The Tax Conundrum
Why it may be wise to discard the idea of 'comprehensive' reform
Whether it happens before or after health care reform—the White House has been sending mixed signals—President Trump has consist-ently promised "massive" tax cuts for the middle class and businesses. He told an interviewer a few weeks ago, "It will be the biggest tax cut since Reagan, and probably bigger than Reagan's."
The president's plan is still being worked out, but based upon his previous statements and the "blueprint" for tax reform presented by House Republicans last year, it will likely contain significant cuts in individual rates, a consolidation of income tax brackets from seven to three, a doubling of the personal exemption for most taxpayers, a reduction in corporate income taxes from 35 percent to 15 or 20 percent, immediate expensing of business investment, reductions in capital gains rates along with the rates on income from pass-through businesses, and perhaps some form of a border adjustment tax. These proposals, if enacted, will undoubtedly reduce taxes for most Americans and, according to forecasters, should help to spur GDP growth from 1.6 percent in 2016 to a level closer to the postwar average of 3 to 4 percent per year.
Whether the putative Trump tax cut would be larger or more significant than President Reagan's is certainly open to debate. After all, President Reagan, with the support of a bipartisan coalition in Congress, reduced marginal rates across the board, indexed tax brackets for inflation, increased the standard deduction, and simplified the tax system by eliminating exemptions and credits in exchange for lower rates. Between 1981 and 1986, the highest marginal rate was cut first from 70 to 50 percent, and then to a postwar low of 28 percent. The tax revolution of the 1980s set in motion a significant redistribution that drastically reduced the income tax burden on middle- and lower-income taxpayers while increasing the share of taxes paid by earners in the highest brackets.
The lingering effects of the Reagan revolution pre-sent today's tax reformers with a conundrum: how to cut income taxes for middle-class taxpayers when they pay little in the way of income taxes to begin with. The other side of the conundrum is this: how to avoid the charge that any major tax cut will "favor the rich," given that the great bulk of the federal income tax is paid by those in the highest brackets. In a situation where "the rich" pay most of the income taxes, "the rich" will reap significant benefits from cuts in those taxes.
Some figures from the Internal Revenue Service and the Congressional Budget Office will serve to illustrate the point. According to the IRS figures compiled by the Tax Foundation, 140 million households paid about $1.4 trillion in individual income taxes in 2014, which covered about 38 percent of federal expenditures in that year. In terms of the distribution of the tax burden, the top 50 percent of income earners paid 97 percent of the total income taxes, the top 10 percent paid 71 percent, and the top 1 percent of earners (starting at $466,000 in gross income) paid nearly 40 percent of all federal income taxes. The tax system has evolved to a point where the bottom half of the income distribution has been taken off the income tax rolls while the burden of those taxes has shifted heavily toward the top 10 percent of income earners.
In terms of the "middle class," the Congressional Budget Office estimates that in 2013 the middle quintile of taxpayers—those making 10 percent above and below the mean household income of $69,700—paid only 4 percent of all federal income taxes, versus 38 percent for the top 1 percent and 88 percent for the top 10 percent. That middle-income group paid an effective income tax rate of 2.6 percent on gross income, compared to 24 percent for the top 1 percent of income earners and a 16 percent rate for the top 20 percent. The top 1 percent of income earners now pays 10 times the amount of federal income tax (and 10 times the effective tax rate) as the 20 percent of taxpayers in the middle of the income distribution.
This shift in the burden of taxation is the direct result of the tax revolution of the 1980s. In 1980, that middle quintile of the income distribution paid 11 percent of the income tax (versus 4 percent now), the top quintile paid 65 percent (versus 88 percent now), and the top 1 percent paid just 18 percent (versus close to 40 percent today). This dramatic shift in tax burdens occurred despite the fact that marginal rates for the highest brackets have come down significantly since 1980. Contrary to expectations, the reduction in rates has led to a much more progressive income tax system. A 2008 study by the Organisation for Economic Cooperation and Development concluded that despite these reductions in marginal rates, the United States has the most progressive income tax system of all 24 OECD countries measured in terms of the share of the tax burden paid by the wealthiest households.
Economists and tax experts have identified various causes of the redistribution in the tax burden. In terms of tax policy, the shift was due partly to steady increases in the standard deduction, reductions in rates, and the introduction of the various tax credits, especially the Earned Income Tax Credit, all of which have reduced taxes for the lower brackets, combined with the Alternative Minimum Tax, whose effects fall more heavily upon those in the higher brackets.
The other important factor has been the evolution in the distribution of income favoring households in the higher income brackets. Across this period, the top 1 percent of households doubled their share of national income from 9 percent in 1980 to 18 percent in 2007 and 2008 and 17 percent in 2012. According to estimates from the Tax Foundation, this share increased again to 20 percent in 2014. The top 10 percent of earners also increased their share of national income, though not as much as the top 1 percent, from 30 percent in 1980 to 38 percent in 2013.
There has also been a startling evolution over the decades in the composition of taxpaying households. Increasingly those in the higher brackets represent two-income households while those in the lower three brackets tend to be single filers. In 1960, according to IRS figures compiled by the Tax Foundation, 68 percent of filers in the middle quintile of the income distribution were married while 32 percent were classified as "single/head of household." By 2006, those figures had reversed themselves: Just 32 percent of the filers in that group were married and 68 percent were single or heads of households. Among the top 20 percent of earners, by contrast, 93 percent were married in 1960, but by 2006 that figure had fallen only to 82 percent. Since most of those in the latter group are two-income households, they naturally claim ever-larger shares of national income.
