Originally published in THE WALL STREET JOURNAL
Tuesday, March 28, 2000
Bush's Tax Plan Is Even Better Than the Campaign Says
By Martin Feldstein
Al Gore keeps repeating the mantra that George W. Bush is putting forth a "risky tax scheme" that will jeopardize Social Security and other programs that depend on federal taxes. Mr. Gore is wrong. By lowering marginal tax rates, Mr. Bushs plan will change taxpayers behavior in ways that will make up for much of the revenue loss.
In the interest of caution, the Bush campaign explicitly assumes that taxpayers will not change their behavior at all in response to the lower marginal tax rates. But taking into account the likely response of taxpayers to lower marginal rates cuts the projected cost of the fully phased-in tax cut by more than 30%.
Lower marginal tax rates change behavior in three ways that increase taxable income and therefore raise tax revenue. Most directly, they induce people to work and earn more. Married women are particularly sensitive to lower rates, responding with higher labor-force participation rates and greater average hours of work per week. Its particularly significant, therefore, that the Bush plan has an extra reduction in the marginal rate for the lower-earning member of a married couple.
High marginal rates also depress taxable income, and therefore tax revenue, by shifting the form of compensation from taxable cash to fringe benefits, to nicer working conditions, and to other ways in which individuals can be rewarded without incurring a larger tax bill. When marginal tax rates decline, individuals shift some of this untaxed compensation to taxable cash.
High marginal tax rates also encourage increased tax deductions for things like mortgage expenses and greater write-offs for business expenses like travel and entertainment. When marginal tax rates come down, such deductions are reduced and individuals spend more of their money on the things they really prefer.
Relatively small changes in the form of compensation and in tax deductions and business expenses can have a big impact on taxable income and tax revenue. The White House Office of Management and Budget estimates that the current revenue loss from such legal tax avoidance activities exceeds $400 billion a year or 40% of personal income tax revenue. And that excludes the revenue that is not collected because individuals choose nicer working conditions and other untaxed forms of compensation that are not counted in the governments analysis.
The high marginal tax rates that distort behavior in these ways are not just an issue for high-income households. A couple with taxable income of $50,000 now faces a total marginal federal tax rate of 43.3% -- 28% in income tax and 15.3% in payroll tax. (State and local taxes add to the burden.) A single individual faces a comparable rate at a taxable income of just $26,000.
Statistical studies show that reducing marginal tax rates raises taxable income substantially. These studies are based on large samples of anonymous tax returns provided by the Treasury Department that follow individual taxpayers before and after the tax reforms of the past two decades. My own analysis of how taxpayers responded to the 1986 tax reform suggests that for each 10% increase in the marginal after-tax share of income taxpayers get to keep, taxable income goes up by about 10%. Lowering the total marginal tax rate from 40% to 34% raises the marginal after-tax share from 60% to 66%, inducing changes in behavior that raise affected workers taxable income by 10%. Other studies, including one recently published by two Treasury Department economists, estimate that a 10% increase in the after-tax share raises taxable income by between 4% and 12%, with the higher estimates more likely for higher-income taxpayers.
All of these estimates suggest that the Bush tax reform would substantially raise taxable incomes, significantly cutting the costs of the reform. To estimate the total effect of the taxpayer responses to the Bush tax plan, Daniel Feenberg and I have used the National Bureau of Economic Research Taxsim model, a computerized accounting calculator that applies alternative tax rates to a sample of more than 100,000 anonymous individual tax returns. Although the Bush plan involves a gradual phase-in of tax rate reductions, we focus on the effect when all of the tax rate reductions have occurred. We do not try to forecast specific future years but analyze the effect for a single year at the year 2000 level of incomes.
We conclude that the lower marginal tax rates in the Bush plan cut its cost by more than one-third. Our calculations imply that the Bush tax plan would reduce income-tax revenue by $135 billion if there were no taxpayer response. But even with the conservative estimate that a 10% increase in a taxpayers after-tax share would raise taxable income by 6%, Mr. Bushs proposed lower marginal tax rates would raise taxable income enough to ingments by $37 billion and payroll tax payments by $8 billion. That $45 billion of increased revenue offsets one-third of the $135 billion static estimate of lost revenue.
The net revenue cost of the fully implemented Bush plan is $90 billion for the year, rather than the $135 billion static estimate. Even this overstates the revenue cost because it does not attempt to take into account the effect of the special lower marginal tax rates on second earners. It also assumes no increase in saving, investment, risk-taking or other drivers of economic growth. Our estimated change is simply the response of individual taxpayers in the amount they work, the form of their compensation and the reduction in their use of tax deductions and other tax-favored forms of spending. Any additional impact that raises the economys rate of growth would further reduce the cost of the reform.
In evaluating the Bush plan or any other plan to lower marginal tax rates, it is important to take into account the favorable effect of lower marginal rates on taxable incomes. Because of the Bush plans emphasis on cutting marginal rates, its likely revenue cost is significantly less than traditional static estimates imply, leaving substantial budget surpluses for paying down national debt and providing for future Social Security benefits.
By Martin Feldstein. Mr. Feldstein, former chairman of President Reagan's Council of Economic Advisers, is a professor of economics at Harvard and an adviser to the Bush campaign.