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Backgrounder #260 on Taxes

April 12, 1983

April 12, 1983 | Backgrounder on Taxes

Seven Reasons for Saving the Tax Cut

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260 April 12, 1983 SEVEN .REASONS FOR SAVING THE TAX CUT INTRODUCTION The corner has been turned. Nearly every economic indicator is signaling a strong recovery. Housing starts are running at 1.7 million a year, up from 900,000 units a year in June 1982 GNP is growing at 4 percent a year. The Stock Market has surged 40 percent since July 19

82. New unemployment claims are down 500,000 and the unemployment rate fell from 10.8 percent in Dece mber to 10.3 percent in March. Economic indicators have surged to a one-month record h1gh.l But the recent spate of good economic signs does not appear to have trickled down to Congress. The House Budget Committee's first budget resolution for FY 1984 att a cked the President's economic program as "the experiment that failed If The Committee's call for 30 billion in tax increases in 1984 is widely seen as taking aim at the July 1 income tax cut, the final 10 percent installment of the Economic Recovery Tax A c t of 1981 The repeal of the third tax cut would raise more than $28 billion in 1984, according to the Office of Management and Budget just about sufficient to meet the House Committee's revenue recommendations. The specter of twelve digit budget deficits i n the next years has convinced many Congressmen that the government cannot afford any revenue reductions. They claim that the third year is just another sop to the rich and must be repealed to prevent interest rates from rising again to levels that would c hoke off economic recovery 1 "First Concurrent Resolution on the Budget-Fiscal Year 1984 Report of the Committee on the Budget, House of Representatives, H. Con. Res. 91 March 21, 1983, pp. 27 and 282. 2 Those calling for repeal of the third year tax cut, however are asking the Congress to make a grave mistake. There are least seven reasons for saving the tax cut 1) to create jobs 2) to boost small business 3) to encourage savings 4) to foster productive investment 5) to shift the tax burden to the rich 6) to help the average American; and 7) to counter bracket creep.

Repealing the third year tax cut would hit hardest middle and lower-income Americans, and it would stifle the recovery now taking place. The tax cut is one of the most potent economic medicines Congress could administer to a recovering economy. The tax cu t will create jobs, encourage capital formation to finance business expansion and the government deficit and put money into the pocketbooks of working Americans for more saving and consumer spending. Repeal of the third year tax cut, on the other.hand woul d throw a wrench into the gears of economic recovery.

The repeal of the third year tax cut would severely'hurt small business--the most powerful generator of new jobs and new technology. Most smaller American businesses are either sole proprietorships or p artnerships taxed through individual tax returns, rather than through the corporate income tax system.

A July tax increase on this dynamic sector of the economy could cause the bottom to fall out of the economic recovery.

The repeal of the third year tax cut would also drive many taxpayers back into tax shelters, just when the tax cuts have begun to lure many taxpayers away from these nonproductive activi ties and into the financial markets. One indication of this shift: estimated income tax payments gen e rally made by upper income individuals, reports Forbes magazine, are 10 percent higher in 1982 than the year before. The Treasury had predicted that the cut in the top bracket rate from 70 percent to 50 percent would actually reduce tax collections by $5 billion.

The repeal of the tax cut, however, would hit hardest of all the middle- and lower-income American. Households making between taxes. These Americans will get about 72 percent of the benefits from the 1983 tax cut. The scheduled 10 percent rate red uction will provide about $175 billion in tax relief between 1983 and 19

86. About $125 billion will go to those families making below 50,000 a year. Those earning above $100,000 will get only 9 percent of the tax relief although they pay 15.7 percent of all income taxes 10,000 and $50,000 a year pay about two-thirds of all income The third.year rate cut, in fact, provides average- and middle-income Americans with the first real income tax relief.