Whatever the causes, the wealthy are paying more of the income tax because they are earning more of the income—and since that income is taxed at higher rates, it provides more revenue for the government than if it were distributed more evenly through the population. Much like state governments that have developed a financial interest in smoking due to the revenues they receive from tobacco sales, the federal government has developed a perverse interest in income inequality because of the greater revenues it generates due to the progressive income tax.
But the progressive income tax plays only a modest role in smoothing out the distribution of income. Over the entire period since 1980, the top 1 percent of the income distribution lost between 1 and 2 percent of its share of national income due to taxes. In 1980 that group claimed 9 percent of pre-tax national income and 8 percent of after-tax income; in 1990 the corresponding figures were 12 and 11 percent; and in 2012, the figures were 17 and 15 percent. The top 10 percent of the distribution generally lost between 2 and 4 percent of national income shares due to taxes (probably because those households take a greater share of income in salaries and wages than in capital gains, which are taxed at lower rates). These losses in shares of national income paid for modestly increasing shares claimed by those in the lower two quintiles of the income distribution.
There are many reasons why the progressive income tax has only limited effects on the distribution of income, but one of them has to do with the limited role of the income tax as a source of federal revenues. Many believe that the federal government is largely funded by income taxes, but this has never been the case. In 2015, the federal government raised $3.2 trillion in revenues, of which 47 percent came from income taxes, 34 percent from payroll taxes, 11 percent from corporate taxes, and the balance from a mix of estate and excise taxes. Since the early 1950s, the federal government has consistently relied upon the income tax for between 40 and 50 percent of its revenues. The payroll tax that funds Social Security and Medicare (plus a portion of the Affordable Care Act) has meanwhile made up between 35 and 40 percent of federal revenues (the average since 1990 is 38 percent). As the payroll tax is a flat-rate tax, it does not have the progressive effects of the income tax; and, since it is a large source of revenue, it diminishes any progressive effects of the income tax.
Middle-income groups do pay their share of payroll taxes because they mostly receive their incomes in the form of salaries and wages. Taxpayers in the middle brackets (and in the bottom two quintiles as well) generally pay the full 7.65 percent tax on wages and salaries to fund the nation's old-age pension and health care programs. (The matching share contributed by the employer is also effectively paid by the employee.) This rate is far higher than the effective income tax rate (2.6 percent) paid by the middle quintile of households. According to CBO calculations, payroll taxes represent around two-thirds of all federal taxes paid by that middle quintile of taxpayers. If we add state and local taxes to the equation, then that middle-income group pays an even smaller share of its total tax bill in the form of federal income taxes.
This will make it difficult to enact "massive" cuts in middle-class taxes by reducing federal income tax rates, since the overwhelming proportion of taxes paid by middle-income groups come in the form of payroll taxes plus state and local income, sales, and property taxes. It will also make it difficult to cut those marginal rates without acknowledging that the lion's share of the benefits will go to those in the highest brackets. The Tax Foundation, in a static analysis of the Trump tax plan announced during the campaign last year, found that it would lead to at least a 0.8 percent increase in after-tax income for all taxpayers but to 10 percent higher after-tax incomes for those in the top 1 percent. This static analysis does not take into account the growth effects of the plan and the potential income gains for middle-class taxpayers. When those effects are taken into account, the same organization found that those middle-class taxpayers stand to benefit significantly from tax reform, but mainly through the growth in incomes rather than through cuts in taxes.
This points to the difficulties in trying to pass a comprehensive tax reform that will provide substantial tax relief for the middle class. For the reasons outlined above, there is no plausible adjustment in income taxes that can achieve that goal. Any comprehensive plan that will cut marginal income tax rates will be vulnerable to attacks that it represents a giveaway to the wealthy. Given the current political environment and the polarization between the parties in Washington, those charges may be persuasive enough to scuttle any comprehensive tax proposal.
One answer to the tax conundrum is to abandon for the time being the effort at comprehensive reform in order to concentrate on those proposals most likely to win consensus in Congress and spur faster economic growth and rising middle-class incomes. According to many experts, tax reforms that reduce the cost of capital provide by far the largest short-term boosts to GDP.
This suggests that the business proposals—especially cuts in the corporate tax rate and allowance for immediate expensing of investment—should receive priority attention. According to the Tax Foundation's analysis of the GOP's "blueprint," the proposals (if fully enacted) would boost long-term GDP by 9 percent, with full expensing representing 5 percent, the corporate tax cut 2 percent, and the remainder coming from lowered marginal rates and compression of income tax brackets. If the principal goals of tax reform are to boost growth and middle-class incomes, cutting the tax burdens on business is the most direct avenue for achieving them. Once the growth kicks in and added revenues pour into the government, it may prove easier to enact other elements of the plan.
The redistribution of the income tax burden over the past three decades has at length altered the debate over tax reform. In the past it was assumed that cuts in personal income taxes were much easier to sell to the public than cuts in business taxes, even though economists have long told us that the latter are much more effective in promoting economic growth. That logic may no longer hold because most households no longer pay much in the way of federal income taxes. Paradoxically, we may have reformed ourselves into a tax system where the easiest taxes to cut are precisely those that are most effective in promoting economic growth.
This piece originally appeared in The Weekly Standard
James Piereson is a senior fellow at the Manhattan Institute.
This piece originally appeared in The Weekly Standard