The Tax Cut: Not as Big as Advertised

This column was first published in Investor's Business Daily, July 2, 2001.
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While critics are still complaining that the $1.35 trillion tax cut is toobig, a review of the numbers shows that about half of the cut simply offsetsautomatic tax increases caused by economic growth. These automatic taxincreases, or “real bracket creep,” occur because growth pushes moreindividual earnings into higher tax rate brackets.

This year’s tax cut did not directly address this problem. Worse, if thetax cut actually sunsets in 2010 as currently written, taxpayers will gethammered as higher tax rates are suddenly applied to a decade’s worth ofreal income gains.

The main source of real bracket creep is the steeply graduated rate bracketsunder the income tax. The five old tax brackets ranged from 15 percent to39.6 percent. The six new tax brackets will range from 10 percent to 35percent when fully phased-in. While tax brackets are indexed for inflation,they are not indexed for real economic growth. This means that every payraise you receive above and beyond inflation boosts your average tax rate.The effect is an annual “stealth” tax increase that no politician isrequired to vote for.

For example, the typical taxpayer in the 28 percent marginal rate brackethas an average tax rate of 14 percent, according to IRS statistics. Everyreal pay increase these taxpayers receive will be taxed at 28 percent, thus having the effect of pulling their overall average tax rate up above 14percent.

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 faceboth a higher marginal tax rate and a higher average tax rate.

The overall effect of these hidden tax increases can be estimated by lookingat 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 taxreceipts. The 0.8 percent rise in the tax-to-GDP ratio is the automatic taxincrease that would have occurred without the $1.35 trillion tax cut.

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

The CBO’s figures illustrate a number of important policy issues. First, asubstantial tax cut is needed every few years just to offset the effect ofreal bracket creep automatically over-filling federal coffers. During the 1990s, strong economic growth led to huge tax increases, even aside fromBill Clinton’s 1993 tax hike. The tax-to-GDP ratio rose from 7.3 percent infiscal 1994, after Clinton’s tax hike was in place, to 9.2 percent in fiscal2001.

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

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 fromeconomic growth almost every year. A straightforward solution would be toindex 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 ourmoney.

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