I have an article in today's Wall Street Journal:
As the presidential campaign heats up, a key issue is whether to extend the 2001 and 2003 income tax cuts, which expire in 2011. John McCain wants to make the tax cuts permanent. Barack Obama and Hillary Clinton want to let the rates rise.The basic story is that the actual tax you pay is a function both of the tax rates (10%, 15%, etc.) and the tax brackets, that is, the dollar values determining to what income each rate applies. Since the brackets are indexed only to inflation while incomes tend to rise faster than inflation, taxes will tend to rise as a percentage of income. There are two ways this can happen: first, you may shift into a higher tax bracket. And second, even if you don't shift brackets, a greater portion of your income will be in the highest bracket to which you are subject, and so your average tax rate will rise even if your marginal rate does not. The tax cuts vs Social Security argument focuses only on the rates, not the brackets, and in this way is misleading.
Opponents of the tax cuts point to spending programs that could be financed by the extra revenues. Chief among these is Social Security. Sen. Obama's Web site, for example, argues that "extending the Bush tax cuts will cost three times as much as what is needed to fix Social Security's solvency over the next 75 years."
Such statements imply that if we return to the seemingly modest tax rates of the 1990s, we could fund the $4.3 trillion Social Security deficit, and so much more. As Mr. Obama recently told Fox News, "I would roll back the Bush tax cuts on the wealthiest Americans back to the level they were under Bill Clinton, when I don't remember rich people feeling oppressed."
This argument seems compelling, but it is misguided. In reality, repealing the tax cuts would raise taxes far above Clinton-era levels. Due to quirks in the tax code, average taxes would be almost 25% higher than during the 1990s.
Mr. Obama's claim that the lost revenue from the income-tax cuts exceeds the Social Security shortfall derives from an analysis by the Center on Budget and Policy Priorities. The Center's conclusions have been widely cited, but rely on dubious assumptions.
The basic methodology is simple: Compare the income-tax revenues if the tax cuts expire to revenues if the tax cuts are extended. The Center measures the difference in revenue 10 years from now – to match the government's 10-year budget measurement period – then extends the difference over 75 years to make it comparable to the 75-year Social Security shortfall.
To account for the effects of inflation and economic growth, analysts compare tax revenues to the size of the economy. The Congressional Budget Office projects that if the tax cuts expire, income-tax receipts in 2018 will be 1.5% higher relative to gross domestic product than if the cuts are made permanent. By comparison, Social Security's 75-year shortfall is just 0.6% of GDP.
So Social Security is a costly problem, but the tax cuts cost much more. Open and shut case, right?
Not exactly. Tax revenues would skyrocket if the tax cuts expire, due to "bracket creep." Average incomes are higher today than in the 1990s, but income-tax brackets aren't adjusted for the growth of earnings. As a result, Americans will shift into higher tax brackets and pay a greater share of their incomes in taxes.
Going back to the tax rates of the 1990s doesn't mean that households will pay 1990s taxes. Because the tax brackets haven't risen along with incomes, average taxes would be significantly higher, and grow each year.
If the tax cuts expire, income-tax revenues by 2018 will rise to 10.8% of the total economy from 8.7% today – an increase of 24%. Compared to the average over the last 50 years, allowing the rates to rise would increase tax revenues by 32%.
Believe it or not, income taxes will rise even if the tax cuts remain in place, because the revenue-increasing effects of bracket creep more than offset the lower rates. With the lower rates, total income-tax revenues will increase to 9.3% of GDP by 2018. This level is 7% higher than today, and 13% above the 1957-2007 average. Thus even with the tax cuts, revenues will increase by more than enough to fix Social Security.
So even if the tax cuts are made permanent, future Americans will pay a greater share of their incomes to the government than in the past. But for some in Washington, that's not enough.
Not surprisingly, neither party highlights these rising tax receipts. They undercut liberal arguments that the government is starved of revenue. And they render conservative claims for the tax cuts unimpressive. ("Vote GOP: A smaller tax increase than the other guys!")
The next president will face difficult choices regarding how much to collect in taxes, and how much to spend on entitlements like Social Security. Future citizens may decide that paying higher taxes is worthwhile. But in any event, the misleading tax cuts vs. Social Security argument should not guide policy makers on this issue.
Mr. Biggs, a resident scholar at the American Enterprise Institute in Washington, D.C., is the former principal deputy commissioner at the Social Security Administration.