Tax policy grabbed headlines in late 2012 as the deadline for avoiding the “fiscal cliff” rapidly approached. The automatic budget cuts were designed as a way to force Congress to overcome partisan gridlock and address fiscal concerns related to the growing national debt. Researchers have cautioned that such cuts would threaten programs from Head Start early education to Medicare senior medical coverage, and bring about significant job losses as the economy struggles to recover from the Great Recession of 2008.
In November 2012, the Congressional Budget Office issued two reports that spell out scenarios related to these issues: “Economic Effects of Policies Contributing to Fiscal Tightening in 2013” and “Choices for Deficit Reduction.” The CBO finds that, should the government fail to reach a deal, the economy could be pushed back into recession and unemployment could rise to 9.1%.
Of course, America’s ballooning national debt carries with it significant consequences. A variety of studies provide historical perspective.
The fundamentals of sound tax policy — limit individual and business tax obligations and provide government with enough funds to function effectively — seem straightforward; how to accomplish this delicate balancing act is not. At the heart of the issue are differing interpretations of fairness for individuals and families, as well as businesses and corporations. Research shows that rising income inequality in America is partly the result of wealthier households deriving larger shares of their income from investments — taxed at a comparatively low rate. Many observers point out that Washington’s policies have simply not kept up — what some scholars call policy “drift.” This means that any discussion of taxes must take into account the practical or “effective” rate.
A 2012 Congressional Research Service report notes the following: “The top income tax rates have changed considerably since the end of World War II. Throughout the late-1940s and 1950s, the top marginal tax rate was typically above 90%; today it is 35%. Additionally, the top capital gains tax rate was 25% in the 1950s and 1960s, 35% in the 1970s; today it is 15%. The average tax rate faced by the top 0.01% of taxpayers was above 40% until the mid-1980s; today it is below 25%. Tax rates affecting taxpayers at the top of the income distribution are currently at their lowest levels since the end of the second World War.”
For a look at how changes in tax rates affect economic growth, a 2010 study in The American Economic Review, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” aims to establish a definitive record of impacts after World War II. Moreover, a 2011 paper by the Sweden-based Research Institute of Industrial Economics, “Government Size and Growth: A Survey and Interpretation of the Evidence,” analyzes 13 previous studies to better understand their contradictory results. Another study compares outcomes in various countries and finds that lower tax rates are generally associated with higher growth and lower unemployment.
In terms of gridlock and the dynamics of public opinion, several recent papers add perspective. A 2012 paper from Cornell titled “Who Says They Have Ever Used a Government Social Program? The Role of Policy Visibility” examines the striking discrepancy between views on government and citizens’ usage of its programs. A 2012 study in Public Opinion Quarterly, “American Public Opinion on Economic Inequality, Taxes, and Mobility: 1990-2011,” analyzes trends in Americans’ perceptions towards divisions of wealth and taxes over this two-decade period. Finally, a 2011 study from Harvard Business School and Duke, “Building a Better America — One Wealth Quintile at a Time,” looks at how Americans might choose different economic distribution models.
The following is a selection of academic papers that address certain aspects of United States tax policy relevant to the current U.S. debate. The papers are presented in four sections: the 2001 Bush tax cuts; taxes and higher-income households; progressive taxation; and consumption taxes.
The Bush Tax Cuts of 2001
“Tax Returns: A Comprehensive Assessment of the Bush Administration Tax Cuts”
Shapiro, I.; Friedman, J. Center on Budget and Policy Priorities, April 2004, 1-76.
Abstract: “The Bush Administration has stood in favor of tax cuts through thick and thin. In the midst of a booming economy and large projected budget surpluses, President Bush’s top economic policy initiative — both as a candidate in 2000 and upon taking office — was to cut taxes. When the economy slowed, the Bush Administration’s response also was dominated by tax cuts. Now, in the face of yawning deficits and its own pledge to reduce them, the Administration has again put forward large, permanent tax cuts as part of its most recent budget. This analysis offers a comprehensive review of the Bush Administration’s tax cuts. It assesses their costs, benefits to different income groups, and economic effects to date, as well as down the road. It both synthesizes previous findings about the individual tax measures and includes new findings about their combined effects, using new distributional analyses by the Urban Institute-Brookings Institution Tax Policy Center and fresh cost estimates by the Center on Budget and Policy Priorities. The early returns on the effects of the tax cuts have not been good.”
“Taxing Capital Income: Effective Rates and Approaches to Reform”
Burnham, P.; Ozanne, L. Congressional Budget Office, October 2005, 1-44.
