SUSAN BROWN: Good morning. I want to welcome you to the Urban Institute's First Tuesdays Forum looking at The 2001 Tax Cut: One Year Later. I'm Susan Brown. I'm the director of public affairs, and I'm standing in today for Bob Reischauer, who is president of the Urban Institute, and unfortunately is on travel. He's very sorry not to be here, because the issues that we'll be discussing today are among the most important that the Institute is addressing.
This is a special session for at least two reasons. First is that it marks the close of our fifth season of First Tuesdays Forums on vital national issues. We'll be recessing for the summer and coming back in October with a new slate of programs.
The second reason that it's special is that it marks the beginning of a new Tax Policy Center, a joint venture of the Brookings Institution and the Urban Institute. The center was created in order to inject facts, objective analysis, and insightful perspectives into what is otherwise often an incendiary and ideologically driven debate on tax policy choices. It brings together a rather extraordinary group of tax experts, experts on social budget and tax policy, and together they are auguring an integrated program of research and communications in at least four areas of overarching issues. The first area is simple, fair, and efficient taxation. The second is long-term implications on tax policy choices. The third is social policy and the tax code. And the fourth is state tax issues.
Today, you will probably hear a little bit on all of those issues in this forum. We are very grateful for the consortium of funders who made this center possible, and they include, among others, the Ford Foundation, the George Gund Foundation, and the Annie E. Casey Foundation.
In your packet and on the table that is in the back of the room are some of the first products of this Joint Tax Center. And when you get back to your office, if you go up on your web site, you can access their new web center, which is www.taxpolicycenter.org. It has a special tax facts section on it that puts together comprehensive, historical tax information, and current projections. It puts those at your fingertips, and Len tells me that if you go up enough on that and try the tax facts, you can become a very well-informed tax pundit, something that is a handy thing to be in Washington.
Two of the Center's three directors are on today's panel: Bill Gale from Brookings and Len Burman from the Urban Institute; and the third, Gene Steuerle, unfortunately, is traveling.
I would like to turn your attention for a moment now to the panel and introduce Jodie Allen, who is our moderator. Jodie comes to us today as the managing editor of U.S. News & World Report for money and business, where she also writes a column on the political economy. She came to U.S. News from Slate Magazine, where she was the Washington Bureau Chief. Prior to joining Slate, you may have known Jodie as the editor of the Sunday Outlook Section of the Washington Post, where she also was an editorial writer and business columnist. Jodie has held several government and private sector positions, and spent some time both at Brookings and here at the Urban Institute. And most recently we are very grateful to her for having joined the Board of Advisors for the new Tax Policy Center. Jodie is a regular member of Diane Rehm's rotating group of Friday news roundup commentators and is frequently on television news programs.
Before I give the panel over to Jodie, I just want to make one housekeeping comment that during our discussion period, before you ask a question, if you would please wait for us to bring the microphone over to you, and then would you please tell us who you are and your affiliation.
So, Jodie, thank you for being at the Urban Institute again and for moderating our panel.
JODIE ALLEN: Thank you, Susan.
Well, as Susan says, we are gathered here today for two purposes, one to celebrate the opening of the new Joint Brookings-Urban Institute Tax Policy Center, and to reflect upon or perhaps to celebrate, depending upon your view, the first anniversary, just a few days hence, of the Tax Cut of 2001, the so-called Economic Growth and Tax Relief Reconciliation Act, and you simply have to love something with such a lovely name. This act goes by the acronym of EGTRRA, a term I don't believe is going to become a household word, but we will use it in the discussions today.
I think that it's an interesting time to look at tax policy, and to this ongoing conflict between theory and reality as it plays out in that arena. It is a truism, of course, no less true for that, that that tax policy is best which governs least, which is to say that experts, tax experts, generally prefer that a tax system be as frictionless as possible. That is that it interfere as little as possible with the decisions that households and businesses would make in its absence. And, it's generally believed that when it comes to taxing income, that implies that the tax system should be as broad-based as possible, and have as low a rate as possible. So as to interfere, as I say, at a minimum level consonant with the often-forgotten need to finance essential public goods.