The 1981 and 1982 income tax cuts, Treasury statistics ind icate, 3 were completely wiped out by bracket creep and Social Security tax increases. If the third year tax cut is eliminated, only the rich will come out ahead. The wealthy received the bulk of their tax cut in 1981, when the top marginal tax rate was r e duced from 70 percent to 50 percent. If the July cut is eliminated, those making between 10,000 and $50,000 a year will lose over 30 percent of the tax relief from the cumulative three-year tax reduction. They will face tax increases in the first year of repeal of between 31 and $8

28. Those making over $200,000, on the other hand, would lose only 13 percent of the three-year tax cut benefits.

The third year of the tax cut should not be put on the chopping block--not even in an attempt to reduce budget de ficits In fact, there is no clear evidence that government deficits have raised interest rates or delayed economic recovery. Between March 1981, the Administration's first budget forecast, and January 1983, the Administration's latest full budget report e stimates of the total budget deficits for 1982-1986 increased by nearly 2,500 percent. Interest rates on government T-bills however, dropped by 50 percent between March 1981 and January 19

83. Those who now claim that budget deficits will sabotage recovery by running up interest rates must explain why interest rates fell so dramatically in 1981 and 1982 After Reagan's three-year tax reductions, the tax share of GNP will finally come closer to the level that it was during the last period of sustained, healt h y growth. The tax share was about 18 percent of GNP in the mid-l960s, and the economy then grew by a robust 5 percent and created approximately one million jobs a year. On the day Reagan took office, the tax share was approximately 20 percent. And even wi t h the full three-year Reagan tax cut and indexing, tax revenues will still constitute about 19 percent of GNP in 1988 Those who claim that the third year cut creates a tax !'short fall conveniently overlook that fact. Tax revenues, even if the full progra m of tax cuts becomes effective will increase by about 8.5 percent a year between 1981 and 19

86. In 1986, federal revenues are expected to be 841.9 billion--up nearly 50 percent from the 1981 tax take of $559.3 billion. Tax revenues are forecast to increa se on average by 57 billion a year between 1981 and 1986 The deficit problem, therefore, does not stem from too little revenue It stems from too much spending and a lackluster economy. The tax cut medicine will help cure these underlying problems. And it i s clear that the prescription is beginnning to work. Congress should not hold back the.last dose of medicine just as the patient shows signs of recovery. There are at least seven reasons why this medicine is needed. 4 Reason No. 1: Creates Jobs The only m e ans of creating new jobs is through economic growth A 5 percent real growth rate, according to one rule of thumb, generates enough jobs in one year for all the new entrants into the workforce and creates one million additional jobs for the unemployed. The July tax cut lays the foundation for an economic upswing that promises to put the unemployed back to work.

Repeal of the July tax cut at this stage of the recovery however, would hurt productivity, savings and investment. The February report of the Congre ssional Budget Office (CBO an organization generally unsympathetic to supply-side economics warned of the dire consequences of raising taxes in a recession Increasing taxes during this recession,Il the CBO cautioned could well make it worse and delay econ o mic recovery Tax increases should be cautiously considered even when the economic recovery is underway, recommended the CBO, since Ifsuch increases could, if not carefully designed, inhibit long-term investment and economic growth Even Keynesian Nobel eco n omist James Tobin recently noted in the New York Times, IIPresident Reagan, to his credit, remembers what even most Democrats forget, the perversity of raising taxes in hard times In short, the economic recovery hinges to a large extent on the July cut. T h e unemployed steel worker in Pennsylvania, the laid-off auto worker in Detroit, and the jobless textile worker in North Carolina desparately need the economic recovery as a lifeline to a new job. The repeal of the July tax cut threatens to cut that lifeli ne for them and millions of other unemployed workers and first-time job seekers.

Reason No 2: Boosts Small Business Repeal of third year of the tax cut would mean a sizable tax increase on the small business sector that is usually the locomo tive of econom ic recovery. About three-fourths of all businesses in the country are not corporations and they do not pay corporate income tax.2 They report their business income through individual tax returns A repeal of the third year personal tax cut would raise thei r taxes, slow the return to full output, and reduce investment in new plants and equipment.

