would require use of about $200 billion from the Social Security Trust Fund, which would violate the general agreement to retain those funds for future retirees. It would provide disproportionately large benefits to the highest income households, while providing meager benefits to households in the bottom half of the income distribution. It would not boost economic growth, and it would reduce future budget discipline by violating the budget rules. And with the economy running at full employment, there is little reason to boost consumer spending by raising after-tax incomes.
Robert D. Burch Professor of Economics and Law - Economics Department, UC-Berkeley
Director - Robert D. Burch Center for Tax Policy and Public Finance
Finally, the case for a tax cut is weakened further by the fact that families at most points in the income distribution will pay a smaller share of their income in federal taxes in 1999 than at any time in the last twenty to thirty years.
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 financing tax cuts.
The Deficit Turned to Surplus
The turnaround in the budget has been astounding. From 1981 to 1995, federal deficits averaged $193 billion. Since then, the budget has improved dramatically. By August 1998, CBO projected a $1.5 trillion, ten-year surplus, and by January 1999, that figure was revised to $2.6 trillion.
The improvements can be attributed to many factors. At least some credit should go to deficit reduction packages in 1990 and 1993. George Bush’s willingness to abandon his no new taxes pledge and Bill Clinton’s 1993 tax increases enhanced the government’s fiscal status. The tax acts also raised the top income tax rate from 28 percent to 39.6 percent. As a result, when upper-income household earnings expanded dramatically in subsequent years, tax revenues rose at a higher than expected rate.
In part due to the deficit packages and the lower interest rates they induced, the economy has grown continuously since 1992 as unemployment and inflation fell. The improved economy also reflected sound monetary policy, low energy prices, a burgeoning stock market, and substantial good fortune.
The deficit packages and the vibrant economy led to reduced spending and increased revenues. Spending fell by 2.9 percent of gross domestic product (GDP) from 1992 to 1998, while revenues rose by 2.8 percent. Most of the spending decline was due to defense, in the aftermath of the demise of the Soviet Union, but other types of spending also fell. Most of the revenue surge was due to rising income tax revenues. In particular, the stock market boom raised revenue from capital gains, and a rise in the income share accruing to high-income taxpayers, who face higher tax rates, raised revenues further.
How Much of the Surpluses Will Materialize?
Whether the $800 billion in projected on-budget surpluses materialize depends on whether these favorable economic, revenue, and spending trends continue. Although all surplus forecasts are uncertain, two key assumptions, both probably overly optimistic, drive the current estimates.
The first is that discretionary spending will decline from 6.6 percent of GDP in 2000 to 5.0 in 2009. This would require nominal spending cuts for fiscal years 2000 to 2002, which politicians already oppose. But holding discretionary spending at a constant share of GDP would cost $1.4 trillion over ten years, completely wiping out the surplus. Even holding discretionary spending constant in real terms, which would still reduce such spending to 5.4 percent of GDP by 2009, would cost $600 billion, or three-quarters of the projected surplus.
The other questionable assumption is that about 85 percent of the income tax revenue surge will prove permanent. Higher capital gains realizations from the soaring stock market accounted for one-third of the recent revenue increases, but equities are unlikely to continue growing at 20 percent per year. If the forecast overstates the actual share of the revenue surge that is permanent by only 10 percentage points, future revenues would fall by $300 to $450 billion over the next decade.
Thus, if the forecast’s assumptions about discretionary spending and the revenue surge prove to be too optimistic, even by relatively small amounts, much or all of the on-budget surplus could disappear.
The Surplus Mirage
Even if they do materialize, the surpluses are only artifacts of the peculiarities of government accounting, not reflections of underlying fiscal soundness. Over the next several decades, the government faces sizable deficits as an aging population puts pressure on Social Security, Medicare, and Medicaid expenditures. The appropriate use 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 long-term fiscal situation.
The CBO estimates that, between now and 2070, the federal government faces an annual fiscal deficit of about 0.6 percent of GDP. That is, even if all of the projected surpluses materialize and are used to pay down government debt over the next ten years, it would require an additional, immediate, and permanent tax increase of $50 billion (with the amount rising over time at the same rate as GDP) to bring the government into fiscal balance through 2070. If the on-budget surpluses over the next ten years are used for tax cuts, the required tax increase to bring about long-term fiscal balance would almost quadruple, to 2.2 percent of GDP.
These estimates, however, understate the financing problem because they stop at 2070 and the government is projected to be running huge deficits after that time. We estimate that an immediate, permanent additional tax increase of at least 1.5 percent of GDP (in current terms, about $125 billion) would be required to maintain fiscal balance in the long-term, even if the surplus is saved.
Because they project so far into the future, these estimates are highly uncertain, but that does not justify ignoring the long-term problems. The very existence of uncertainty makes the case for corrective action stronger, since it means that larger future imbalances, which would be very costly to deal with, are possible. In addition, even with uncertainty about the exact magnitude of the required tax increases, it is clear that the government has a financing problem: for example, no one would dispute that Social Security and Medicare are in need of long-term repair. It is equally clear that tax cuts or delays in efforts to establish fiscal balance will only make the long-term financing problem worse.
Thus, proper accounting for long-term federal liabilities shows that, despite current surpluses, the government faces a long-term fiscal deficit, which provides no justification for a large-scale tax cut.
The 10-Percent Tax Cut: Closeup
The Joint Committee on Taxation (JCT) has estimated that a 10-percent across-the-board cut in income tax rates would reduce tax revenues by $776 billion over the next ten years. Counting the added net interest payments due to higher national debt, the total cost would be $984 billion, about $200 billion more than the projected ten-year, on-budget surplus. The difference would have to be made up by raiding the Social Security Trust Fund.