Now, I don't have to tell you that that principle is honored much more in the breach than in the observance, and the disregard for it is a bipartisan pursuit. Both Republicans and Democrats have, over the last decade, joined hands in messing up the reformed tax code that had been left behind by the 1986 tax reform. Now, the 1986 tax reform did not remove all the shelters and all the curlicues; in fact, it added a few. But it was, I think anyway, and most observers did, a step in the right direction. But it was barely dry when the undoing of it began.
I remember my first realization of how severe this was likely to become was shortly after Bill Clinton was elected president and I went to that first Renaissance Weekend after his election, and some of us were given three minutes to tell the president what should guide him when he took office, the president-elect. And I used my three minutes to tell him, "Don't mess up the tax code." And I repeated the reasons why he should not. And when I got done, I was walking out, and one of his top economic aides looked at me and said, "Well, that was a misguided message." He said, "Clinton never met a tax break he didn't like." And that did certainly play out over the next decade.
As I say, it was one play in which the Republicans contributed their share, both sides recognizing that since Ronald Reagan had effectively labeled any sort of government spending evil, that the way to finance public purposes that they preferred was to disguise them as a tax cut, which of course was good.
Now, when the George W. Bush administration came into office, many of its top economic people were people who had long espoused the general principle of keep it simple, but, in fact, the tax pact that was President Bush's signature domestic policy initiative did lower rates, but it did nothing to simplify the tax code. In fact, it added a few new curlicues that our panelists will discuss today.
So, how on balance should we rate the EGTRRA? We have four experts with us here today, and I will introduce them now in the order in which they're going to speak. I'll do it all at once, and very briefly. You have their longer resumes. Our first speaker will be William Gale, otherwise known as Bill Gale, who holds the Arjay and Frances Miller Chair in Federal Economic Policy in the Economic Studies Program at Brookings, and who is codirector of the new Tax Policy Center. Before joining Brookings in 1992, Bill was an assistant professor in the Department of Economics at the University of California at Los Angeles and a senior staff economist for the Council of Economic Advisors.
Our second speaker will be Eric Engen, who is a resident scholar at the American Enterprise Institute, where his research focuses on tax and budget policy, Social Security, household spending behavior, financial markets, and the macroeconomy. Before joining AEI, Engen was a section chief and senior economist at the Federal Reserve Board.
Third is Len Burman, a senior fellow the Urban Institute, and research professor at Georgetown University. He is codirector of the Urban-Brookings Tax Policy Center, and has served as deputy assistant secretary [DAS] of the Treasury for Tax Analysis from 1998 to 2000, and also with the Congressional Budget Office [CBO].
And last, but certainly not least, is William Frenzel, who has been a guest scholar at the Brookings Institution since January 1991, when he retired from the U.S. House of Representatives, where many of us knew him as he served his Minnesota constituency for 20 years. Congressman Frenzel was the ranking minority member on the House Budget Committee, and was the principal Republican economic spokesman in the House.
So, let's begin.
WILLIAM GALE: Thank you very much, Jodie, and I just want to say by way of starting that it's a great pleasure to be involved in the Tax Policy Center with Len and the rest of the Urban Institute. And we have high hopes for the Center, and we would very much like to hear your interests or concerns, hopes or fears, for the Center as well.
My purpose this morning in the talk is to give an overview of the economic issues relating to last year's tax cut. But to do it with two things in mind: One is, I want to give you a sense of how the issues link to each other. Too often we talk about tax cuts, we sort of talk about distributional effects here, and growth effects there, and revenue effects somewhere else. These issues are all linked, and we need to think about them in a joint manner.
The other constraint on my talk is, I don't want to steal the thunder of any of the other speakers. So I will try not to step on any toes here. All of the items that I mentioned are documented in the paper that you have in your folder that I wrote with Samara Potter, which is sort of a more full evaluation of last year's tax cut.
All right. Let me start with just a summary of the main features. The basic elements of EGTRRA involve income tax rate reductions which are phased in over time, and reductions and eventual repeal of the estate tax starting in 2010. Aside from that, there are also numerous tax cuts aimed at children, marriage, retirement, savings, education, and so on. But the main features are the income tax cuts and the repeal of the estate tax.
