Raise Taxes? Not Because of These Figures

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Much has been made of the recent reports that the 2009 tax season saw Americans paying the lowest amount since 1950. Some Members like Nancy Pelosi have tried to take credit for this decline, saying that “Democratic leaders in Congress and President Obama have produced the lowest tax bills for the American people in more than half a century…because of changes Democrats have made in tax policy, more than 100 million Americans have more money to support their families." On the other hand, some budget hawks are now also pointing to these same figures (the recent decline in tax revenue) as the reason rates should be increased across the board.

Before calls to increase taxes get too loud, let’s examine the primary reasons why tax revenues appear to be significantly lower this year – and also review how the other side of the ledger (spending!) looks these days.

Most of the stories and posts about this historic low cite data from the Bureau of Economic Analysis (BEA). They argue the BEA data shows that in 2009, “Americans paid, on average, 9.17% of their personal income in Federal, state and local taxes. This is the lowest share of income paid in taxes since 1950.” Additionally these stories claim that this “rate is far below the historic average of 12% for the last half-century.”

On the surface, these statements are true. The income tax burdens were lower in 2009. But, the secondary conclusion – that because income tax burdens are so low, Americans should shoulder an increase in tax rates (especially right now) – is not only flawed but dangerous. Why?

The tax burdens have eased recently for several reasons, but they ALL have to do with the current state of the economy – not the permanent (or semi-permanent) state of the tax code.

Consequently, proponents of (immediate) tax increases are using this data to incorrectly call for a permanent increase in federal income tax rates.

1. Temporary reductions in income have resulted in lower income taxes collected. Because of the relatively large gaps between the different income tax brackets, the number of families shifting down a bracket due to a modest reduction in income during a recession can have a big impact on total revenues collected. This “reverse bracket creep,” can trigger large drops in tax revenue for the federal government. The reductions in income due to the recession also mean that more families are qualifying now for tax credits and deductions (that they would otherwise have been disqualified for based on their old income levels). These credits and deductions only further reduce their taxable income – and the government’s revenue. This phenomenon is (again) due to the slower economy, and should not be counted on or viewed as a permanent reduction. When incomes are restored, tax burdens will be restored as well.

Although IRS data is not yet available for 2009, we can see some of the effects of the recession on individual income taxes through data from the Bureau of Labor Statistics here. Payroll employment was down 8.3 million from December, 2007 to December, 2009. That means 8.3 million people who used to get paychecks and pay taxes in 2007 did not in 2009. Finally, average weekly hours worked fell from 34.7 hours in December, 2007 to 33.8 hours in December, 2009. Less work means less income and less tax revenue.

2. Slowing capital gains have reduced taxable income, again temporarily. In addition to the other factors that affect “reverse bracket creep”, the slowing economy and downturn in the stock market have likely had a significant effect on taxes paid for capital gains in 2009. Because capital gains are reported as individual income for tax purposes, the temporary reduction in capital gains revenue due to the economic slowdown will temporarily reduce the perceived income tax burden on families. This effect should not be viewed as permanent, and like bracket rates, it should not serve as a justification for those that claim that tax rates have gone down too much and (obviously) need to be increased now.

3. Stimulus tax credits reduced taxable income. Drilling down deeper, the stimulus bill specifically included tax credits that reduced income taxes for a large percentage of the population – primarily the Making Work Pay tax credit, which reduced income taxes by $800 for married couples earning up to $150,000. This tax credit is not permanent, and soon expires.

4. Many people also point to the reduced sales tax burden on families. Drops in consumer spending (and therefore reduced sales tax revenues) should be excluded from any discussion of permanent income tax rates. Not only is decreased consumer spending a drag on the economy, it has nothing to do with a comprehensive conversation about federal income tax rates going forward.

Additionally, it is worth noting that while individual income tax burdens may have decreased this year, overall revenues (including things like corporate taxes) are still comparatively strong. Tax revenues need to be understood in a cyclically adjusted context. This means that revenue losses or gains that automatically occur – during a recession or boom – should be excluded from the discussion.

Check out the following CBO paper to learn more about this. This report shows how revenue changes are caused by movements of the business cycle and thus are likely to prove temporary. For example, “compensation bonuses…tend to be concentrated among taxpayers in relatively high tax brackets and thus affect the effective tax rate on total wages and salaries.” In particular, Table 2 from this paper is worth reviewing:

A comprehensive review of the overly-complicated tax code should certainly be conducted. Few would argue that the tax code should neither be simplified nor improved (see this piece for more on e21’s views on this topic). But, the long-term budget picture under current law as seen by the Congressional Budget Office (CBO) reveals that the primary U.S. budget problem is not one of inadequate revenues.

In fact, if we don’t change the law so as to reduce tax growth (long-term), Americans will be taxed as they have never been taxed before. As CBO explains:

“After 2019, revenues would rise relative to GDP. Over the 2009–2035 period, they would rise from almost 16 percent of GDP in 2009 to almost 22 percent in 2035, an increase of roughly 6 percentage points (see Figure 5-1). Over the long term, the cumulative effects of inflation and real (inflation-adjusted) growth in income interact with the tax system . . . The result is higher average tax rates – that is, taxes as a share of income – and a significant change in the distribution of taxes.”

In the coming months, Congress is poised to begin a review of the tax code – just as the 2001 and 2003 tax cuts (and corresponding bracket rates) are set to expire. This review process should be allowed to play out, and any calls to increase income tax rates (in the meantime), simply because revenues are temporarily low, should be ignored.

Jennifer Pollom is the Director of External Affairs at e21 and was the Appropriations and Budget Counsel for the Senate Republican Policy Committee.