The President's Tax Cut Proposal

Testimony of

Martin Feldstein
Professor of Economics, Harvard University

The Senate Budget Committee
February 13, 2001

Thank you, Mr. Chairman. I am pleased to appear before this Committee again and to talk about President Bush's tax cut proposal. I have five points to make in this brief statement.

First, the large current and projected budget surpluses give Congress an unprecedented opportunity to strengthen and improve the American economy by substantially reducing marginal tax rates. Our budget surplus last year was 2.4 percent of GDP and the Congressional Budget Office projects a baseline budget surplus of $5.6 trillion over the next 10 years, about 4 percent of projected GDP. It is useful to contrast this favorable budget situation with the large budget deficits (both actual and standardized) when the Kennedy and Reagan tax cuts were enacted. Even after setting aside the projected Social Security surpluses, the projected 10-year on-budget surplus is more than $3 trillion or about twice the officially estimated cost of the Bush tax plan. In other words, a $1.6 trillion tax cut is compatible with protecting Social Security, increasing the outlays for Medicare and defense, and still having additional money left for further debt reduction.

Second, the true cost of reducing the tax rates is likely to be substantially smaller than the costs projected in the official estimates. Studies of past tax rate reductions show that taxpayers respond to lower marginal tax rates in ways that increase their taxable income. They work more and harder and take more of their compensation in taxable form and less in fringe benefits. At the National Bureau of Economic Research we have used a large publicly available sample of anonymous tax returns to estimate how the actual revenue loss would compare to the official estimates that ignore this behavioral response. Our analysis shows that when the proposed Bush tax cuts are fully phased in the net revenue loss would be only about 65 percent of the officially estimated costs.

That implies, for example, that the revenue loss in 2010 that the Joint Committee on Taxation estimated as $233 billion would actually be only about $150 billion. If we apply that ratio to each year's revenue loss, the total revenue loss would be cut from $1.6 trillion to only about $1 trillion. Because of the timing of the tax cut and the taxpayers' lags in responding to it, I think a safer estimate of the total 10-year revenue loss would be about $1.2 trillion, still less than half of the non-Social Security surplus.

Third, the distorting effect of high marginal tax rates on individual behavior - on the way people work and the form of their compensation - causes substantial waste. If high marginal rates induce someone to work less or to work less productively, both he and the nation lose. If high marginal rates also induce someone to take his or her compensation in the form of fringe benefits or more expensive perks rather than in taxable cash, they lose even more. Economists call such waste the deadweight loss of a tax. The proposed reduction in marginal tax rates will not just allow individuals to keep more of their income. It will also produce an enormous net gain in national well-being. Using the same tax return data that I mentioned a moment ago, we have calculated that the marginal tax rate reductions in the Bush plan would cut that waste by about 40 percent of the officially estimated revenue cost, that is, by about $600 billion dollars over the next ten years. That raises American's real incomes by $600 billion that would otherwise be lost to waste. While the President's proposed tax cut would save taxpayers about $1.2 trillion over 10 years it would increase their real incomes by $1.8 trillion.

The gain from reducing distortions is a permanent gain that will continue in the future if marginal tax rates are kept down. This gain is separate from and additional to any increase in the rate of economic growth that results from the improved incentives to save and invest and take risks with that capital.

Fourth, the distribution of President Bush's tax cut is essentially proportional to existing taxes. Those who now pay more in taxes will get bigger tax cuts. But the proportional reduction is about the same in every income group. If anything, the lower income groups get bigger proportional reductions and will pay an even smaller proportion of the overall tax burden than they do now.

It is useful to compare the marginal tax rate reductions at high income levels proposed by President Bush with the tax rate cuts enacted by President Kennedy. The two highest income groups in the Bush plan would see their marginal tax rates reduced from 39.6% and 36% to 33%, reductions of 17% and 9% respectively. In comparison, the two top marginal rates were reduced under President Kennedy by more than 20%.

I hope that Congress will pass the tax legislation quickly and then turn to Social Security reform. As members of this committee know, I have long been an advocate of a mixed Social Security system that would supplement the existing pay-as-you-go Social Security benefits with annuities paid from individual investment-based accounts. One of the major advantages of doing so would be to avoid the future payroll tax increases that, according to the Social Security actuaries, would otherwise require raising the current 12.4% OASDI employer-employees tax to more than 18%. If that long-run saving of 6% of earnings up to the maximum taxable earnings for Social Security (now $80,400) is seen as part of the current fiscal reforms, the combined effect is to reduce the relative tax burden on low and middle income families even more.

Fifth, the large tax cut coming at this time will help to assure a stronger short-term recovery from the current economic slowdown. Although I do not believe that temporary increases and decreases in tax rates are useful for reducing business cycle fluctuations, it is certainly convenient now to have a tax cut that is going to be made for other reasons. The increase in after-tax incomes and the expectations that such increases will continue in the future will boost confidence as well as spending power. Increasing the short-term effect by starting the tax cuts at the beginning of the year would reinforce this favorable effect.

Thank you.