Even though President Bush signed his big tax cut bill into law this month, the real tax debate is only beginning. The reason is that the law is so riddled with flaws and distortions that it will almost certainly require mid-course corrections. Its full cost, which was masked by implementation delays and sudden "sunset" provisions, would otherwise swallow up virtually all the available budget surplus.
Bush's gambit was to use the first days of his presidency to allocate as much of the projected surplus as possible to tax cuts for upper-income households. This ensured that for the rest of his term Democrats would be forced to scramble for leftover funds for their priorities: health insurance for the uninsured, tax cuts for the working poor, education, research, Medicare reforms, debt reduction and Social Security finances, and other issues.
The President got a lot of what he wanted. Excluding the dubious sunset provisions, which Congress passed knowing that they would have to be overturned, the tax bill costs more than $1.7 trillion over the next decade, not the widely cited $1.35 trillion. Including extra interest, the total cost of the tax cut is about $2.2 trillion, which reduces the available budget surplus to nearly zero.
On the brighter side, some determined centrist U.S. Senators succeeded in balancing Bush's tax cuts for those in the upper-income brackets with important and genuinely progressive tax breaks that Bush opposed.
Now the hard part begins: setting priorities and making difficult choices. The last time Congress rushed through a major tax cut without worrying about the consequences was in 1981, during the first year of President Reagan's term. That tax cut was scaled back in 1982, 1983, and 1984 when it became obvious that deficits would explode if other priorities, like national defense, were fully funded.
Members of Congress should not let this tax cut deter them from pursuing a progressive New Economy agenda. Like the 1981 law, this tax cut will probably be changed many times. The good news is that many of the progressive features of the 2001 tax bill start immediately, and many of its more regressive and budget-busting provisions are delayed. We have time to savor the good and to fix the bad.
The best features of the tax bill are the modest new tax breaks for low-income workers with children. The bill expands the Earned Income Tax Credit (EITC) for married couples by $210, and makes the $600 Child Tax Credit partially refundable (that is, available as a refund even if no income tax is owed) to families with earnings over $10,000. In combination, those two provisions take a small step toward encouraging work and relieving marriage penalties among low-income families.
Another small but welcome feature of the bill is a new tax credit that matches part of the retirement savings of low-income taxpayers. The credit is 10 percent of the amount saved in IRA or 401k or comparable savings plan (up to annual savings of $2,000) by taxpayers with incomes up to $25,000 ($50,000 for couples). The percentage match is 50 percent for those with incomes under $15,000 ($30,000 for couples). This tax credit is not refundable, so families with no income tax liability -- generally larger families who qualify for refundable credits like the EITC or the new, partially refundable Child Tax Credit -- cannot benefit from the matching funds. However, it will help boost the retirement savings of many single workers or childless couples, especially young people for whom the power of compounded investment returns can make early retirement savings especially beneficial.
The main tax break for the middle class is the new 10 percent tax bracket for the first $6,000 of taxable income ($12,000 for married couples). That amounts to a tax cut of $300 for single taxpayers and $600 for married couples, and the law adopts the Democratic lawmakers' suggestion that refund checks be distributed later this year (rather than requiring taxpayers to wait for next year's returns to get this year's tax break).
Reducing the tax rate from 15 percent to 10 percent for the lowest tier of taxable income gives an equivalent tax cut to middle- and upper-income taxpayers. That is a fair and progressive approach. Some middle-class families will also be aided by the tax law's higher limits for tax-free retirement savings in IRAs and 401k plans, a new deduction for college tuition, the $600 Child Tax Credit (up from $500 last year), and a slightly more generous tax credit for childcare expenses. The downside for many middle-income folks is that the $300 or $600 check is all they will get, now and in the future. The really big tax cuts are reserved for those with higher incomes.
In general, the new tax law goes awry after 2004. After that point, the bill is a budgetary fraud and a policy mess. The main fraud is its use of gimmicks and distortions to reduce its apparent cost. The gimmicks include "backloaded" tax cuts that phase in so slowly that their costs are not apparent until the end of the 10-year budgeting period. Perhaps the most egregious gimmick is a sunset provision that ends all of the tax cuts on December 31, 2010, a full year before the end of the 10-year budgeting period. The architects of this tax bill have hidden its true cost behind the assumption that on January 1, 2011, tax rates will snap back to their 2000 levels. That would be a sudden, massive tax hike, and no Congress would let that happen.
The second-worst deception is fixing the Alternative Minimum Tax (AMT) only through 2004. The AMT was designed years ago to prevent rich taxpayers from using deductions and loopholes to avoid income taxes. Because it was not indexed for inflation, however, it will start burdening the middle class in this decade. About 1.5 million taxpayers are required to pay the alternative tax now, but under the new tax bill it will gobble up the tax cuts promised to as many as 36 million taxpayers by 2010.
