CBO Data Show Tax Cuts Have Played Much Larger Role than Domestic Spending Increases in Fueling the Deficit
By Ruth Carlitz and Richard Kogan
Revised January 31, 2005
The new Congressional Budget Office budget projections released today show that the nation faces a fourth consecutive year of substantial budget deficits. Some seek to portray “runaway domestic spending” or growth in the costs of entitlement programs as the primary cause of the shift in recent years from sizeable surpluses to large deficits. Such a characterization is incorrect. In 2005, the cost of tax cuts enacted over the past four years will be over three times the cost of all domestic program increases enacted over this period.
The new CBO data show that changes in law enacted since January 2001 increased the deficit by $539 billion in 2005. In the absence of such legislation, the nation would have a surplus this year. Tax cuts account for nearly half — 48 percent — of this $539 billion in increased costs. [1] Increases in program spending make up the other 52 percent and have been primarily concentrated in defense, homeland security, and international affairs.
The Administration has repeatedly defended its tax cuts as a needed stimulus during the recent economic downturn. But the downturn is behind us, and the cost of the tax cuts is scheduled to increase in the years ahead. Indeed, some of the tax cuts enacted in 2001 that benefit only high-income households have not even started to take effect yet. The repeal of the “personal exemption phase-out” for high-income taxpayers, as well as repeal of the limitation on itemized deductions for high-income taxpayers, do not start to phase in until 2006 and do not take full effect until 2010. Estate tax repeal also does not take effect until 2010.
A growing number of studies from highly respected institutions and economists have concluded that the negative effect on long-term growth of the increased deficits that the tax cuts are generating is likely to cancel out — and quite possibly to outweigh — any positive effects on long-term growth from reductions in marginal tax rates and other tax incentives in the 2001 and 2003 tax-cut packages. Stated simply, the tax cuts are more likely to reduce long-term growth than to increase it.[2]
Taxpayers responded to President Bush's tax cuts in 2001 and 2003 by generating greater taxable income, according to a new paper to be published this fall in the National Tax Journal. In fact, taxpayers reported so much more income than was anticipated, it likely offset as much as 40% of the revenue that was lost by lowering the top two tax brackets, the paper, authored by a vice president for economic policy at the Tax Foundation, Robert Carroll, and economists Gerald Auten and Geoffrey Gee of the Department of the Treasury, found.
"This research illustrates that, while the lower tax rates have not paid for themselves, they do provide important economic benefits and can expand the tax base to such an extent that they cost the federal government substantially less revenue than the casual observer might think," Mr. Carroll, who was previously the deputy assistant secretary for tax analysis in the Office of Tax Policy at the Treasury, wrote.
As the Bush tax cuts are scheduled to sunset at the end of 2010, and the presidential candidates are busy finalizing their tax plans, understanding the effects of Bush's tax policy is critical. This paper, "The 2001 and 2003 Tax Rate Reductions: An Overview and Estimate of the Taxable Income Response," contends that lower taxes create a behavioral response in taxpayers, including working longer hours or taking higher-paying jobs, that generate greater taxable income.
This behavioral response, however, also means that when taxes are raised, there is a shift in behavior, and the tax increases often generate less revenue than anticipated.
"This is an important point, one that Obama is not taking into consideration," a resident scholar at the American Enterprise Institute, Alan Viard, said. "The Obama campaign is not taking into consideration any behavioral reaction, which means that the revenue gain that Obama is predicting from his tax increase is not going to be as large as they say."
Senator Obama's economic policy director, Jason Furman, disputes this, saying that the presidential candidate does take into consideration some behavioral response, or so-called elasticity.
"The conservative estimate we use for budget purposes comes from the Tax Policy Center, and it does take into consideration some elasticity," Mr. Furman said.
Some other economic analysts also took issue with the paper.
"Even taking the 40% response at face value, that's a long way from 'tax cuts paying for themselves,'" a senior fellow at the Brookings Institution, Douglas Elmendorf, said. "That is, McCain needs serious spending cuts to pay for his tax cuts, and he doesn't have any."
The paper examined more than 168,000 tax returns between 1999 and 2005 from taxpayers earning $50,000 or more. Looking at the change in taxable income as reported on their tax forms and the change in their tax rates, and after controlling for a number of factors, such as age and marital status, the researchers found that every 1% increase in a taxpayer's after-tax share — if the tax rate is 35%, the after-tax share is 65% — results in a 0.4% increase in reported taxable income.
A taxpayer who reported $500,000 in taxable income saw the tax rate drop from 39.6% to 35%, saving the taxpayer around $12,300 in taxes.
The tax cut increased the taxpayer's after-tax share from 60.4% to 65%, or an additional 7.6%. Multiplying 7.6% by 0.4% leads to an increase in taxable income of 3.04%. That means the taxpayer would have an increase in taxable income of $15,200. Taxed at the 35% rate, this translates into an extra tax payment of $5,320. Therefore, the behavioral response offsets about 43% of the $12,300 in revenue that was lost.
The paper also notes that the 0.4% increase in taxable income is based on the behavioral response of all taxpayers earning more than $50,000, not just those subject to the top two tax rates. It is widely acknowledged that taxpayers in the top brackets have a larger behavioral response than those in the lower tax brackets because they have more discretionary income. So, it is likely that responsiveness for high-income taxpayers is greater than 0.4%.
"There is uncertainty about the impact of the behavioral response to tax cuts, but this research is certainly well within the range of possibility, and is a very serious estimate," Mr. Viard said.