However, EGTRRA also left significant unfinished business, you might call it, in two respects. The first is that the entire tax cut sunsets at the end of 2010, that is, all the provisions expire, and we go back to the system that existed in 2001 indexed as it would be for inflation over the decade. No one thinks that that's actually going to happen, that the tax cut would actually sunset, although some of us might harbor secret hopes. But at the very least, it leaves a lot of residual uncertainty about the course of tax policy.
The second element of unfinished business has to do with the alternative minimum tax [AMT], which Len will talk about in his presentation. But basically the issue here is that under EGTRRA the number of taxpayers that will face the AMT is going to rise to something like 40 million, or over a third of all taxpayers by the end of the decade. No one thinks that's going to happen either. But that's a very expensive problem to fix, and Len is going to talk about that.
What I want to do is focus on three issues. One is tax cuts in the context of fiscal policy. The second is the distributional effects of the tax cut. And the third is the effects on economic growth. And the reason I want to talk about tax cuts with respect to fiscal policy first is that if you understand this issue, then you understand why all the other issues are linked. So, let me start there.
Last year, we heard that tax cuts were affordable because the government was running a surplus. The surplus, if you recall, was $5.6 trillion over the next decade, and the tax cut was just $1.3 trillion. Those are very misleading numbers in a number of regards. I won't go into the details now, but I think it's fair to say that in an economic sense, there was no surplus. There certainly is no surplus in an economic sense now. Part of this is that we face long-term deficits in Social Security and Medicare, and part of it is a variety of other concerns. But EGTRRA as a tax cut basically made a bad fiscal situation worse. That is, there was already an imbalance between long-term receipts and long-term spending. By cutting receipts, EGTRRA made the imbalance worse.
That has two implications. One is, it means that EGTRRA is not fiscally sustainable as is. That is, if we made EGTRRA permanent, something else would have to change. And the second issue is, what's that something else? Well, either we'd have to have future spending cuts, which will have effects on economic growth and distribution, or we'd have future tax increases, which will also have effects on economic growth or distribution. So, when we analyze the tax cut, we have to realize we've only got sort of half of the cut in place; we need to know what the second part of the puzzle is in order to give a full analysis.
However, there is one aspect of it that I would like to point out. We usually talk about the cost of tax cuts over a 10-year horizon, and we talk about the cost of things like Social Security reform over a 75-year horizon. That's very misleading for lots of reasons, both of those, but what's particularly misleading is to do both of those at the same time. It turns out, if you look at the tax cut on the same time horizon as Social Security reform, you find out that if the tax cut is extended, it will cost more than twice as much money as it would take to fix Social Security over the next 75 years. To put it differently, extending the tax cut would cost 1.4 percent of GDP; fixing Social Security costs only 0.7 percent of GDP over the next 75 years. There's stuff beyond that, too, but over that horizon, the tax cut is quite large, it's a very large fiscal event relative to what we normally think of as large fiscal events. In fact, the entire tax cut, counting what's been passed now plus making it permanent, costs just about as much as it would take to fix Social Security and Medicare over the next 75 years.
So something has to change, and that's the bottom line from the tax cut's fiscal policy part. We're on an unsustainable course.
Let me turn to the distributional effects. There's a very simple message here: EGTRRA is regressive. Maybe we all want to say it together, but we don't have to. By any reasonable measure, and in the paper we provide about 10 of them, EGTRRA provides a disproportionately large tax cut for the top 1 percent of the income distribution. That is, the tax cut that they get is bigger than the share of taxes that they currently pay. It's a bigger share of income than any other group. It's a bigger reduction than their average tax rate, etc. You can look through the table, or I'd be happy to talk to you. But I think there should be no debate about the fact that by reasonable measures of distribution, EGTRRA is a regressive tax cut that in particular gives very high cuts to the top 1 percent. And to be clear, most of that is the estate tax. The income tax cuts in and of themselves are less regressive, but are still somewhat regressive.
Now this tax cut—we can argue until we're blue in the face about what's fair. I don't claim to have any crystal ball that tells me what's fair or what's not fair. But there are a couple of things to point out. One is, the top 1 percent has had the biggest increase in after-tax income over the last 20 years, that's after-tax income, despite the tax increases in '93, which hit the top 2 percent only. The increase in before-tax income for the top 1 percent is much, much larger than any other income group. So, this tax cut comes on the heels of a 20-year period where the top 1 percent have already done much better, grown much faster, than the rest of the population.
