Federal Tax Policy 101

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Federal Tax Policy 101

• Aviva Aron-Dine and Ellen Nissenbaum
• Center on Budget and Policy Priorities
• December 10, 2007

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Part 1 Federal Tax Issues The Basics
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Why Work on Tax Issues?

• Federal tax policies
• Determine whether there are adequate revenues to
  fund important programs
• Can narrow or widen gaps between rich and poor
• Directly affect low- and moderate-income
  households (EITC Child Tax Credit)

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Key Criteria for Tax Policy

• Revenue adequacy
• Equity
• Progressivity Taxes higher as a share of income
  for high-income households
• Efficiency
• Effect on overall economy
• Success in promoting specific social goals
• Simplicity/ Administrability

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Where Do Our Tax Dollars Go? The Federal Budget
in 2006
Interest on the Debt
Social Security
Other Entitlements
Medicare Medicaid
Non-Defense Discretionary
Defense Discretionary
Source Congressional Budget Office.
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Where Do Tax Dollars Come From? Federal Revenues
in 2006
Corporate Income Tax
Individual Income Tax
Payroll Tax
Other (Estate, Excise, etc.)
Source Congressional Budget Office
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Federal Tax System Is Modestly Progressive Overall
2004 Income Shares
Note - For a family of four, income cut-offs are
bottom fifth, up to 35,000 second fifth,
35,000-60,000 middle fifth, 60,000-85,000
next fifth, 85,000-130,000 top fifth, above
130,000 top 1 percent, above 500,000. Source
Congressional Budget Office
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Federal Tax Policy Poverty The Earned Income
Tax Credit Child Tax Credit

• The EITC is a refundable tax credit the CTC is
  partially refundable. Refundable credits are
  available to people with incomes too low to owe
  taxes.
• The EITC lifts more children out of poverty than
  any other federal program.
• Studies have found that the EITC boosts
  employment among single mothers.
• The refundable CTC also has a significant
  anti-poverty impact.
• Opportunities exist to improve both credits.

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Last 25 Years Have Seen Rapid Income Growth at
the Top, Virtually No Growth at the Bottom
Growth in Average Real Pre-Tax Income, 1979-2004
Source Congressional Budget Office
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Federal Tax System Has Become Significantly Less
Progressive
Effective Federal Tax Rates, 1960-2001, and
Projected Tax Rates for 2004
Top Hundredth of One Percent
Top Tenth of One Percent
Top One Percent
Middle Quintile
Source Thomas Piketty and Emmanuel Saez, based
on IRS data
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Looking Ahead Tightening Budget Squeeze
Source CBPP calculations based on Congressional
Budget Office data
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Major Tax Policy Decisions Will Be Made in Next
Few Years

• Which tax cuts will be extended and which allowed
  to expire?
• Will the costs of extensions be offset?
• What will happen to the estate tax and the
  Alternative Minimum Tax (AMT)?
• These choices will have major implications
• for revenues, programs, and the distribution
• of income.

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Part 2 The 2001 and 2003 Tax Cuts
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The 2001 and 2003 Tax Cuts An Overview

• Components
• Reduced income tax rates for top 4 brackets
• Provided Alternative Minimum Tax relief
• Cut capital gains and dividend rates
• Phased out and repealed estate tax
• Middle-class provisions Child Tax Credit, 10
  percent tax bracket, marriage penalty relief
• Cost About 2 percent of the economy (GDP) or 10
  percent of all federal revenues annually
• Key Feature Expire at the end of 2010

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Provisions of the 2001 and 2003 Tax Cuts
Share of Annual Cost When Fully in Effect
Upper-Income Marginal Rate Cuts 22
Additional AMT Relief Costs Due to The Tax
Cuts 22
Estate Tax Repeal 20
Middle-Class Provisions 10 percent bracket,
Child Tax Credit, marriage penalty relief 23
Capital Gains and Dividend Tax Cuts 9
Other 4
Source Joint Committee on Taxation, CBPP.
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Large Surpluses to Large Deficits
Cumulative Surpluses/Deficits, 2002-2011
Source Congressional Budget Office. Assumes
continuation of AMT relief, phasedown
of operations in Iraq and Afghanistan, and the
Presidents defense spending request.
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Legislation Adding to DeficitsMostly Tax Cuts
and Defense
Cost, 2002-2011, of legislation enacted since
January 2001
Tax Cuts Defense, Homeland Security and
International Entitlements (mostly Medicare Part
D) Domestic Discretionary (except Homeland
Security)
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Source CBPP calculations based on Congressional
Budget Office data. Assumes extension of tax
cuts and Alternative Minimum Tax relief.
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Tax Cuts Cost More Than MostAgency Budgets
2006 Agency Budgets, Tax Cuts if Fully in Effect
in 2006
Source CBPP calculations from CBO and OMB data
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Nation Faces Serious Budget Problems Problems
Far Worse If Tax Cuts Extended
Debt as a Share of the Economy
Debt If Tax Cuts Expire
Additional Debt With Tax Cuts Extended
Source CBPP calculations based on Congressional
Budget Office data.
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The Distribution of the Tax Cuts When Fully in
Effect
Average Value of the Tax Cuts in 2012
Source Tax Policy Center
21
The Tax Cuts Exacerbate Inequality

Percent Increase in After-Tax Income From 2001
2003 Tax Cuts When Tax Cuts Are Fully in Effect
Source Tax Policy Center
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Given that Tax Cuts Eventually Must Be Paid for,
Most Households Likely to Lose

• Tax cuts typically presented as if they were a
  free lunch, with no one ever footing the bill.
• In reality, deficit-financed tax cuts eventually
  must be paid for with spending cuts or tax
  increases.
• Even if eventually paid for with a balanced
  package of spending cuts and tax increases, the
  bottom 80 of households are likely to lose, on
  average, from the combination of tax cuts
  financing.

