Originally published in THE NEW YORK TIMES
Wednesday, July 21, 1999
Finally, Were Ready to Cut, but How?
By MARTIN FELDSTEIN
"For squabbling Republicans, a guide to chopping taxes"
CAMBRIDGE, Mass. It seems that a tax cut is ~ inevitable. But no one, including the Republicans in Congress, seem to agree on the specifics. How much? Who should benefit? And how should alternative ways of cutting taxes be judged?
Taxes now take a higher share of our incomes than ever before. Some of this reflects the 1993 Clinton tax increases, rationalized then by the need to reduce the budget deficit. Economic growth also raises the total share of national income collected by the Government, by automatically pushing incomes into higher tax brackets.
These rising tax revenues have replaced budget deficits with large and growing surpluses. Earlier this year President Clinton said that the projected surpluses were large enough to save Social Security, strengthen national defense, reduce the national debt and cut personal taxes.
Since then the Administration has increased its 15-year budget surplus projection by an amazing $1 trillion, providing the basis for a much larger tax cut. Indeed, the Congressional Budget Office estimates that taxes can be cut by nearly $900 billion over the next decade without touching the payroll tax revenue earmarked for Social Security.
Despite the huge projected surpluses, President Clinton has proposed only a $250-billion tax cut over 10 years. The rest of the surpluses would go primarily toward expanding Medicare and increasing spending on a variety of domestic programs. At a time when we are worried about the increasing cost of entitlements for the aged, however, a major Medicare expansion would be a move in the wrong direction.
In contrast, Senator William Roth, the chairman of the Finance Committee, and Representative Bill Archer, chairman of the House Ways and Means Committee, have put forward two Republican plans that would cut taxes by about $800 billion over 10 years, bringing the share of taxes as a percentage of gross domestic product back to its earlier level.
Both plans would improve economic performance and limit Congresss ability to start major new spending programs. But they are also very different, and its important to think about the principles that should guide the choice between them or the design of a compromise between the two. Such principles would also help if the total tax cut needs to be scaled down, as advocated by some Republican moderates.
Senator Roths plan encourages saving. It would allow individuals to contribute more per year to their 401(k) plans and to Individual Retirement Accounts, as well as introduce a new education saving account. This plan would also lower the 15 percent tax rate to 14 percent and would reduce the marriage penalty by allowing couples to file single returns on a combined tax form.
Mr. Archers plan, on the other hand, would give everyone an across-the-board 10 percent rate cut, lower the capital gains tax, gradually reduce the inheritance tax and increase the tax deduction for married couples.
So which plan is better? Mr. Roths plan gives most of the tax cuts to low- and middle-income households. With about three-fourths of this tax cut going to those with incomes under $100,000, the share of total taxes falling on those with above average incomes would rise.
While shifting the tax burden would make it easier to gain support from Congressional Democrats, it would intensify the opposition of those who think that higher income groups have been unjustly bearing a rising share of taxes throughout the past decade.
But tax policy involves much more than who gets the tax cuts. Taxes not only transfer incomes to Washington, they also distort economic decisions in a way that hurts the economy, lowers the standard of living and reduces the rate of economic growth. Alternative ways of cutting taxes should be judged by how much they reduce these distortions and increase real incomes.
The extent of the distortion depends on each individuals marginal tax rate -- the additional tax paid when taxable income rises by one dollar. For example, someone who earns $35,000 a year now faces a marginal tax rate of 48 percent, a 28 percent personal tax rate, a is percent employer-employee payroll tax and a typical 5 percent state tax. An extra hour of work that pays $20 produces only $10.40 after taxes.
The high tax rate not only takes away nearly half of any additional earnings but also reduces the incentive to work and to obtain training. Extra training that brings an annual raise of $1,000 only increases take-home pay by $520. The individuals standard of living is thus doubly reduced.
High marginal tax rates also shift compensation in wasteful ways by encouraging fringe benefits instead of taxable cash. And high taxes reduce the incentive to establish new businesses, to expand existing ones and to take the risks of introducing new products and new ways of producing. This reduces economic growth and the creation of better jobs. Moreover, a high marginal rate reduces the return to savings. With a 6 percent rate of interest, $1 saved at age 40 becomes $8 at age 75. A tax that lowers that return to 4 percent reduces the amount at age 75 to just $4. Tax-free saving accounts of the type emphasized in Mr. Roths plan allow individuals to receive the full pretax return. This not only makes the individual better off but, by raising the national saving rate, also causes the creation of additional capital that increases productivity and real wages.
So there are tough choices in the design of a good tax plan. Mr. Archers plan, by focusing on cutting tax rates, is better at reducing the distortions that affect income, training and entrepreneurship. Mr. Roths plan, by focusing on saving, is better at reducing the distortion in savings and capital formation.
A combination of the two plans would be better than either alone. But the important thing is to use this unprecedented opportunity to improve the structure of our tax system in ways that reduce distortions, strengthen incentives and raise real incomes.
Martin Feldstein, an economics professor at Harvard, was chairman of the Presidents Council of Economic Advisers from 1982 to 1984.