The other issue is that fixing the AMT, depending on how it's done, could provide further tax cuts for high-income households, and so we need to keep our eye on the AMT issue if we want to fully understand the distributional effects, particularly if the AMT is just cut, that will make the tax cut more regressive than it currently looks. On top of that, if we cut spending to make up the fiscal imbalance, and we think that spending predominantly goes to low- and middle-income households, then it's likely that that would make the tax cut even more regressive. If you look at the spending cuts that the administration has proposed, they're targeted on areas that likely affect low- and middle-income households, community and reasonable development, job training, things like that. So the distributional effects not only depend on how we fix the AMT, but they also depend on how we resolve the fiscal gap.
All right. Let me turn to the third issue, which is the impact on long-term economic growth. EGTRRA affects economic growth in several ways. I think what we're seeing recently is sort of some new thinking on economic growth.
Let me point out four ways that EGTRRA will impact economic growth. The first way is by cutting marginal tax rates. That's the standard supply-side effect that we've all heard about, lower tax rates encourage labor supply, they encourage saving, they encourage entrepreneurship, they encourage investment, etc. . . . My estimates using the economic research literature suggest that these effects, by themselves, will raise GDP by almost 1 percent over a decade. Now, the key word[s] in there [are] not raise GDP by 1 percent, it's by themselves. That is, just looking at these effects in isolation, you'll get an almost 1 percent increase in GDP over the next decade. The reason the by themselves part is important is that the tax cut also reduces public saving, and that reduces national saving, which reduces our ability as a nation to save and invest. And the estimates for the reduction in public saving suggest that that will cause GDP to fall by 1.6 percent over the next decade. So the decline in public savings knocks out more GDP than the incentive effects create based on conventional economic estimates. And then there's some capital inflows because if we have lower tax rates, and we have less national saving, we finance some of our investment from overseas. And, again, using estimates from the literature, I estimate that that bumps GDP back up. The net effect is a net decline in GDP of three-tenths of a percent over 10 years.
Now, all of this depends on the government financing the tax cut by raising the budget deficit. Eric will talk more, and we will all talk more, I presume, about what happens if the government cuts spending. But what the analysis shows is that the tax cut by itself is not sufficient to raise economic growth, and that's the finding not only of our paper, but of several other papers that have appeared in the last several months. So the net result, I think, is either that we get little effect, or possibly a negative effect on growth over the next 10 years, or we do get a growth effect that comes from the decline in spending, not from the decline in taxes.
I think I'll stop and turn it over to my colleague.
JODIE ALLEN: Now Eric is going to address some of the same issues, but bringing a different perspective.
ERIC ENGEN: I'm honored to be included in the inaugural event of the Urban-Brookings Tax Policy Center. I've the utmost professional respect for both Bill and Len. I count them both as friends, and certainly wish them well with the Tax Policy Center.
The issues I'm going to talk about today will be published in a paper that I'm working on that will come out in the National Tax Journal. And today I'll be making four basic points that I think are the most important related to the tax cuts. I'll be expanding a bit on some of the things that Bill discussed, and bringing up a couple of other issues.
Here this slide shows the ratio of total federal tax receipts to GDP in the post-World War II period. And what you can see here is that top peak to the far right there was when taxes reached a postwar high in fiscal year 2000 of almost 21 percent. Now, as well noted here in the second point, the average over the postwar period has been about 18 percent of GDP. Now, even after EGTRRA, as Bill noted, which is a big fiscal event, federal taxes are still expected to remain above 19 percent of GDP, just slightly above. Obviously it will be quite a bit higher if they do sunset. But one important point here to take away is that the total federal tax burden is still above the average, and only about a percentage point or two above the all-time highs.
Okay. The second point I'd like to make is that as well as Jodie noted in her introduction, one of the laudable features of the tax reform of 1986 was that it lowered marginal individual income tax rates. After 1986, we had the two statutory rates of 15 and 28 percent. Tax people will also know that there was also an effective 33 percent rate over a range of income, allowing for various phaseouts. But one of the features of the unwinding that we saw in the nineties, starting with the tax bill in '90 and then going on to '93, was that we had a marked increase in the marginal rates, particularly at the top end.
