Spread-out tax cuts mask true impact: The rich win again

Tax professionals are working hard to come to grip with the intricate details of the $1.35 trillion tax law recently signed by President Bush. This attention to detail has distracted many, particularly the public, from the real economic and political significance of the 2001 tax cuts.

The reality is that the much-heralded, huge tax cut start out quite small. The significant cuts don’t begin until 2006. The total taxpayers will save for the first two fiscal years combined, for example, is only about 8 percent of the projected savings over the law's 10-year life.

Why would tax-cut advocates defer so many of the changes, particularly if they believe that slashing Taxes will get our faltering economy back on its feet? There are two plausible explanations, both of which have more to do with politics than economics.

The first is that by deferring the big cuts, Congress can take credit for providing tax relief, without having to slash spending for social programs. Congress put off the cuts until years when it estimates the government will have so much money that it can allow tax breaks, but not have to chop services. The problem is embedded in that word "estimates." If congressional projections about the economy's growth prove too optimistic the tough choices will fall to whoever is in charge several years from now. They will either have to revoke some tax cuts, shrink the government or tread back into deficit spending.

The second possible explanation for deferring cuts is that doing so underplays the benefit to the rich. Those benefits increase over time, while the breaks for less-wealthy Americans stay constant or decrease. Congress does not look at the distribution of tax cuts among the income classes beyond the first five years after a law's enactment. Most of the later tax cuts in the 2001 legislation go to those who are relatively wealthy.

For example, the current 39.6 percent highest tax rate is reduced to 38.6 percent on July 1, through 2003, and reduced again to 37.6 percent for 2004 and 2005. But the biggest drop, down to 35 percent, does not take place until calendar year 2006, and does not affect federal revenue materially until 2007, when taxpayers file 2006 returns. Similarly, the big cuts in the estate and gift taxes do not kick in until 2007.

Of course, the huge scheduled future cuts may never take effect. The law sets up an interesting game of political chicken: Supporters of tax relief for the rich are gambling that future Congresses will not have the will to cancel the scheduled cuts. Those focusing on less well-off taxpayers may think it is easier politically to renege on a promised tax cut that hasn't yet put money in people's pockets than to reverse a cut already in effect.

The game playing in the 2001 legislation may be unprecedented. It is important, however, to see that the politics and structure of this act are consistent with the pattern of tax cuts for the rich over the past 20 years.

First, we had the Reagan tax cuts. These were the halcyon days of "supply side" economics. Under the supply-side sales pitch, tax cuts for the rich would encourage saving, which in turn would increase investment in the business activities of American companies.

The highest marginal tax bracket was cut from 70 percent to 50 percent in the Economic Recovery Tax Act of 1981. (Note how the supply-side rationale was reflected even in the name of the legislation.) The economy did recover. Economists are still trying to fully understand why. But it is clear that supply-side did not work as promised: The saving rate fell.

Then came the Tax Reform Act of 1986. Its proponents said tax shelters were destroying the tax system, but that it was not fair just to get rid of the shelters. No, the rich were to be rewarded for giving up their tax breaks with a tax-rate cut. The marginal statutory rate on the highest-income taxpayers was cut from 50 percent to 28 percent.

Thus, in just five years, the highest rate fell from 70 percent to 28 percent. All economic evidence suggests that the rich made out like bandits from these cuts. The loss of tax shelters - which tended to be lousy investments, after all - hurt the wealthy very little, while the tax cuts helped the rich considerably.

The 1986 act set up a future face off that was the reverse of this year's situation. The rich got their tax cut immediately. Reformers also got rid of shelters for rich individuals immediately, but gambled that they could then raise rates.

Congress did raise taxes, eventually, to address the country's huge deficits - resulting, in part, from the tax cuts for the rich significantly reducing government revenue. After some tinkering, in 1993, the highest rate was bumped up to its current level of 39.6 percent. Nevertheless, the rich were still much better off than under the 70 percent rate in effect in 1981.

Which brings us to the beginning of this year. This time, tax-cut proponents - led by Bush - argued that, since the government was running operating surpluses, it should give the people back their money. The tax-cutters also said that because the rich pay more taxes, they should get the biggest cut. -And they promised that tax relief would stimulate consumer spending and jump-start the economy. (After all, the 1981 act proved that tax cuts do not increase saving, the opposite of spending.)

Congress bit, and the Economic Growth and Tax Relief Reconciliation Act of 2001 was enacted. (Note how the two arguments - encourage spending and give the people back their money - are reflected in the name of the legislation.)

One of the worst results of deferring so much of this year's tax package, is that it obscured the long-term significance of this law and limited the public debate. If Congress had been more straightforward, perhaps the public debate would have been more pointed. It would seem that, before shifting so much of the tax burden off the rich, Americans should have discussed the relationship between tax burdens and the benefits that citizens receive from living in the United States.

The 2001 tax cutters' argument that all tax money belongs to the people tacitly assumes that we get nothing from our government. This move enabled them to get the policy analysis exactly backward. After all, if the government does nothing, nobody should pay taxes. But our government provides much, particularly to the rich - everything from personal security to the best economy in the world; from regulation of capital markets that makes them among the world's most trusted to a legal system that ensures contracts are enforceable.

Fortunately, Congress cannot easily stand back and let the 2001 legislation take full effect because it will soon push many more taxpayers into the alternative minimum tax, significantly boosting how much they owe the government. Today, 1.5 million Americans owe that tax, which was devised to ensure the wealthy pay their "fair share." Unless lawmakers do something, that number will spike in 2005 to nearly 13 million, many of them middle-class taxpayers who were not the intended objects of the tax.

It would be extremely difficult politically for Congress to let that happen. And perhaps, as Congress drafts legislation to deal with this problem, our lawmakers will have the debate they should have had this year: one about who should pay for the government we all enjoy.

 

By George Mundstock



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