The tax cut would provide benefits to the highest income taxpayers in excess of the proportion of federal taxes they pay. The reason why is that the tax cut applies only to income taxes, which are only about half of federal revenues. Most lower- and middle-income households pay more in payroll taxes than in income taxes. Only among the highest income households are income taxes the biggest component of federal tax payments.
The top 1.8 percent of taxpayers, with incomes above $200,000, would pay 25 percent of all federal taxes in 2001 under current law, but would receive 31 percent of the proposed tax cut. The bottom 70 percent of tax filers, with incomes below $50,000, pay about 22 percent of all taxes, but would receive only 16.6 percent of the tax cut.
The increase in after-tax income also would be uniformly higher the higher the income group. The top 1.8 percent of taxpayers would receive an average tax cut of $9,221. In contrast, for the bottom 70 percent of taxpayers, the average tax cut would be $128. Households with income between $10,000 and $30,000 would receive an average $77 per year cut. For households with income below $10,000, the average tax cut is $1. These effects are presumably much less progressive than using the surplus to lessen the needed restructuring of Medicare and Social Security.
Tax cut advocates claim an across-the-board tax cut would produce beneficial economic effects by boosting personal saving and labor supply. But the effects on saving and labor supply are likely to be tiny, both because the increase in after-tax returns would be small, and because saving and labor supply are not particularly sensitive to tax rates. Rough calculations indicate that personal saving would not rise by more than 2 percent. However, since funds spent on tax cuts cannot be saved by government in the form of debt repayment, national saving would fall, which would hurt prospects for economic growth. Almost all of the tax cut would be used for personal consumption spending. But in a strong economy, the rationale for stimulating consumer spending is weak.
Tax Cuts and the Budget Rules:
Large-scale tax cuts would require a waiver of the 1990 budget rules which were designed to avoid deficits, and which dictate that tax cuts be offset by other tax increases or mandatory spending cuts. Because reducing the surplus has exactly the same effects as raising the deficit—lower national saving, higher government debt and interest costs, and increased financial burdens placed on future generations—there is little justification for removing the rules, especially when the surplus is an artifact of arcane and internally inconsistent accounting procedures.
Are Americans Overtaxed?
Although aggregate tax revenues are at or near all-time highs relative to GDP, families at most points of the income distribution face federal taxes in 1999 that are as low or lower than anytime in the past twenty to thirty years. Overall tax payments have risen because the rich have gotten richer at an impressive rate and because they have faced higher tax rates due to policy changes in 1990 and 1993.
Congressional Budget Office estimates indicate that, for households in the bottom 60 percent of the income distribution, the burden of all federal taxes is at its lowest level since at least 1977 (Figure 1). Only among the top 20 percent of households have tax burdens risen since the 1980s, and only to levels slightly higher than in the 1970s. However, real income for the top 20 percent of households was about 40 percent higher in 1999 than in 1977. In a progressive tax system, average tax rates are expected to rise a little bit as real income rises, so the tax bite on high income households is hardly devastating. In fact, even with their rise in average tax rates, pre- and post-tax income grew much faster among the top 20 percent of households between 1977 and 1999 than in the next 20 percent, and in the bottom 60 percent both pre- and post-tax income fell.
Other research confirms that taxes are lower for most households. The Treasury Department estimates that, for a four-person family with wages of $55,000, income taxes in 1999 will be at their lowest levels since 1966. A four-person family with wages of $110,000 will face in 1999 its lowest tax rate since 1972. A similar family with wages of $27,500 will face its lowest income tax burden since at least 1955.
These studies suggest that all federal, state, and local taxes account for about 26 to 30 percent of income for middle-income families. Even this figure overstates tax burdens, however, since about 40 percent of the total tax burden and two-thirds of the federal burden consist of payroll taxes, which are associated with future Social Security benefits. And many families, of course, pay substantially less: a family of four can earn $28,200, or about $540 per week, and pay no federal income taxes.
American tax burdens also are low compared with those in other industrialized countries. Among the twenty largest Organization of Economic Cooperation & Development countries in 1996, the United States reported the lowest ratio of taxes to GDP.
Nevertheless, tax cut advocates like to report that the typical two-earner family paid nearly 40 percent of its income in taxes last year. This claim, however, is flawed and vastly overstates tax burdens. The misleading estimate comes from a study by the Tax Foundation, a Washington organization that tracks tax policy. Close inspection of the Tax Foundation’s study, by the Center on Budget and Policy Priorities and others, reveals several problems. The foundation’s tax measure does not include adjustments for popular deductions like child credits or flexible spending accounts. The measure of income overlooks pension contributions and health insurance. The study includes estate taxes, which are only paid in about 1.5 percent of all deaths. The foundation adds corporate taxes to families’ tax burdens, but does not add corporate earnings to families’ income. It includes property taxes, but not the imputed income from housing.
Ultimately, whether Americans are overtaxed is a judgment call. The measure of appropriate tax levels depends on many factors, including an analysis of how the money is used. But the evidence speaks clearly in at least two dimensions: the vast majority of American families pay nowhere near 40 percent of income in taxes, and they forfeit a smaller share of their income to taxes today than they would have in the past with the same income.
Some tax cut advocates have argued that tax revenues belong to the American people and that any excess should be returned to them. The problem is that the future liabilities of government also belong to the American people. The question in each case is, which American people, today’s or tomorrow’s? It would be irresponsible for taxpayers, or government, simply to ignore the impending retirement of the baby boomers and the spending obligations that the American people’s congressional representatives have incurred.
The emerging federal surpluses are no minor achievement, but are only first steps toward long-run fiscal sustainability. The short-term surpluses are an accounting illusion, and the long-term forecast shows a significant fiscal deficit.
U.S. fiscal policy and the economy have benefitted from a demographic holiday during the last fifteen to twenty 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.