There are other curious flaws. The popular deduction for college tuition and the matching credit for the retirement savings of low-income people are inexplicably dropped in the middle of the decade. Conversely, some of the law's marriage penalty provisions targeted to middle-class taxpayers are not implemented until the middle of the decade, and even then are phased in very slowly. Likewise, most of the promised "doubling" of the Child Tax Credit from $500 to $1,000 is not actually done until 2009 and 2010-at the very end of the 10-year budgeting period.
In addition, the much-touted "complete repeal" of the estate tax occurs suddenly in 2010, and then is itself repealed 12 months later, creating a brief 365-day window of tax-free inheritance opportunities for the heirs of really rich folks (in the prior 10 years, the exemption level for the estate tax will have been raised to the point where only the wealthiest families faced the tax anyway). Finally, the law fiddles with the timing of corporate tax payments, delaying $33 billion in revenue collections by two weeks later this year (from September 2001, the last month of the government's fiscal year, to October 2001, the first month of fiscal year 2002).
Most of those gimmicks -- ending the tax cut in 2010, failing to fix the AMT after 2004, dropping popular deductions and credits in midstream, and delaying others for half a decade or more -- are political contortions designed to make the tax cut look much less expensive than it actually will be. Changing the timing of corporate tax payments is just weird. That was presumably done to pump up revenues in fiscal year 2002 (at the expense of 2001) and allow politicians running for reelection in 2002 to claim that the surplus in 2002 was not adversely affected by the tax cuts. (By election time, the greatly reduced surplus for 2001 would be forgotten.)
Hence the tax cut's inherent recklessness. Even if, as some economists believe, this year's tax refunds help prevent a recession by stimulating consumer spending, the longer-term effect of this tax package could easily be to drive the nation back to deficits and economic problems. There's a good chance that any short-term positive economic effects of lower taxes will be more than offset by the negative long-term impact of higher debts and interest rates, and by new uncertainties about the government's ability to finance the retirement of the baby boom generation.
The Progressive Policy Institute (PPI) estimates that the hidden cost of the worst gimmicks in the tax bill -- the sunset provisions -- is about $365 billion. According to the official revenue estimates from the Joint Committee on Taxation, the total cost of the tax package is $1.35 trillion between 2001 and 2011. Extending the pension tax credit after 2006, the tuition deduction after 2005, the AMT relief after 2004, and the entire tax cut after 2010 adds $365 billion during those years, for a total cost of over $1.7 trillion (see attached table). The cost of additional debt service -- extra interest payments on national debt that would have been retired but for the tax cut -- is about $450 billion between 2001 and 2011. Therefore, the total cost of the tax law, including extensions of expiring provisions, is about $2.2 trillion between 2001 and 2011.
Including the hidden costs of the sunset provisions, the tax cut alone uses up all but $0.6 trillion of the general revenue surplus (the surplus that remains after setting aside the surpluses in the Social Security and Medicare funds) during the ten-year budgeting period from 2002 through 2011. Assuming that the growth of discretionary appropriations (for national defense and domestic programs) is somehow held to Bush's target of 4 percent would further reduce the general revenue surplus to only $0.1 trillion.
Under the more realistic assumptions that discretionary spending grows by 5 percent and that Congress spends $300 billion for Medicare benefits and reforms, the overall surplus falls to $2.2 trillion over the 2002-2011 period, effectively using the entire Medicare surplus and $0.3 trillion of the Social Security surplus to fund tax cuts and current spending. Adding the cost of funding personal accounts for Social Security ($1.3 trillion including debt service) reduces the remaining overall surplus to less than $0.9 trillion, all in the Social Security fund.
While the 2001 tax bill contains some good features in the first few years, in the latter part of the decade its costs far outweigh its benefits. That's why it should be revised. At the very least, the additional tax cuts for the ultra-high-income taxpayers should be suspended. No tax cut enacted now for implementation in the distant future should be allowed to subvert the national goal of paying off the nation's debt by 2010.
The most disappointing aspect of the tax cut is its cynicism. Political leaders routinely push tax cuts early in their terms -- it is a way to demonstrate to their constituents that they will take seriously the tasks of sound budgeting and fiscal discipline. However, Bush's tax cut did just the opposite. It was not accompanied by a plausible budget that laid out the nation's investment and revenue needs. For example, Bush's budget didn't even include his own defense and Social Security proposals -- Bush's incomplete budget was as deceptive as the tax cut it was designed to promote. Bush's tax cut was designed to crowd out alternative uses of the surplus before a national debate on the full set of priorities could develop.