Small businesses, recent evidence shows, are on the cutting edge of job creation and technology development. David Birch and Susan McCracken of th e MIT Center on Neighborhood and Regional Change estimate that two-thirds of all net new jobs are generated by businesses with fewer than 20 employees, and about 80 percent Bruce Bartlett The Future of Small Business in America Cat0 Institute Policy Repor t , February 1983. 5 by firms with 100 or fewer employees.3 These small businesses also generate 48 percent of the nation's business output, 43 percent of the GNP, and more than 50 percent of all industrial inventions and innovations. Small business is alre ady being taxed at a higher rate than most large corporations; a tax increase on this crucial sector could stop the economic recovery in its tracks.

Reason No. 3: Encourages Savings in new saving, which was up 30 percent in the third quarter of 1982 to 6.9 percent of personal disposable income. The increased pool of saving is a direct result of both the personal tax cuts and the reduction in inflation and is one of the most important conditions for a sustained recovery. Seventy percent of all new enterpris e s, according to a National Federation of Independent Business survey, obtain.their seed capital from personal savings.4 A major problem for new enterprises and small businesses recently has been the scarcity of such funds An enhanced environment for capit al formation is therefore the key to increasing the number of new business starts, and the pace of economic growth A repeal of the third year cut would deaden this important stimulus to capital formation.

Reason No 4: Fosters Productive Investment Repeal o f the third year tax cut could induce some taxpayers to withdraw their money from taxable investments and shift it once again into tax-exempt bonds, tax shelters or nontaxable consumption expenditures--leaving those who cannot afford such options to toil under a heavier income tax load. For this reason the proposal to restrict the tax cut to low- and middle-income Americans is particularly dangerous.

One such proposal would limit the tax cuts to 700 per return, which would eliminate the third year of the t ax cut for all families with an annual income greater than 46,500 ($35,700 for single return). This cap would raise only some $18.7 billion between 1984 and 19

86. Yet it could wreak havoc with the economy because savings would be seriously reduced. Those who make an after tax income above 50,000 a year save over 64 percent of their post-tax income, while those who make $10,000 a year after tax income manage to save only 12 per~ent David Birch Who Creates Jobs The Public Interest, No. 65 (Fall 1981); see also The Venture Capital Industry--A Brief Overview (Wellesley Hills, Massachusetts: Capital Publishing Corporation, 1982), p. 64.

Jonathan A. Scott, Assistant Professor of Finance Southern Methodist University, statement before the Subcommittee on Tax, Access to Equity Capital, and Business Opportunity of the House Small Business Committee Washington, D.C., May 20, 1982.

U.S. Department of Labor, Bureau of Labor Statistics, Bulletin No. 1997 and 1985, 1972 6 Reason No. 5: Shifts Tax Burden to the Rich As Forbes magazine reported, there are now strong indica tions that the first two stages of the Reagan tax cuts may have generated much higher tax revenues from upper-income Americans than the Treasury had predicted. Estimated quarterly income tax payments f o r FY 1982 are far above Treasury expectations. These quarterly tax payments, generally made by those in the higher tax bracke.ts, had been expected to fall from 77 billion in EY 1981 to about $72 billion in 1982, largely because of the reduction in the to p marginal rate from 70 percent to 50 percent. But the actual tax take was 85 billion, 10 percent more than in 1981 Writes Malcolm S. Forbes, Jr If you let people keep a little more of each additional dollar they earn, everyone, including the tax collector , comes out ahead.Il6 The best way to Ilsoak the rich" it seems, is to lower their tax rates.

This will come as no surprise to economists who have studied past tax cuts. Both the Mellon tax cuts in the 1920s and the Kennedy tax cuts in the 1960s shifted th e tax burden substantially toward upper-income taxpayers, while cutting rates on that group.7 In 1921, Americans with incomes over $50,000 paid 44 percent of all the personal income taxes collected. But in 1928, following the Mellon cuts, this income grou p paid 78 percent of the income taxes.

In 1963, the top 5 percent of all taxpayers contributed 35.6 percent of all personal income tax revenue. Following the Kennedy cuts in 1965, those taxpayers contributed 38.5 percent of the income taxes. While the full IRS figures for 1982 are not yet available it appears that the Reagan tax reductions are shifting the tax burden to wealthier taxpayers, even though the tax rates on high incomes have been cut.