EGTRRA pulled the rates back to the rates shown here, and as pointed out in the next slide, EGTRRA only partially rolls back the increases in the top rates that were enacted in the 1990s, and one feature it does do is create a lower marginal rate at one of the low-income ends.
Now, one important thing to realize is one of the big factors, or one of the important factors in increasing federal taxes as a share of GDP, particularly in the late nineties, as we saw very robust growth, was that we had real economic growth pushing taxpayers into higher tax brackets. In other words, we had real bracket creep. And that is where [some people], because their real wages are rising, even though the tax code is indexed for inflation it's not for real economic growth, are moved up into higher brackets.
Also, there is a greater proportion of income that will be taxed at higher tax rates, even if you do stay in the same bracket, because of the fact that it's not indexed for real economic growth. Now, one of the things that the tax cuts do is simply offset some of this automatic tax increase that is built into the system, because of the lack of indexation for that feature.
Now, my third point is, to follow up on one of the things that Bill chose to emphasize—and that is looking at taxes and economic growth. Now, lower marginal tax rates also have positive effects on economic activity in general. As Bill mentioned, although there is uncertainty in estimates, there probably is a consensus in the literature that lower marginal rates increase labor supply, also that lower marginal rates increase private saving. There's a range of estimates on these that can be debated, but I think both Bill and I agree that those effects are positive here.
As well, more uncertain type of effects may come through on taxes' effects on human capital, in other words the productivity of labor and the productivity of capital, although the economic analysis, and particularly statistical analysis, is much thinner and is definitely more uncertain. I think the bottom line is that we would tend to believe that the tax reductions would increase labor, increase capital, which would increase real GDP.
If, for example, and it's not implausible, after 10 years GDP was in the range of 1 to 1 1/2 percent higher, relative to CBO's estimates of about a $16 to $17 trillion economy 10 years from now, that would translate into about $20 billion. So not an insignificant amount of real income. In other words, another way to think of this is the economy would simply have to average 1/10 of 1 percentage point of additional growth each year over the next 10 years.
The fourth and final point that I want to make on the next slide is this issue of taxes and government spending. Now, much of the debate over the tax cuts, when thinking about the overall effect on the budget, have taken one of two polar extreme assumptions on this. On the one hand, some have assumed that if there's a tax cut spending remains the same, and so every dollar of tax cut feeds into a dollar of increased deficit, or lower surplus, whichever is the case. The other extreme is that some have outright just assumed that a reduction in taxes will feed through to an equal dollar reduction in spending. But, essentially little, or almost no actual analysis or research has been done on whether or not either one of these assumptions seems to actually be the case when we look at the U.S. experience.
Now, we would expect when budget constraints become tighter, we expect households and businesses to lower their spending, that's standard in terms of economic thought. An analysis of post-World War II federal taxes and spending suggest this is true for policymakers also. Indeed, an analysis that's detailed more in the paper I referred to earlier, at the end of the day I conclude that my best statistical estimates are that a $1 decrease in taxes would lower spending by about 50 cents.
Now, a couple of things about this. First of all, the offset is not complete, there's still in a sense in these estimates a tendency for deficit spending. A second important factor here is that, say, for example, you took Bill's calculations of the overall growth effect, where he has the positive effects from private behavior, that is then swamped by the increase in the deficit that is assumed, if you apply these estimates for what the spending response would be, to the numbers that he does, you actually would then have a positive growth effect at the end of the day. So one of the things I think that's important is that this area of behavioral analysis, what policymakers' response to tax cuts, to changes in the budget constraints are, is everywhere as important as it is when we think about households and businesses, in terms of their response.
Finally, as well as Bill alluded to, government spending, particularly transfer payments, are also often found to have growth—economic growth effects, oftentimes on a negative side. So reducing certain types of transfers that have been shown to distort labor and saving decisions may increase growth further. Now, obviously that will have distributional consequences, any fiscal policy will have distributional consequences, but those are things that have to be weighed.