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Estate Tax Repeal Costs More Than 1 Trillion
Over 10 Years
Cost, With Interest, 2012-2021
Interest cost
Revenue loss
Source Joint Committee on Taxation and CBPP
24
Reform and Compromise Options Still Very Costly
Proposal would tax the value of an estate up to
25 million at the capital gains rate the value
above that at 30.
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Rising Exemption Level Sharply Reduces Share of
Estates Owing Tax
The estates of 3 in 1,000 people who die would
owe any tax under 2009 law.
675,000 Exemption
1 million Exemption
2 million Exemption
3.5 million Exemption
Source IRS, Urban-Brookings Tax Policy Center
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Tiny Number of Small Businesses Farms Owe Any
Estate Tax
Number of Taxable Farms and Small Businesses
Nationwide Had Various Exemption Levels Been in
Place in 2000
(Actual 2000 Exemption)
Source Congressional Budget Office
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Estate Tax and Other Priorities

• Supporters of estate tax repeal and expensive
  compromises seek to make estate tax reform seem
  more urgent than other expiring tax provisions.
• No reason to let estate tax reform cut to the
  front of the line ahead of middle-class tax cuts
  that are also set to expire (and ahead of other
  national priorities).

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Part 3 Talking About Taxes and the Economy
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Taxes and the Economy

• Tax cuts often promoted with exaggerated claims
  about economic effects
• Difficult to actually establish effects of taxes
  and tax cuts on the economy
• Three main approaches
• Historical and cross-country studies
• Studies of work and savings decisions
• Economic simulations

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Investment Increased Following the 2003 Tax Cuts
Quarterly Percent Growth in Non-Residential
Investment
2001 Tax Cuts
2003 Tax Cuts
Source CBPP calculations based on Commerce
Department data
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But Increased More Following the 1993 Tax
Increase
Quarterly Percent Growth in Non-Residential
Investment
1993 Tax Increase
1990 Tax Increase
Source CBPP calculations based on Commerce
Department data
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Economys Overall Performance Somewhat Better in
1990s
Average Annual Growth Rate, Adjusted for Inflation
Source BEA, BLS data
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Taxes and the Economy Work and Saving Decisions

• Empirical studies consistently find little effect
  on work effort of primary earners.
• Private saving probably not very responsive to
  taxes.
• Congressional Research Service Most empirical
  evidence seems to point to little savings
  response.
• Revenue levels influence government savings.
• Deficits government dissaving
• National saving private public saving

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Treasury Simulations Effects of Tax Cuts on the
Economy Are Small
Percent Increase in Real GDP through 2025
Tax Cuts Extended Paid for With Spending
Cuts (Treasury Better-Case Scenario)
Tax Cuts Expire
Note Treasury did not provide year-by-year
numbers to the specific annual path is
illustrative only.
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Unpaid-For Tax Cuts As Or More Likely to Hurt
Than Help the Economy
"Nearly all of the simulations  done of the tax
cuts' effects on the economy  showed that the
tax cuts would have positive effects in the short
run and negative effects in the long run.  Often,
the long-run effects did not entirely materialize
by the end of the traditional 10-year forecast
window."  -- Congressional Research
Service Making the 2001 and 2003 tax cuts
permanent would raise the cost of capital for new
investments, reduce long-term investment, and
reduce economic growth. -- William Gale,
Brookings Institution and Peter Orszag
(formerly of the Brookings Institution, now
director of Cong. Budget Office) Studies by
Federal Reserve economists, the Congressional
Budget Office, the Joint Committee on Taxation,
and other noted experts have produced similar
findings regarding the effects of unpaid for tax
cuts.
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Economists Across the Political Spectrum Agree
Tax Cuts Lose Revenue

• Senior White House economists reject the claim
  that tax cuts pay for themselves
• I certainly would not claim that tax cuts pay
  for themselves.
• Edward P. Lazear, Chair White House Council of
  Economic Advisors
• There is no credible evidence that tax
  revenues rise in the face of lower tax rates.
• N. Gregory Mankiw, Former CEA Chair
• Analyses by CBO, the Joint Committee on Taxation,
  academic economists, and the Administrations own
  Treasury Department find tax cuts nowhere near
  pay for themselves. They may cost more than
  expected if financed by deficits, which harm the
  economy over the long run.

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Bottom Line Need to Decide What Sort of
Government We Want Fund It

• Main effect of taxes is to raise revenue.
• Economic effects are modest.
• Question is what level of revenue funds a
  government that meets the nations needs.
• Persistent, large deficits i.e. failure to fund
  the government we choose are economically
  damaging.