Reason No. 6: Helps the Averaqe American The income tax cut is the major tax relief plank for the average American in the three-year Reagan package the first rate reduction of the Reagan program that will actually cut the tax rates of middle and low income taxpayers after taking into account bracket creep and Soci a l Security. People who make between 10,000 and $50,000 a year will pay about 67 percent of the personal income taxes in 1984 and they will get about 72 percent of the tax relief from the third year tax cut. Those making above 200,000 a year, on the other hand will receive only 1.8 percent of the tax relief, although they pay 7.1 percent of all personal income taxes (see Chart I It will be Forbes magazine, February 14, 1983, p. 31 Chris Frenze The Mellon and Kennedy Tax Cuts: A Review and Analysis,"

Joint Economic Committee, June 18, 19

82. See also Thomas M. Humbert A Surcharge: The Worst Tax?" Heritage Foundation Backgrounder No. 180 April 23, 1982.

Adjusted gross income class 7 CHART I The Effect of the Third Year Rate Reduction Distributed by Adjusted Gross Income Class 1981 Levels, 1984 Law Share of all taxes paid under 1984 law Share of benefits from the third year rate reduction 000 Less than 10 10 15 15 20 20 30 30 50 50 100 100 200 200 and over Total percent 2.1 5.8 8.1 20.7 29.9 17.7 8.6 7.1 100. 0 percent 2.6 5.8 8.5 23.1 32.1 18.8 7.2 1.8 100.0 Source: Office of the Secretary of the Treasury Office of Tax Analysis Assumes 4.5 percent rate of inflation for prior year.

Note: Details may not add up to totals due to rounding Wealthy Americans received the bulk of their tax benefits in 1981 when the top marginal tax rate was reduced from 70 percent to 50 percent. Those making over $200,000 a year, for instance receive abou t 13 percent of the total tax relief package from the third year tax reduction. The third year cut, in other words gives them relatively little. Middle- and lower-income taxpayers however, receive about one-third of their relief from the third year tax red uction.

Those who say the tax cut is only for the rich ignore the fact that the rich get a greater tax cut in money terms only because they pay much more in taxes. The family earning $10,000 is scheduled to receive a $31 reduction in taxes in 1984, while a family earning $100,000 a year will receive a $2,368 tax cut.

That is not unreasonable given that the $100,000 income family pays $24,424 in federal personal income taxes, while the $10,000 income family pays just $3

22. The only fair way to view the ta x cut is as a percentage of a taxpayer's current tax liability see Chart 11 8 "Description of Possible Options to Increase Revenues Joint Committee on Taxation and the Committee on Finance (JCS-24-82 June 15, 1982, p 85. 8 Chart I1 Reductions in 1984 Inco m e Tax Liability Due to the Third Phase of the Across-the-board Rate Reductions Enacted in ERTA Four-person, One-earner Family dollars 1984 Tax Reduction in tax liability liability without from Income 3rd rate reduction 3rd rate reduction Amount Percentage 10,000 20,000 30,000 40,000 50,000 100,000 200,000 322 1,713 3,363 5,394 7,993 24,424 62,566 31 164 360 520 828 2,368 4,366 9.6 9.6 10.7 9.6 10.4 9.7 7.0 Source: Office of the Secretary of the Treasury Office of Tax Analysis Note: Tax liabilities are calc u lated assuming deductible expenses equal to 23 percent of gross income and that all income is wages Reason No. 7: Counters Bracket Creep All income groups depend on the third year tax cut to offset bracket creep. During the 1970s, taxpayers whose income s imply kept pace with inflation found themselves shoved into ever higher tax brackets. The result: their after-tax purchasing power actually decreased, because the government took a greater and greater tax bite from their incomes.