In conclusion, those are my four basic points. The federal tax burden is still above the average in the postwar period. Lower marginal tax rates tend to take back some of the changes that I think many of us up here thought were good with the tax reform in '86. And also, where I think there should be more discussion is that as well it takes away some of the effects of real bracket creep. Lower marginal rates tend to increase economic growth, I think is my conclusion at the end of the day. I find it hard to believe that economic growth would be boosted by raising taxes. And finally, lower tax revenue will tend to restrain federal spending to at least some degree.
JODIE ALLEN: Thanks, Eric.
Now we will turn to Len who will—well, actually I don't want to spoil the effect here. He will tell you what he's going to talk about.
LEONARD BURMAN: I'm going to come to the podium, because I want to use this neat laser pointer without actually doing laser surgery on Congressman Frenzel.
I want to summarize some joint research with Bill Gale, Jeff Rohaly, and Ben Harris. I'm going to talk about something really scary, which is the alternative minimum tax, indescribable, indestructible, nothing can stop it. Bill was optimistic that actually the AMT would be fixed. I'm going to maybe shed some cold water on that thought.
Where did the blob—I mean, the AMT come from? In the 1958 movie it came from a meteor in space. The AMT came to our planet in 1969 when the Secretary of the Treasury Joseph Barr reported that 155 individuals with income over $200,000 paid no income taxes in 1967. His testimony unleashed a firestorm of protest. There were actually more letters to Congress complaining about those 155 high-income tax avoiders in 1969 than there were letters complaining about the Vietnam War, which was really remarkable. So Congress created that AMT, it expanded, and ultimately it morphed into this ugly alternative tax system that hit many people who aren't millionaires. It's not indexed for inflation, so every year inflation pushes more and more taxpayers onto the AMT.
One of the big disappointments of the 2001 Tax Act is that it missed an opportunity to simplify—you can see that even before the enactment of EGTRRA, the number of people on the AMT was scheduled to explode. It was going to increase to 22.6 million by 2012. Well, EGTRRA did pass some reforms for three years, they were even more temporary than the rest of the bill. And then after that those reforms—the increase in the exemption level expires, then the number of people on the AMT just explodes. It's almost twice as high by 2012, assuming that EGTRRA is extended, than it would be without the 2001 Tax Act. Even in 2010 there are 35 million people on the AMT. And this happens because the 2001 Tax Act cuts tax rates under the ordinary income tax, but it didn't do anything to tax rates under the AMT.
Well, the effect is that essentially we had two tax bills. There's the one that's advertised, and this chart sort of shows that—there's this big tax cut, that as Bill pointed out is regressive, the biggest cuts are for high-income people, and this is only the income tax part, not the estate tax part. But, then there's also effectively the take back, which are the little red lines. The red lines show what people actually get from the 2001 tax cut, after the effect of the AMT. And you see for people with incomes between $75,000 and $500,000 more than half of the tax cut is effectively rescinded by the AMT. People who were on the AMT before the tax cut was effected get no benefit from the income tax cuts, because they're not on ordinary income tax, and a lot of people were pushed on the AMT as well.
Now, it could be that this is a secret plan to build support for another big tax cut a few years from now, but basically it's not what was advertised. I didn't show the people over a million, you can never fit them on the same scale. What you can see is that the AMT isn't really so much a problem for really rich people, it's for moderately—somewhat rich to actually middle-income people [that] the AMT is a much bigger deal. Virtually all of the tax cut for millionaires actually goes to millionaires, even after the effect of the AMT.
We can look at this another way with this chart. This shows the percentage of tax filers who get any benefit at all from the 2001 tax cut, and what you can see is that starting at about $50,000 of income, and then most dramatically the $200,000 to $500,000 category, that a lot of people don't get any benefit at all. Half of the people in the $200,000 to $500,000 category get no benefit from EGTRRA. And the largest numbers of people are in the $50,0000 to $200,000 category, because that's where more of the taxpayers are. Most of the 30 to 35 million people who are going to be hit by the AMT are in those moderate-income brackets.
Well, who does the AMT hit? Obviously it increases with income up to a point. It's a tax on families. By the year 2010, almost half of families with two or more children will be on the AMT. And it's also a tax on people in high-tax states, because you can't take your state and local income taxes against the AMT. Unfortunately, EGTRRA makes it a lot harder to fix the AMT. Even before the enactment of EGTRRA, if you were to repeal the alternative minimum tax it would cost about $300 billion over 10 years. There are other options that are less expensive, and I'll talk about a couple of them. But, fundamental reform of AMT is very expensive.