Congress should be prepared to fix Bush's tax plan, so that is does not thwart the larger objectives of paying off the nation's debts, preparing for the retirement of the baby boom generation, and investing in education, research, and other items that spur economic productivity and opportunity. We should hold off on many of the tax cuts that are scheduled for implementation more than two or three years from now. Under almost any economic scenario, the following rule should apply: If the budget surpluses don't materialize, neither should the tax cuts.
Finally, Congress must work harder to keep the income tax code progressive. Payroll and other taxes -- even state and local taxes -- are already regressive enough. The income tax should be based on the ability to pay. The Bush tax cut spreads its most generous benefits not on those most at risk for layoffs or economic dislocation, but instead on very high-income taxpayers who are already set for life. Here's what Congress should do to begin fixing the new tax law:
- Pay down the debt first. Most importantly, Congress should ensure that the nation remains on track to pay off its debts before the baby boom generation begins to retire and demand entitlement benefits. If that means delaying tax cuts, Congress should not hesitate. The budgetary progress made during the 1990s-when chronic deficits switched to historic surpluses and the national debt actually began to fall-should not be derailed because of a gimmick-filled tax cut passed this year.
- Suspend the rate cuts in the top brackets. The 2001 tax bill reduces the tax rates in the top income brackets by 1 percentage point immediately and by another full point in 2004. In 2006, the upper rates are scheduled for another full percentage point cut, except for the top rate (for taxable income above about $300,000), which will be reduced by an additional 2.6 percentage points. The 2004 and 2006 rate cuts should be made contingent on satisfactory progress toward paying down the national debt. Lower tax rates for the highest-income Americans are a luxury that should be enjoyed only when the nation's necessities -- including debt reduction, Medicare, Social Security, education, and research -- are secured, and only after the middle-class tax cuts and the tax cuts for the working poor are fully phased in and their sunset provisions are repealed.
- Skip the full estate tax repeal. Over the next nine years, the exemption from the estate tax will be raised to such a point that only the heirs of truly wealthy families will feel any pinch. Full repeal is unnecessary and regressive, and Congress should just forget it.
- Scrap budget rules that are easy to evade. Finally, Congress should reconsider some of the budgetary rules that make the extended phase-ins and sudden sunset provisions possible. The bill's sheer complexity and the uncertainty about how its provisions will evolve or be changed by future Congresses will keep tax accountants and investment advisors busy for years.
This should be the last large tax cut written under expedited "reconciliation" procedures. Those procedures were intended to help Congress reduce deficits during times of economic and budgetary stress, not to ladle out huge tax cuts (or huge spending increases, for that matter) under fast-track rules. At the very least, the budget procedures should allow for additional time so that members of Congress can study the provisions of tax laws before being forced into rushed-through votes. The voters also deserve a chance to see the provisions of gigantic and complicated tax laws with sufficient time to contact their representatives; the biggest gimmicks in this law were unveiled only hours before the final votes.
If budget surpluses do materialize as hoped, our first priorities should be education, research, Medicare, and Social Security. Once those needs are met, Congress should accelerate the tax cuts for the working poor and the middle class. Substantial tax credits for health insurance should be a top priority. The Child Tax Credit should be more promptly phased up to $1,000 per child, and the provisions allowing for its refundability to low-income, working households should be fully implemented immediately. Marriage penalty relief for the middle class and those claiming the EITC should be accelerated.
Another priority is retirement savings. At the insistence of the centrist senators, especially Max Baucus (D-Mt.), the tax bill raised limits on the amounts that can be saved in IRAs, 401k plans, and other tax-favored retirement vehicles; it also added a new matching credit for savers with very low incomes. At the least, the credit for retirement savings should be made permanent. However, there is much more work to be done. Congress should enhance the matching funds so that more families can benefit and build financial wealth. It should also enact a variety of other tax simplifications that will benefit up-and-coming investors.
Finally, Congress should fix the AMT permanently before it even considers reinstating the rate cuts in the top tax brackets. It was irresponsible for Bush to promise tax cuts to middle- and upper-income taxpayers and then take them away via an alternative tax.
The tax cut of 2001 will prove to be a disappointment for many Americans. Congress should stand ready to fix the bill to maintain its fairness, strengthen its pro-investment features, and prevent its cost from hurting the economy or bankrupting our country when the baby boomers retire.
Editor's Note: For a detailed, year-to-year breakdown of Table 1, please see the PDF version of this paper. (Requires Adobe Acrobat Reader.)
Blueprint Keywords: Extra Budget