Even the three-year Reagan tax cut package will not offset the tremendous bracket creep of the 1970s. Yet it will provide most Americans with some relief from further inflation-induced income tax increases. A family of four earning $25,000, for instance, received a basic tax cut o f $305 in 1982--thanks to the Reagan package.g Assuming that the family's income rose at the rate of inflation, bracket creep measured from 1980 raised that family's taxes by $3

02. Bracket creep, therefore, eliminated virtually all of the tax cut. In July, when the third stage of the income tax cut takes effect, the family's 1983 tax cut will grow to $609 cut of $1

86. Even this reduction, however, will be offset by a Bracket creep will take $423, leaving a net tax These and the following figures on brack et creep and tax cuts assume that a family's income keeps pace with inflation and are based on Treasury projections of inflation rates. Bracket creep is figured using 1980 as the base year and Social Security tax hikes are increases from 1980 rates. 9 152 Social Security tax increase from the 1980 rates. In all Social Security tax increases and bracket creep will eradicate about 94 percent of the tax reduction in 19

83. If the third year cut is eliminated by Congress, the same family in 1983 will experience a substantial tax increase over its 1980 taxes.

Similarly, a family of four earning $15,000 is counting on this year's 10 percent tax cut to keep ahead of bracket creep and Social Security taxes. In 1982, this family received a tax cut of $151, but brac ket creep actually increased its taxes by $154 for a net tax boost of $

3. Social Security tax hikes from 1980 rates added a further burden of $

85. Rather than receiving a tax cut in 1982;the $15,000-a-year family actually paid $88 more in taxes In 1983 , this family is due to receive a $248 tax cut but 86 percent of the tax cut ($214) will be offset by bracket creep. With a Social Security tax hike of $90, the family will suffer a $ tax increase in 1983--even with the July cut.

Upper-income taxpayers also feel the ill effects of bracket creep and Social Security levies. The family making $40,000 is due to receive a $1,318 tax cut in 19

83. Yet bracket creep will take $1,008, offsetting 76 percent of the tax cut. After the Social Security tax hike of $362, the $40,000 taxpayer will actually face a $52 net tax hike in 19

83. Again, the July I'cutI is no more than a slowdown in tax increase.

This situation will not change in later years. The $40,000 family will still pay $21 more in taxes in 1984 than in 1980 after bracket creep and planned Social Security tax hikes. By 1988, the tax bill will be $477 more than in 1980, even if Congress allow s the full Reagan tax cut program to go into place. And these numbers don't even include the effects of last summer's enormous 100 billion tax bite, the gasoline tax increase or the huge new Social Security tax hikes recently passed by Congress Indeed, alm o st every income group will face, at best, only a modest tax cut--even with the third income tax cut in place. If that 10 percent tax cut is repea1ed;virtually every income group, save the very rich, will pay steeply higher taxes than before the Reagan Adm inistration took office. In short, the promise to give average- and lower-income taxpayers some relief from bracket creep and Social Security taxes can only be fulfilled if the third year of the tax cut remains on the statute book.

THE ISSUE OF DEFICITS Th ose seeking repeal of the third year tax cut say that government deficits, especially in future years, will sabotage economic recovery. They claim that as the economy begins to recover, the private demand for new investment capital will collide with the g o vernment's voracious credit appetite, and the resulting competition for funds will bid up interest rates to levels that will abort economic recovery. Repeal of the July cut, say these critics, is needed to reduce the deficit pressure 10 Their theory, howe ver, ignores reality. There is no simple or direct correlation between government deficits and interest rates In March 1981, the cumulative federal deficit was project ed at 33 billion for the period 1982 to 19

86. The President's January 1983 budget messa ge revised this total to $850 billion an almost 25-fold increase. According to the scenario sketched by opponents of the tax cut, these soaring deficits should have driven up interest rates. They did not. Instead, while deficit projections have skyrockete d, interest rates have plummeted. The rates on government Treasury bills, for example, reached a high of 16.3 percent in May 1981, but dropped to 7.81 percent by January 19

83. The prime rate fell from a high of 20.5 percent in August 1981 to 11 percent in January 1983 In short, deficits have climbed 2,500 percent since March 1981 while interest rates have dropped nearly 50 percent: The recovery is proceeding briskly, despite the deficits and contrary to the fears of many of the President's own advisors A f ar more dangerous threat to economic recovery is the lurking possibility of another tax increase. At this stage of the economic recovery a new hike would probably plunge the federal budget into an even deeper deficit, rather than curb it. As Chart I11 sho ws, higher taxes have not reduced budget deficits.