After EGTRRA the cost of repealing the AMT more than doubles, it goes up to $600 billion, and if EGTRRA is extended past 2010, then the cost would increase by another $150 billion over the next 10 years. And the cost in the out years, you can see that the revenue costs of the AMT, or repealing the AMT is three times as high after EGTRRA by the year 2012, as it is if EGTRRA had not been enacted. Now, as I said before, this might be deliberate. Throwing 35 million people under the AMT might build a constituency for another huge tax cut for the rich, but it also might backfire, because if EGTRRA isn't extended soon, people are going to start to notice that the AMT is a problem. And the cost of dealing with EGTRRA—the cost of dealing with the AMT might preclude extending a lot of the EGTRRA cuts.
We went through in a paper, which will be available soon—we looked at a number of options for retargeting the AMT. This one is fairly dramatic. What it does is it gets rid of all of the things that have nothing to do with tax shelters, the original purpose of the AMT. It takes middle-income people, and a lot of upper-income people, off the AMT. We would index the AMT for inflation, so there wouldn't be bracket creep on the AMT, just like bracket creep was eliminated for the ordinary income tax, we allow people to take their state and local taxes, to take deductions for their children, to use personal credits against the AMT, and miscellaneous itemized deductions. The effect of this is that it removes 34 million people from the AMT roles. The cost would be about $133 billion in the year 2010, so it's expensive, and it would be a huge tax cut for the rich.
Well, how would we pay for this? The next chart shows what we call the poetic justice offset. This is only the income tax portion of it, but what this does is it eliminates the high income rates cuts that were enacted in 2001. So for the 28 percent brackets and above, if those rate cuts were eliminated you'd offset most of the cost of this reform option, you could pay for the rest of the cuts by freezing the estate tax at its level in 2008, which would be a $2 million exemption at a 45 percent tax rate, but not eliminate it altogether. This is my favorite option, but maybe not one that's going to pass this Congress.
In your handout there are a number of options for reducing the hit from the AMT. The more effective ones are more costly. The bar shows the cost with different options. The major reform, which is what we just showed, would cost about $133 billion over 10 years. If you just indexed the AMT, and allow personal credits and children, it's still over $100 billion. And as you move to the right fewer and fewer people are on the AMT.
Now if, like Eric, you think the 2001 tax cut wasn't too big, and there's room for more, maybe this isn't a big problem. If you worry about the growing fiscal hole that we're digging ourselves into, then dealing with the AMT is likely to require some leadership and political courage. Unfortunately, both parties continually defer serious action on the problem, arguing that the other one should pay for it. This is the latest example from Tax Notes April 22: Chairman Thomas of the Ways and Means Committee said he consciously decided to skip extending the AMT correction in the 2001 tax package while making all the other provisions permanent, because he was hoping to give Democrats another chance to rectify the situation they helped to create. So there's basically a bipartisan agreement that the other party should deal with it. Fortunately, we have Congressman Frenzel to explain the politics to us, and I'll defer to him.
JODIE ALLEN: Thank you, Len.
WILLIAM FRENZEL: Thanks very much, Len, I sure wanted to talk about the blob. I think I'll leave you to the searching questions of the multitude. My part of the program is going to deal with most of the issues that the other panelists have raised, but not being burdened with an economist's training, my evaluations will be more those of a politician, and some speculation about the future.
Some parts of EGTRRA I like better, and some I like less well. But, in general, I'm comfortable with the bill. I don't think most people believe that 40 percent is an effective marginal rate. I don't think people argue about IRAs and 401s, and estate tax reductions. As a matter of fact, when you call the role of the elements of EGTRRA, you probably are not surprised that the public liked it better than economists did. But, the public is fickle. The Clinton veto in '99 of a similar bill was not unpopular. Just this last December when the Senate closed down, deciding that it couldn't do a secondary, following stimulus bill, that action was unpopular. And when the Senate came back it was obliged to pass a second one. So one never knows in this business where one tracks with the public.
