Friday, May 9, 2008

Obama's Faulty Tax Argument

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.

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.
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.

7 comments:

Anonymous said...

First, Obama hasn't proposed rolling back all the Bush tax cuts, but "Supports restoring the top two personal income tax brackets and rates on dividends and capital gains to Clinton era levels" (http://www.taxpolicycenter.org/taxtopics/election_issues_matrix.cfm)

Second, "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%."

Why the switch from talking about the 90's to the "last 50 years"? Perhaps because income taxes in 1998 and 1999 were 9.6 percent of GDP, and in 2000 they were 10.3 percent?

Andrew G. Biggs said...

On the first point, the theme of the article was to respond to the factoid that the tax cuts cost several times more than the Social Security deficit, a factoid Senator Obama's campaign has utilized even if he favors repealing only the income tax cuts for higher earners. To respond to that factoid requires looking at the total cost of the tax cuts. The Center on Budget and Policy Priorities has looked at the cost of the tax cuts for high earners only, saying it's a bit more than the Social Security deficit. The same counter argument holds for either claim: that real bracket creep means that affected individuals would pay significantly higher taxes than they did before the tax cuts were put in place.

Second, I consider the current level of taxation and the long-term historical averages to be the best comparisons. However, Senator Obama himself cited taxation in the 1990s, saying that we would merely be going back to those levels. For that reason, I compared future revenues/GDP to levels from 1993-1999. Including the year 2000 wouldn't change the results significantly (it would be 22% higher rather than 25%). Moreover, even if we focused on only one year -- 2000, when income revenues were at the highest level ever relative to GDP -- letting the tax cuts expire would still increase taxes.

Arne said...

Again I agree with your conclusion, but find your reasons a bit off.

SS premiums are paid through payroll taxes in a reasonable compromise to create a retirement insurance to cover all workers. Income tax is different.

Comparing SS funding to income tax receipts is wrong to start with, so arguing about the details of the numbers is wrong. If Obama says the number of days in a week exceeds the number of fingers on his hand, telling him to count both hands is just as silly as his original remark.

Andrew G. Biggs said...

Arne,
Your comment makes sense. My first reaction to the 'tax cuts are bigger than Social Security shortfall' argument was 'so what?'. They're different things, and income tax cuts have only a very minor impact on Social Security financing (through reduced collections of income taxes levied on SS benefits).
But since many people don't accept the 'so what' argument, I thought people would find this approach interesting.
Andrew

Bruce Webb said...

Arne's comments always make sense. Perhaps because he is an engineer and not a theoretician.

As both Arne and Andrew point out the relation between marginal rates on the income tax side and some putative unfunded Social Security liability over the 75 year actuarial window is at best tenuous.

Which doesn't mean returning to 90's level brackets doesn't make sense. It might require adjusting the initial levels to avoid the bracket creep problem, if we have to adjust the new 39% bracket to not kick in until $400,000 instead of $260,000 (to pick figures out of the air) then we could do that, I'll take that revenue loss in order to get that extra 4% from the millionaires and billionaires. But to argue that bracket creep for certain upper middle class earners is a reason to not return to progressive taxation of the wealthy and ultra wealthy seems a little like special pleading.

Andrew G. Biggs said...

If you index the tax brackets to the growth of incomes then total tax collections will stay relatively constant as a share of GDP. Some factors will still thrown things off: e.g., increases in the non-taxable share of compensation (health, etc.), the distribution of income, and the rest. I think some folks at the Urban Institute have talked about ways to index the tax code to keep things more constant over time, though I haven't looked at it in a while.

But the larger question of how progressive the tax code is or should be is a broader one that depends both on moral values and judgments on how people react to tax rates.

Arne said...

My view of the data on tax revenues suggests that tax cuts were due during the Bush administration. Average revenue per return increased (inflation adjusted) by 50 percent from 1995 to 2000. 2005 was still above 1995. So by one measure, we are keeping even.

Since the economy has grown faster than inflation, revenue as a percentage of GDP has dropped dramatically, so by a second measure we are falling behind. Median real income is pretty stagnant - bracket creep is real, but most of the increase in average revenue per return comes from the fact that high earners have had incomes rise significantly faster than inflation, so it bracket creep has not reduced their buying power.

Combining all of the above with "moral values and judgments on how people react to tax rates", I conclude the Bush tax cuts were timely, that indexing brackets was not enough, but that what was put in place was too much.

Nowhere in my discussion of the tax cuts does SS show up at all.