They are, in fact, associated with higher government outlays and deficits. All that tax increases seem to do is reduce the pressure on lawmakers to cutback spending CHART I11 Tax Receipts, Government Spend ing, and Deficits Period Tax Receipts as a Federal Deficits Federal Spending a percentage of as a percentage of as a percentage of GNP GNP GNP 1950-54 18.6 06 18.6 1955-59 18.1 06 18.1 1960-64 19.0 29 19.0 1965 -69 19.7 30 19.7 1970-74 20.5 -1.14 20.5 197 5 -79 21.8 -2.19 21.8 1980-82 23.8 -3.12 23.8 Source: Economic Report of the President, February 1983 Tax increases simply unleash more government spending rather than stem the flow of budget red ink. Tax receipts grew from $40 billion in 1950 to a projecte d $659 billion for 1984, a sixteen-fold leap in revenues. Receipts grew 1.4 times faster than GNP and 3.8 times faster than inflation. But.even this cover Congress's spending explosion. Government outlays over the same period skyrocketed twenty- fold, from $43 billion to almost $850 billion for 19

84. Outlays increased 1.2 times faster I 11 than government revenues, 1.6 times faster than GNP and 4.5 times faster than the inflation rate. As a result, government deficits grew from 06 percent of GNP to 3.12 percent of GNP in 1482.

The unbalanced budget is a symptom--not a cause--of the economy's poor economic performance. Rising unemployment automa tically increases expenditures for income support programs, while recessions reduce profits and wages a nd, along with them, govern ment revenues. The budget will not conceivably come into balance unless there is a strong recovery. And that will not happen if Congress taxes yet again.

There is strong recent evidence to support the view that tax increases ex pand, rather than contract, the deficit. Consider last summer's 100 billion tax hike. Paul Craig Roberts, former Assistant Secretary of the Treasury, explained in a Wall Street Journal article, the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) was supposed to "narrow the budget deficit by 100 billion over the 1983-1985 period and by $229 billion over 1983 19

87. Instead, Roberts discovered the five-year deficit projections widened by $612 billion between the mid-session review (summer 1982) and the end of the year." The only way to reduce the deficit is to maintain and extend the tax cuts.

According to the usual rule of thumb, four years of 5 percent real economic growth will lower the unemployment rate by four percentage points A four percentag e point drop in the unemploy ment rate would reduce the expected $200 billion deficits by between $120 billion and $140 billion. What are the chances of attaining this high level of economic growth for a sustained period? Nobody knows for certain, of cour se. But one thing is clear: the repeal of the third year tax cut would lower the trajectory of U.S. economic growth--just as it,appears the economy is recovering--making it far less likely that the budget gap will be reduced or new jobs generated.

CONCLUSI ON The repeal of the July tax cut would put the burden of balancing the budget onto the backs of working and lower-income Americans, leave them with the effects of past bracket creep and deny them their promised tax cut. The campaign to repeal the July ta x cut betrays a callous cynicism when it comes to the plight of working Americans determination to continue its spending splurge. If the third year tax cut is eliminated, the recovery will slow, deficits will rise and income taxes on average Americans will soar to higher levels than at the end of the Carter Administration It seems motivated only by Congress's lo Paul Craig Roberts Big Taxes and Big Deficits The Wall Street Journal January 14, 1983. 12 The budget can be balanced only through vigorous economi c growth, coupled with spending reductions. The July cut promises to spur the economy into a robust and sustained recovery that will help generate more revenues to balance the budget recovery has already been launched successfully; it is no time to change the flight plan The Thomas M. Humbert Walker Fellow in Economics

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