Sometimes the biggest tax increases are not written into law. That’s true for the tidal wave of new revenues our federal tax system is generating this year. Federal tax receipts have already risen by 11 percent ($100 billion) over what they were this time last year, and there are still five months left in the fiscal year.
But last year Congress enacted a tax cut. How can revenues be soaring? Part of the answer is the effect of lower tax rates on capital gains. Capital gains receipts have nearly doubled since 1995. No surprise here: over the past 40 years, every time Congress has cut the capital gains tax rate, tax collections on capital gains have risen. Cutting that tax remains the one tried and true method of soaking the rich.
But there’s another more important explanation for record tax collections this year: American workers are suffering from “real income bracket creep.” Real income bracket creep is a natural result of the graduated income tax. Graduated income tax rates mean that in a time of economic growth — like the one we’re experiencing today — Americans’ higher incomes push them into higher tax brackets. Income gains in the past five years have pushed millions of middle-income families out of the 15 percent marginal tax bracket into the 28 percent bracket. Hundreds of thousands of others have been pushed from the 28 percent bracket into the 31 and 36 percent brackets, and so on.
Bracket creep is economically destructive and morally disastrous. One of its consequences is that, during economic expansions, the government’s fiscal intake rises faster than the family’s. In the past three years, federal income tax receipts rose at almost twice the pace of wages and salaries. For example, this year income is up a respectable 6 percent, but tax receipts are up 11 percent. This exacerbates what House Majority Leader Dick Armey has called the “middle class squeeze.”
What is the effect of real bracket creep over time? Today, federal taxes are more than 20.2 percent of gross domestic product — the highest burden since the end of World War II. On the margin, the yearly change in individual tax receipts as a share of the change in personal income (less transfer payments) has reached an extraordinary 38 percent. This is the real effective tax burden on middle-income working Americans. Thirty-eight percent is way, way too high.
To protect against future bracket creep, Congress should also adjust the tax brackets for inflation plus real income growth.
Real bracket creep allows Congress to collect more and more tax revenues from the public without ever having to go on record as raising taxes. Hence, income tax bracket creep is the ultimate invisible tax hike. It gives politicians the best of all worlds. Newt Gingrich and Trent Lott can sanctimoniously thump their fists on their chests and boast about tax cuts passed by the GOP Congress while they pluck more feathers from the geese than ever before. No, Newt and Trent haven’t raised our income tax rates. But they might as well have. They simply have allowed the built-in bracket creep in the tax system to do the dirty work for them.
Congress’s top tax priority this year should be to reverse five years of real income tax bracket creep. It’s an easy problem to solve. First, expand the income threshold for the 15 percent tax bracket to apply to most middle-income families and to reverse five years of real income bracket creep, just as Sen. Paul Coverdell (R-Ga.) and Rep. John Thune (R-S.C.) have proposed.
Second, to protect against future bracket creep, Congress should also adjust the tax brackets for inflation plus real income growth. Recall that in 1981 Ronald Reagan began to adjust the income tax brackets for inflation. That was a huge bonus for taxpayers. But that procedure was insufficient. Milton Friedman recently announced his support for adjusting the income tax brackets for real income growth in the Wall Street Journal.
Here’s how the new policy would work. Assume that in a given year inflation is 3 percent and real income growth is 2 percent. Under current tax rules, the income tax brackets would rise by 3 percent. Under the new rules, the brackets would rise by 5 percent. The government would still receive a dividend from higher growth, just not a bigger dividend than workers get. Taxes as a share of GDP would stabilize.
One attractive feature of this proposal is that it costs very little in terms of lost revenues in the short term. The five-year cost of adjusting the income tax code would be small, thus mitigating budget rule problems of “paying for” the tax cut. But the tax savings multiply dramatically over time because of the odious compounding effect of real bracket creep.
For four years congressional Republicans have talked ad nauseam about the middle-class squeeze. Yet — because of bracket creep — the squeeze has become a bear hug after four years of a GOP Congress. Here’s a sensible policy to loosen the government’s grip.