- Introduction
Over the last three years, Congress has passed and President Bush has signed two major tax bills, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Some of the major provisions of these laws include:
- Reductions in individual marginal tax rates for all tax brackets. For example, the top marginal tax rate of 39.6 percent has been reduced to 35 percent. However, the original higher rates are scheduled to be reinstated in 2011.
- A 15 percent maximum tax rate on dividends and on long-term capital gains. The previous tax rules, under which dividends were taxed as ordinary income, and long-term capital gains faced a 20 percent maximum rate, will be reinstated in 2009.
- Increases in the child tax credit from its previous value of $500. The credit is now $1,000. Under current law it will fluctuate over time, and be set at $1,000 in 2010. However, it reverts to $500 in 2011.
- Reductions in the potential tax penalty (and increases in the potential tax subsidy) associated with being married. The previous tax treatment is reinstated in 2011.
- A phased-in repeal of the estate tax, fully effective for decedents dying in 2010. The estate tax is fully reinstated for decedents dying in or after 2011.
As can be seen, all of these provisions will expire at the end of 2008 or the end of 2010. Clearly, it is undesirable to have massive uncertainty about what the tax law will look like at the beginning of the next decade. The estate tax provides a particularly vivid illustration of this point—there's no tax on people dying in 2010, but potentially heavy taxes on those dying in 2011. A natural way to resolve the uncertainty is to pass legislation now to make these tax cuts permanent. That said, if the tax cuts are somehow misconceived, it does not make sense to extend them, whatever the benefits in terms of reducing uncertainty. Today I would like to argue that the tax cuts will enhance efficiency and economic growth, and should be made permanent.
- The Benefits of Lower Marginal Tax Rates
2.1 The Economist's Concept of Efficiency
While the new tax laws have a number of provisions, at their heart is a reduction in personal income tax rates, and that will be my main focus. I begin with a truism: taxes impose a cost on the taxpayer. It is tempting to view the cost as simply the amount of money that he or she pays to the government. However, this is only part of the story. A tax distorts economic behavior--in general, consumers buy fewer taxed goods and more untaxed goods than otherwise would have been the case. Their decisions are not based entirely on the merits of the commodities themselves. The same logic applies to individuals' decisions about the amount of labor to supply and the amount to save. And similarly, business owners make investments based in part on tax considerations, as opposed to economic fundamentals. Because a tax distorts economic activity, it creates a loss in welfare that actually exceeds the revenues collected. Economists refer to this as the excess burden of the tax. An excess burden represents pure waste to the economy--it is not a transfer of economic resources from one person or group to another; it is simply a loss to the economy as a whole. Excess burden is the economist's standard measure of the efficiency of the tax system.
Excess burdens depend on the marginal tax rate levied on an activity--the tax rate on the last dollar generated by that activity. An important result is that the excess burden of a tax increases with the square of the tax rate --doubling a tax quadruples its excess burden, other things being the same. This means that, in general, high marginal tax rates exact a high toll on the economy. One recent academic study calculated that in the United States , the marginal excess burden of the income tax--the incremental excess burden associated with the last dollar of revenue collected--is 35.2 cents (Jorgenson and Yun [2001, p. 302]). To see the implications of this estimate, note that the Joint Committee on Taxation estimates that, in fiscal 2010, the reduction in taxes associated with lower marginal tax rates will be $118.4 billion. This will reduce excess burden in that year by $41.7 billion (=$118.4 billion x 0.352). In effect, this will have the same impact on American taxpayers' well-being as if they had received a $41.7 billion lump-sum tax rebate. To put this figure in perspective, note that it is roughly the size of the rebates of $36 billion that taxpayers received in 2001. Of course, any particular figure must be taken with a grain of salt, but virtually all estimates suggest that the U.S. tax system is highly inefficient in the sense of generating large excess burdens.
In all the official documents relating to the details of government spending and taxing, one would look in vain for an “excess burden budget” documenting the distortionary impact of government fiscal policies. It is not hard to understand why. Excess burden does not appear in anyone's bookkeeping system; it is conceptually a rather subtle notion; and it is not trivial to calculate. Nevertheless, although the losses in real income associated with tax-induced changes in behavior are hidden, they are real, and they are probably very large. Reductions in marginal tax rates are the centerpiece of EGTRRA. These reductions will substantially reduce excess burdens in the economy. Making the tax law permanent would lock in this benefit--the “rebates” associated with lower excess burdens would be repeated every year. Indeed, the rebates would grow with the size of the economy. Assuming a long-term growth rate of 3 percent, by the year 2020, the annual reduction in excess burden from making the tax reductions permanent would be about $56 billion.