Abstract: “Congress is considering whether to extend reductions in the tax rates on capital gains and dividend income beyond their scheduled expiration date at the end of 2008. Proponents of these extensions often argue that stock ownership is widespread and thus the benefits of extending these tax cuts will be widespread as well. In other analyses, we have shown the fallacy of this argument; data from sources such as the Urban Institute-Brooking Institution Tax Policy Center clearly show that the large majority of the benefits from such an extension would go to very-high-income households. This analysis goes one step further, showing that the benefits of tax cuts for capital income have become more concentrated over time…
Specifically, CBO data released in December 2005 indicate that capital income — income from interest, dividends, rents, and capital gains — that is subject to taxation has become considerably more concentrated over time among the top one percent of the population. This finding has not received attention, largely because these data lie beneath other aspects of a new, data-rich and rather technical CBO report. The new data show that the policy of lowering taxes on capital gains and dividend income is likely to have even more regressive effects (that is, the benefits of such tax-cut measures are likely to be even more concentrated among very-high-income households) than was the case in the past.”
“An Economic Evaluation of the Economic Growth and Tax Relief Reconciliation Act of 2001”
Gale, W.G.; Potter, S.R. National Tax Journal, March 2002, Vol. 55, 133-186.
Abstract: “This paper summarizes and evaluates the Economic Growth and Tax Relief Reconciliation Act. Enacted in 2001, EGTRRA is the biggest tax cut in 20 years, and features income tax rate cuts, new targeted incentives and estate tax repeal. Our central conclusions are that EGTRRA will reduce the size of the future economy, raise interest rates, make taxes more regressive, increase tax complexity, and prove fiscally unsustainable.”
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Taxes and Higher-Income Households
”Possible Effects of the ‘Buffett Rule’ and Higher Taxes on the Wealthy”
Hungerford, T.L. Congressional Research Service, October 2011, No. R42043, 1-14.
Findings: “U.S. taxpayers with annual incomes less than $100,000 pay on average 35% of their income in taxes, while 65% of millionaires pay on average less than 30% of their income in taxes. However, when examined using Adjusted Gross Income figures, “roughly one-quarter of all millionaires (about 94,500 taxpayers) face a tax rate that is lower than the tax rate faced by 10.4 million moderate-income taxpayers (10% of all moderate- income taxpayers).” Of the U.S. small businesses reporting income, 74% earn below $100,000 annually and 72% (many sole proprietors and business owners) also report income in addition to their own business; this means that “the small share of taxpayers with small business income in the millionaire category suggests that tax reform policies designed to ensure adherence to the Buffett Rule will affect few small businesses”…. The report acknowledges that observers fear that increasing taxes on capital gains and dividends will ultimately reduce savings and investments… Consequently, the effect of capital gains taxes on private saving is likely to be small.” Moreover, “saving rates have fallen over the past 30 years while the capital gains tax rate has fallen from 28% in 1987 to 15% today (0% for taxpayers in the 10% and 15% tax brackets). This suggests that changing capital gains tax rates have had little effect on private saving.”
“Estate Taxation, Entrepreneurship, and Wealth”
Cagetti, M.; De Nardi, M. American Economic Review, March 2009, Vol. 99, No. 1, 85-111.
Abstract: “We study the effects of abolishing estate taxation in a quantitative and realistic framework that includes the key features that policy makers are worried about: business investment, borrowing constraints, estate transmission, and wealth inequality. We use our model to estimate effective estate taxation. We consider various tax instruments to re-establish fiscal balance when abolishing estate taxation. We find that abolishing estate taxation would not generate large increases in inequality, and would, in some cases, generate increases in aggregate output and capital accumulation. If, however, the resulting revenue shortfall were financed through increased income or consumption taxation, the immensely rich, and the old among those in particular, would experience a welfare gain, at the cost of welfare losses for the vast majority of the population.”
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”How Progressive is the U.S. Federal Tax System? A Historical and International Perspective”
Piketty, T.; Saez, E. Journal of Economic Perspectives, winter 2007, Vol. 21, No. 1, 3-24.
Abstract: “Over the last 40 years…there has been a dramatic decline in top marginal individual [U.S.] income tax rates. In the early 1960s, the statutory individual income tax rate applied to the marginal dollar of the highest incomes was 91%. This marginal tax rate on the highest incomes declined to 28% by 1988, increased significantly to 39.6% in 1993, and fell to 35% as of 2003. Second, corporate income taxes as a fraction of gross domestic product have fallen by half, from around 3.5-4.0% of GDP in the early 1960s to less than 2% of GDP in the early 2000s (for example, Auerbach, 2006). Meanwhile, corporate profits as a share of GDP have not declined over the period, suggesting that capital owners — who are disproportionately of above-average incomes — earn relatively more net of taxes today than in the 1960s. Third, there has been a substantial increase in payroll tax rates financing Social Security retirement benefits and Medicare. The combined employee-employer payroll tax rate on labor income has increased from 6% in the early 1960s to over 15% in the 1990s and 2000s. Moreover, the Social Security payroll tax applies only up to a cap — equal to $90,000 of annual earnings in 2005 — and is therefore a relatively smaller tax burden as incomes rise above the cap. However, the conclusion that these three changes have reduced the progressivity of the federal tax system is less obvious than it may at first appear.”
