Originally published in the WALL STREET JOURNAL

Monday, December 6, 1999

Board of Contributors

His opponents attack the plan. But Governor Bush puts the focus where it ought to be
- on cutting marginal rates.

Bush's Tax Plan Makes Sense

Martin Feldstein

George W. Bush's opponents took turns attacking his tax-reform proposal during last week's New Hampshire debate. But Mr. Bush's plan is a good one. Because it emphasizes cutting marginal tax rates, it would significantly improve the economy's performance as well as increase after-tax incomes. And it's not just the rich who would benefit.

High marginal tax rates are not reserved for those with high incomes. An unmarried taxpayer who earns $35,000 a year can face a marginal tax rate of more than 50%. An extra $100 of earnings means an extra $28 of personal income tax, $15 of employee-employer payroll tax, plus state income taxes that can take the total to over $50.

Because this marginal tax rate cuts in half the reward for extra personal productivity, it discourages the pursuit of skill-enhancing education and of on-the-job training. And why make extra effort or work longer hours or take additional responsibilities or assume increased risks if the government is going to take half the extra reward?

Marginal rates can be higher still for low-income families. A family of four with $25,000 of income faces an effective marginal tax rate of about 60% as a result of federal income and payroll taxes that total 30%, the loss of federal cash welfare benefits (the earned-income tax credit) at a rate of 21 cents for every extra dollar of earnings, state taxes and the loss of food stamps, housing subsidies and other benefits as income rises. A fiscal system in which the government takes nearly two-thirds of any extra income is a poverty trap. It is also a powerful temptation to shift to the underground economy, where work is often less productive and less well paid but more attractive because it is untaxed.

The Bush proposal to double the child credit would totally eliminate the income tax for millions of such low-income families, reducing their marginal tax rate by 15 percentage points. Reinstating the Reagan second-earner rule--a 1/10th reduction in the tax on the first $30,000 of wages earned by the married partner with the lower earnings--would further reduce the adverse effect of marginal tax rates on low- and moderate-income families.

The Bush emphasis on reducing marginal tax rates stands in sharp contrast to Al Gore's defense of the status quo and Bill Bradley's proposal for a health-insurance subsidy that would be phased out as income rises--which amounts to an increase in marginal rates on low- and middle-income people of 20 percentage points.

Like the Bradley proposal, the increased marginal tax rate that results from phasing out the earned income credit is just one example of the high marginal rates that are a byproduct of almost all government transfer programs. The Social Security earnings test reduces benefits by 33 cents for every extra dollar earned above a threshold amount by Social Security recipients in their 60s. Combining that with the income and payroll tax rates and with the state income and sales taxes produces a marginal tax rate for this group of more than 80%. It's not surprising that many elderly people who would prefer to work choose instead to retire early. The Bush proposal to end the Social Security earnings test would cut their marginal tax rates by 33 percentage points.

When the resulting loss of individual productivity and individual income is added up over the 100 million taxpayers whose behavior is distorted by high marginal tax rates, the loss in national income is billions of dollars per year. And by discouraging saving and entrepreneurship, the high marginal tax rates lower our nation's long-term rate of innovation and growth.

High marginal rates also waste income by distorting the form of compensation individuals and their employers choose. Instead of taking cash and spending it on what they want, employees are encouraged by the tax law to favor untaxed fringe benefits and other workplace amenities. If an individual faces a 45% marginal tax rate, he is better off if his employer spends a dollar providing fringe benefits that are only worth 60 cents to him rather than having the employer give him the dollar as taxable wages of which he sees only 55 cents. And for taxpayers who itemize their deductions, high marginal tax rates compound the distortion by encouraging spending on tax-deductible things like mortgage interest.

Taxes that induce individuals to produce less and to spend on things they value less cause a loss of real income that economists call the excess burden of the tax. My own research shows that every dollar of tax reduction that results from an across-the-board cut in income tax rates would also cause an additional benefit by reducing this burden by between 50 cents and $1.

It is strange, therefore, that much of the public debate is about "how much the tax cut costs." From the nation's point of view, cutting taxes produces a gain, not a cost. Instead of talking about the cost of the tax cut, it would make more sense to say that a reduction in tax revenue of $100 billion a year raises real national income by $50 billion to $100 billion, in addition to allowing taxpayers to keep $100 billion more of their money.

The revenue effect of specific tax changes is of course important if we are to avoid a return to budget deficits. Any sensible estimate of the effect of tax rate reductions on government revenue would take into account their favorable impact on work effort, skill development, risk-taking and other factors that increase taxable income. But the strange rules adopted by Washington's official revenue estimators ignore these favorable effects, making tax-rate cuts look more expensive than they turn out to be in practice. I estimate that such favorable feedback effects would offset about one-third of the traditionally estimated revenue loss from cutting the top tax rate to 33% from 39.6% as Mr. Bush proposes. The governor nevertheless opted to use the traditional scorekeeping rules in order to avoid any challenges to his claim that the tax cut fits responsibly within the available budget surpluses.

The tax cuts of the 1980s provided a strong stimulus to individual initiative and economic growth. In the 1990s marginal tax rates rose sharply, and the percentage of income taken by the income tax jumped. Now we are at a point of national choice. The projected long-term budget surpluses present a remarkable opportunity to reduce marginal tax rates once again and to do so without creating budget deficits. It is an opportunity that should not be missed.

By Martin Feldstein, former chairman of President Reagan's Council of Economic Advisers. He is a professor of economics at Harvard and an adviser to the Bush campaign.