Another source of excess burdens is the corporate income tax, which taxes the returns of corporate shareholders twice, once when earned at the corporate level, and again when received by shareholders, either in the form of dividends or capital gains. Double taxation distorts a number of economic decisions, including the choice between investing in the corporate or non-corporate sectors. While it is difficult to quantify their impact, the reductions in the marginal tax rates on capital gains and dividends represent an important move in the direction of reducing this source of excess burden.
2.2 Economic Growth
It is widely agreed that entrepreneurial activity is central to American economic growth. A key question is therefore whether reductions in marginal tax rates spur entrepreneurial activity. In a series of recent papers 1, several collaborators and I statistically analyzed the tax returns of thousands of sole proprietors in 1985 and 1988. This choice of years is significant because they bracket the Tax Reform Act of 1986, which reduced the top marginal tax rate from 50 percent to 28 percent, inter alia. We looked at the impact of the reduction in marginal tax rates on how quickly the entrepreneurs grew their firms; whether or not they invested in capital assets and if so, how much; and whether or not they hired any workers.
The results suggested that high marginal tax rates have a significant depressing effect on entrepreneurial activity. The reduction in marginal tax rates associated with the 1986 tax reform increased the proportion of sole proprietors who invested in physical capital, and conditional on investing in physical capital, they bought more. Similarly, more entrepreneurs hired outside labor, and their payrolls expanded. Further, the greater the reduction in their marginal tax rates, the greater the increase in the size of their businesses. More specifically, the estimates suggest that reducing an entrepreneur's marginal tax rate from 39.6 percent to 35 percent would increase the size of her enterprise (measured by gross receipts) by about 6.4 percent.
These estimates imply that the reductions in marginal tax rates associated with EGGTRA and JGTRAA will stimulate substantial entrepreneurial activity. If these reductions are not made permanent, we should expect to see an eventual decrease in entrepreneurial activity, other things being the same.
It is difficult to quantify precisely the effects of tax decrease on overall growth. A good starting point is Engen and Skinner's [1996] estimate that a 5 percentage point cut in marginal tax rates would lead to a 0.2 to 0.3 percentage point increase in the growth rate of Gross Domestic Product. Taking the midpoint of this range and noting that marginal tax rates are roughly 3 percentage points lower than they were prior to the tax cuts, we calculate that the rate reductions will increase growth by 0.15 percent annually. To assess the consequences of this figure, assume that it takes two years for these growth effects to have their impact. The Congressional Budget Office estimates that GDP in 2005 will be about $12 trillion. A 0.15 percent increase is about $18 billion. And if the tax law is made permanent, this figure will increase over time due to the power of compounding. Assuming again for illustrative purposes a 3 percent long-term growth rate, the increase in GDP by 2015 would be about $266 billion (in 2005 dollars).
2.3 Other Benefits from Lowering Marginal Tax Rates
High marginal tax rates contribute to a number of other problems in the tax system. To begin, the higher the marginal tax rate, the greater the incentive to seek legal tax avoidance. If one's marginal tax rate is 10 percent, then the most one is willing to pay a lawyer or tax advisor for advice on how to shelter a dollar from taxation is 9.9 cents. With a tax rate of 39.6 percent, one is willing to pay as much as 39.5 cents to find a way to shelter income from taxation. Hence, resources get diverted from productive activities to tax avoidance activities. Relatedly, much of the complexity in the tax law is due to the existence of increasing and high marginal tax rates. For example, a complicated body of law deals with the tax consequences of transferring property to one's children. The idea is to keep parents with high marginal tax rates from avoiding taxation by transferring property to their children, who have low marginal tax rates. To the extent that marginal tax rates are reduced, the problems associated with such avoidance schemes become less severe.
Similar logic suggests that high marginal tax rates lead to more illegal tax evasion. Evading taxes has a cost--there is the threat of detection and punishment, plus whatever guilt the individual feels over breaking the law. An individual balances these costs against the benefits of cheating, and the greater the marginal tax rate, the greater the benefit. Indeed, high income tax rates can be viewed as a tax on honesty. In short, another advantage of maintaining the lower marginal tax rates embodied in present law is to reduce tax avoidance and tax evasion.
- What About Fairness ?