“Progressive Taxation and the Subjective Well-Being of Nations”
Oishi, S.; Schimmack, U.; Diener, E. Psychological Science, 2012, Vol. 23, No. 1, 86-92.
Findings: “Progressive taxation is positively associated with overall well-being and satisfaction with daily life; however, a progressive taxation policy or a nation’s wealth in and of itself may not create a happy society. ‘It is the use of the nation’s wealth to provide citizens with better public goods that results in increased well-being.’ As government spending as a percentage of gross domestic product increases, reported levels of satisfaction with daily life and overall quality of life decline…Controlling for income inequality and variations in national wealth, individuals in countries with more progressive taxation consider their lives as being closer to ideal and evaluated their daily lives more positively than those in nations with less progressive taxation. The association between higher levels of subjective well-being and more progressive taxation ‘was mediated by citizens’ satisfaction with public goods, such as education and public transportation.’”
“Can State Taxes Redistribute Income?”
Feldstein, M.; Wrobel, M. Journal of Public Economics, June 1998, Vol. 68, No. 3, 369-396.
Abstract: “Since individuals can avoid unfavorable taxes by migrating to jurisdictions that offer more favorable tax conditions, a relatively unfavorable tax will cause gross wages to adjust until the resulting net wage is equal to that available elsewhere. The current empirical findings go beyond confirming this long-run tendency and show that gross wages adjust rapidly to the changing tax environment. Thus, states cannot redistribute income for a period of even a few years. The adjustment of gross wages to tax rates implies that a more progressive tax system raises the cost to firms of hiring more highly skilled employees and reduces the cost of lower skilled labor… Shifts in state tax progressivity, by altering the structure of employment in the state and distorting the mix of labor inputs used by firms in the state, create deadweight efficiency losses without achieving any net redistribution.”
“Does Growing Inequality Reduce Tax Progressivity? Should It?”
Slemrod, J.; Bakija, J. NBER working paper 7576, March 2000, 1-43.
Abstract: “This paper explores the links between two phenomena of the past two decades: striking increase in the inequality of pre-tax incomes, and the failure of tax-and-transfer progressivity to increase. We emphasize the causal links going from inequality to progressivity, noting that optimal taxation theory predicts that growing inequality should increase progressivity… The paper also addresses the opposite causal direction: that it is changes in taxation that have caused an apparent increase in inequality. Finally, we discuss the “non-event-study” offered by the large changes in the distribution of income–with no major tax changes– since 1995, and discuss its implications for the link between progressivity and inequality.”
“The Case for a Progressive Tax: From Basic Research to Policy Recommendations”
Diamond, P.; Saez, E. Journal of Economic Perspectives, fall 2011, Vol. 25, No. 4, 165-190.
Abstract: “This paper presents the case for tax progressivity based on recent results in optimal tax theory. We consider the optimal progressivity of earnings taxation and whether capital income should be taxed…. We obtain three policy recommendations from basic research that satisfy these criteria reasonably well. First, very high earners should be subject to high and rising marginal tax rates on earnings. Second, low-income families should be encouraged to work with earnings subsidies, which should then be phased-out with high implicit marginal tax rates. Third, capital income should be taxed.”
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“Taxing Consumption and Other Sins”
Hines, Jr., J.R. Journal of Economic Perspectives, December 2006, Vol. 21, No. 1, 49-68.
Findings: “Heavy American reliance on income rather than consumption taxation has not served the United States well. The inefficiency associated with taxing the return to capital means that the tax system reduces investment in the United States and distorts intertemporal consumption by Americans, meanwhile discouraging U.S. labor supply no less than would a consumption tax alternative. While the economic logic of consumption taxation is compelling even for a closed economy, it is even more powerful for an open economy exposed to the world capital market. Consumption taxes in the form of excises can be designed to help protect the environment and control other externalities, whereas it is much more difficult to pursue the same goals with income taxes. Excise taxes can also serve the function of more closely aligning tax burdens with the benefits that taxpayers receive from certain government services. There are understandable concerns about the distributional consequences of consumption taxation, but a system that relies heavily on consumption taxes, particularly if accompanied by an income tax, can be made as progressive as any income tax the United States would realistically want to adopt.”
”Salience and Taxation: Theory and Evidence”
Chetty, R; Looney, A.; Kroft, K. National Bureau of Economic Research, August 2007, working paper 13330, 1-83.
Findings: “In this paper, we showed empirically that behavioral responses to commodity taxes differ significantly depending on whether taxes are included in posted prices. Individuals are well informed about commodity taxes when their attention is drawn to the topic, suggesting that salience is an important determinant of behavioral responses to taxation. We showed that introducing small cognitive costs of computing tax-inclusive prices into the neoclassical model of consumer choice can explain our empirical .findings as well as other stylized facts. These small cognitive costs can have substantial impact on the welfare consequences of tax policies.”
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