Commentary

A Large Tax Cut? It’s Actually Small, As Bracket Creep Eats Into Salaries

This article originally appeared in Investors Business Daily on July 2, 2001.
While critics are still complaining that the $1.35 trillion tax cut is too big, a review of the numbers shows that about half of the cut simply offsets automatic tax increases caused by economic growth. These automatic tax increases, or “real bracket creep,” occur because growth pushes more individual earnings into higher tax rate brackets. This year’s tax cut did not directly address this problem. Worse, if the tax cut actually sunsets in 2010 as currently written, taxpayers will get hammered as higher tax rates are suddenly applied to a decade’s worth of real income gains.

The main source of real bracket creep is the steeply graduated rate brackets under the income tax. The five old tax brackets ranged from 15 percent to 39.6 percent. The six new tax brackets will range from 10 percent to 35 percent when fully phased-in. While tax brackets are indexed for inflation, they are not indexed for real economic growth. This means that every pay raise you receive above and beyond inflation boosts your average tax rate. The effect is an annual “stealth” tax increase that no politician is required to vote for.

For example, the typical taxpayer in the 28 percent marginal rate bracket has an average tax rate of 14 percent, according to Internal Revenue Service statistics. Every real pay increase these taxpayers receive will be taxed at 28 percent, thus having the effect of pulling their overall average tax rate up above 14 percent.

To make matters worse, every year hundreds of thousands of taxpayers receive pay increases that push them into higher rate brackets, say from the 28 percent bracket into the 31 percent bracket. These unlucky taxpayers face both a higher marginal tax rate and a higher average tax rate.

The overall effect of these hidden tax increases can be estimated by looking at Congressional Budget Office (CBO) revenue projections. Before this year’s tax cut was in place, the CBO projected that individual income taxes would increase from 9.0 percent of gross domestic product (GDP) in fiscal 2000, to 9.8 percent by fiscal 2011. These figures exclude capital gains tax receipts. The 0.8 percent rise in the tax-to-GDP ratio is the automatic tax increase that would have occurred without the $1.35 trillion tax cut.

This seemingly modest increase in the share of GDP going to the government adds up to big bucks over time. In fact, the rise of revenues from 9.0 percent to 9.8 percent would have added about $661 billion to federal coffers during the 2001-2011 fiscal years. This represents 49 percent of the $1.35 trillion tax cut over 11 years. Put another way, the tax cut really only reduces taxes by about $689 billion below levels in 2000.

The CBO’s figures illustrate a number of important policy issues. First, a substantial tax cut is needed every few years just to offset the effect of real bracket creep automatically over-filling federal coffers. During the 1990s, strong economic growth led to huge tax increases, even aside from Bill Clinton’s 1993 tax hike. The tax-to-GDP ratio rose from 7.3 percent in fiscal 1994, after Clinton’s tax hike was in place, to 9.2 percent in fiscal 2001.

Again, these figures exclude capital gains taxes. During 1990s, capital gains taxes magnified the federal tax grab by more than tripling from $36 billion in fiscal 1994 to $129 billion in fiscal 2001. The CBO currently projects that capital gains tax receipts will drop to under $110 by the end of this decade. That seems unduly pessimistic; it is more likely that individuals will be paying a growing burden of capital gains taxes in coming years.

A second policy upshot is that a permanent solution needs to be considered to end real bracket creep. Since the economy is in recession only about once every eight years, taxpayers encounter automatic tax increases from economic growth almost every year. A straightforward solution would be to index income tax rate brackets for both inflation and real wage growth. That way, Congress would actually have to take a vote to get more of our money.

Perhaps most importantly, these estimates highlight the urgent need for Congress to make this year’s tax cuts permanent. If they don’t, taxpayers in 2011 will be slammed not only with today’s high tax levels, but also a decade’s worth of hidden tax increases caused by real bracket creep.

Chris Edwards, a former senior economist with the Joint Economic Committee of Congress, is director of fiscal policy studies at the Cato Institute.