Evaluating the fairness of any tax proposal is as difficult as it is important. One's perceptions of fairness depend on philosophical and ethical judgments over which reasonable people can disagree. A good starting point for a discussion is provided by the distributional tables produced by the Urban-Brookings Tax Policy Center . The Tables include estimates of the distribution of the individual income tax burden for 2003 under EGTRRA and JGTRRA. They also simulate what the distribution would have been had EGTRRA and JGTRRA not been enacted. The calculations indicate that the average effective income tax rate (income taxes divided by income) for households in the top decile of the income distribution fell from 21.1 percent to 18.2 percent as a consequence of EGTRRA and JGTRRA. At the same time, their proportion of federal income taxes paid increased from 67.2 percent to 71.1 percent. That is, upper-income households bear a somewhat greater proportion of the federal tax burden after the change than before it. Although the marginal rate reductions tend to favor those in the upper income brackets, apparently this is about balanced by other provisions (such as the expansion of the child credit) that favor mostly middle and lower-income households. Indeed, income taxes for households in the 40 th to 50 th percentile range fell by 64 percent, while the comparable figure for those in the top decile was 13 percent.
Now, one could still argue that the pre-law distribution of taxes was unfair, so that preserving that distribution is a bad thing. It's difficult to know how to respond to such a view, other than to note that it is hard to characterize an income tax system in which about 85 percent of the burden is borne by households in the top two deciles as being oppressive to the middle and lower-income classes.
Another possible limitation of these calculations is that the proportional reduction in tax liability should be computed with respect to all tax payments. It is not easy to obtain data on all taxes, but the Tax Policy Center presents information on income plus payroll taxes, which comprise the bulk of federal taxes. However, bringing payroll taxes into the analysis requires that we also consider the transfer payments that they finance (Social Security, Medicare Part A, and unemployment compensation). These transfers provide significant benefits to lower income groups, generally giving them a better payback per dollar than that received by higher income groups.
The logical conclusion of this argument is to look at taxes minus transfer payments. Unfortunately, the Tax Policy Center documents do not include data on transfer payments. For purposes of this analysis, I have included data concerning the distribution of Social Security benefits across different income groups in 1992.2 The numbers should be roughly valid today, because there have been no significant legislative changes to the program, although the income definitions are not identical to those used by the Tax Policy Center . The analysis suggests two interesting conclusions. First, for the lowest 40 percent of the income distribution, tax liabilities net of Social Security benefits were negative before the tax cuts. Second, the tax cut relative to income plus payroll taxes minus social security benefits was lower for high-income groups than for other groups. For example, in the 40 th to 50 th percentile the reduction was 48 percent, while in the top decile it was only 10 percent.
An important caveat is required here. Following convention, the Urban-Brookings study assumes that there is no shifting of the personal income tax. This assumption helps simplify the analysis considerably, but standard theoretical considerations suggest that it is questionable, especially in the long run, when taxes on capital income may be shifted to labor.
- Estate Tax
The estate and gift taxes are a relatively minor part of the federal revenue system, accounting for only about 1.4 percent of revenues in fiscal 2000. Nevertheless, one of the most contentious elements of the new tax law is the phase-out and eventual elimination of the estate tax in 2010 (the gift tax would be reduced but retained). Proponents of the estate tax view it as a valuable tool for creating a more equal distribution of income. Indeed, from its inception, this tax was viewed as a way to counterbalance undue concentration of wealth. Even if such redistribution is a worthwhile goal, however, the estate tax may backfire and create a less equal distribution. Joseph Stiglitz [1978], Nobel Laureate and Chairman of the Council of Economic Advisers under President Clinton, noted that if the estate tax reduces saving, the capital stock will decline. This will lead to a lower real wage for labor and likely a smaller share of income going to labor. To the extent that capital income is more unequally distributed than labor income, the effect is to increase inequality. Stiglitz's warning is particularly cogent in light of recent econometric research which suggests that the estate tax does, indeed, reduce saving (Kopczuk and Slemrod [2000] and Holtz-Eakin and Marples [2001]). Based on the Kopczuk and Slemrod study, a rough prediction is that wealth accumulation would rise by 1.5 percent if the estate tax were eliminated. This would be a substantial benefit to the economy.
Another reason that the estate tax is unlikely to achieve much of an impact on the income distribution is the fact that many avoidance strategies are available. The estate tax is famously referred to as a "voluntary tax" because the only people who pay the tax are those who neglect to do the appropriate planning. However, even in cases where the tax generates no revenues, it may create excess burdens and/or compliance costs for people who modify their behavior to avoid it.
Finally, critics of the estate tax view it as capricious. It seems unfair and arbitrary to pick out property transfers at death as special objects of taxation. If Smith spends $10,000 on a trip to Europe , Jones spends $10,000 on his daughter's college education, and Brown leaves a $10,000 bequest to his son, why should Brown face a special tax?
My own view is that doubts about the ethical foundations of the estate tax together with its failure to achieve its putative goals render it a good candidate for removal. Extending the elimination of the tax beyond 2010 is a good idea.
- What About the Deficit?
Much of the discussion of the new tax law has focused on its effect on the deficit. This raises two questions. First, what is the impact of the new law on the federal deficit; and second, does it matter?
According to estimates of the Joint Committee on Taxation, the 2001 and 2003 tax laws are expected to reduce revenues by about $1.7 trillion over the period from fiscal 2001 through fiscal 2011. In general, the JCT's calculations do not take into account changes in macroeconomic behavior that could affect GDP. The actual increases in the deficit due to the tax reduction are likely to be less than the official estimates once we take behavior into account.
However, one could accept this view and still argue that any increase in the deficit is a bad thing. In current policy debates, the main criticism of deficit spending is that it leads to higher interest rates which lead to less private investment. Unfortunately, it has proven very difficult to test the validity of this hypothesis. This is due to the fact that a number of variables affect interest rates. Various econometric studies that attempt to estimate the independent effect of interest rates have found conflicting results. My own view is that increased deficits do increase interest rates, although the effect is modest, particularly in an environment in which there is considerable slack in the economy.
In any case, it makes little sense to evaluate the economic operation of the public sector primarily on the size of the deficit or surplus. The real burden of government is the transfer of resources that it entails from the private to the public sector. Deficit spending is merely one way to effect such a transfer; it may be less efficient than some methods (such as a consumption tax) and more efficient than others (such as the corporate income tax). The fact that a given fiscal policy entails deficits does not necessarily make the policy undesirable. One must consider the entire set of benefits and costs associated with the policy.
In the long run, of course, the government budget must live within its means. If balance is achieved by raising marginal tax rates, then all of the benefits of low marginal tax rates to which I have alluded will be lost. That is why a better approach is to move toward balance through reductions in spending. This is the tack taken in the budget that the President submitted last February.
- Conclusion
Recent changes in the tax law are likely to enhance efficiency and economic growth. While fairness is in the eyes of the beholder, no evenhanded assessment of the income tax could conclude that these improvements come at the cost of unfair transfers from the poor to the rich. And to the extent that the new law stimulates entrepreneurial activity, it will increase incomes, which will make most Americans better off and, incidentally, increase tax revenues and reduce the deficit. Making the law permanent would lock in these benefits for the future, and reduce the uncertainty facing taxpayers today.
Thank you.
1 See Carroll, Holtz-Eakin, Rider, and Rosen [2000a, 2000b, 2001]. The actual computations were done by duly authorized employees of the U.S. Treasury.
2 These data are from a study by David Pattison in the Summer 1995 Social Security Bulletin.
References
Carroll, Robert, Douglas Holtz-Eakin, Mark Rider, and Harvey S. Rosen, in Joel Slemrod (ed.), Does Atlas Shrug? The Economic Consequences of Taxing the Rich, Harvard University Press, 2000a.
Carroll, Robert, Douglas Holtz-Eakin, Mark Rider, and Harvey S. Rosen, "Income Taxes and Entrepreneurs' Use of Labor," Journal of Labor Economics, April 2000b.
Carroll, Robert, Douglas Holtz-Eakin, Mark Rider, and Harvey S. Rosen, "Personal Income Taxes and the Growth of Small Firms," in James Poterba (ed), Tax Policy and the Economy, MIT Press, 2001.
Engen, Eric and Jonathan Skinner, "Taxation and Economic Growth," National Tax Journal, December 1996, pp. 617-642.
Holtz-Eakin, Douglas and Donald Marples, "Distortion Costs of Taxing Wealth Accumulation: Income Versus Estate Taxes," Working Paper Number 8261, National Bureau of Economic Research, April 2001.
Jorgenson, Dale W. and Kun-Young Yun, Investment Volume 3: Lifting the Burden: Tax Reform, the Cost of Capital, and U.S. Economic Growth, The MIT Press, 2001.
Kopczuk, Wojciech and Joel Slemrod, "The Impact of the Estate Tax on The Wealth Accumulation and Avoidance Behavior of Donors," Working Paper Number 7960, National Bureau of Economic Research, October 2000.
Stiglitz, Joseph E., "Notes on Estate Taxes, Redistribution, and the Concept of Balanced Growth Path Incidence," Journal of Public Economics, 1978, pp. S137-50.
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