In reviewing the bill for me the most important element is the marginal rates. Eric went into that with some thoroughness, and I'll not dwell on it, except to say that in 1986 we were told the Tax Reform Act did wonderful things by getting rid of tax preferences and allowing us to buy down the marginal rates to around 30 percent. A couple of years later it got sent right back up, one-third higher. I've got to tell you, I didn't vote for the 1986 act anyway, but I certainly would vote to undo undoing that portion of it.
With respect to the economic—
[TAPE CHANGE.]
WILLIAM FRENZEL: —this rattling around inside the economy. In fact, the economic report of the president, written by the CEA, calls the passage of the act propitious timing, adding a tax stimulus of $57 billion in '01, and $69 billion in '02. It seems the public felt that it needed more when the second act was passed.
I now want to go to the point that—another point that Eric made about taxes being too high. That is that the Congress is always going to spend any revenue creep. Whenever our revenues go up, Congress is not going to salt them away, if it can possibly help it. If it is burdened by the discretionary caps, or the pay-go provisions, it will resist the temptation for a while, but eventually, as it has year before last, last year, and this year, it will bust loose and spend them. And therefore, I really believe that we should never tax above the average percentage of the last couple of decades. Eric calls it 17.9 percent, that's good for me. We were up almost 3 percentage points above that in 2000. Obviously, taking too much tax money out of the economy—[inaudible]
Next question is progressivity, that's been mentioned on the panel, as well. I think the tax rates in this country are extremely progressive. I believe in a progressive system. I'm not a flat taxer. But, I do not believe that every change in the tax law has to make the taxes more progressive. And I find it very hard to make a tax cut without giving some money back to taxpayers. And if you are going to have the top 10, 5, or 1 percent contribute the lion's share of tax revenues, if you're going to have a tax cut you're going to have to give some back to them. That does not offend me, as long as our tax code remains fundamentally progressive.
With respect to affordability, again, the prime standard of affordability to me is what the tax take is at the level that I think it should be, around 18 percent. If we are going to be driven slavishly by 10-year budget projections, I think we are going to find that at the end of 10 years there is no reality. And those budget projections we have seen from last year are in the tank already. The ones we are making now will be in the tank next year. It is, I think, in a practical sense unwise to believe that either our tax code or our economy is going to stay static for 10 years. It simply isn't going to happen.
I've got the same malady everyone else has up here. You remember in 1986 when we said we were going to lower the marginal rates, and we had a lot of comment on that, well, they went in a hurry, and certain elements of this tax cut will go in a hurry. I think with respect to my friend Len, that even the blob is going to be changed, as difficult as it looks.
For the future, there are going to be lots of changes; we are not living in a static society. The first has already occurred in tax policy this year, when the extra stimuli bill was passed. There will be lots more. We've also raised our discretionary spending 10 percent last year, and we're already on the road to do it this year. And heaven knows what it's going to be for 2003, probably at the same rate, all of which makes our estimates look pretty silly. As the changes occur, therefore, the 10-year budget runouts, the extrapolations, are going to be at variance with reality at every step along the way.
Third, a tax reform, a burning need, will be as elusive in the immediate future as it was in 1986. Members of Congress do not run on nothing, they run for something, and a lot of the somethings they run for deal with tax policy. They know that tax stimuli are very powerful, and they don't mind using them. And so anything that you think is reform is likely to be swiftly undone in future years. But a thorough going reform is going to be extremely difficult.
Tax cuts may slow spending, and some people have referred to this on the panel, in the long term, but I wouldn't bet the rent money on it in any kind of short-term situation. We do not have any surpluses now; Congress is having no difficulty spending money, now using the excuse of emergency. But, tax cuts—I mean, spending is a little bit like the blob, it's irresistible. And it simply goes forward.
Last thought is that an ambivalent public will continue to like tax cuts sometimes, and at the same time, many people will continue to complain sometimes, that taxes at the traditional proportion of GNP are destroying our surplus and causing deficits. But, I won't.
JODIE ALLEN: Thank you so much.
I want to thank all our panelists and now I want to—we are running a little behind our schedule, so I'd to turn it over now to members of the audience. Please identify yourselves, and remember to wait for the microphone.
PETER ORSZAG, Brookings Institution: Combining Bill's point that if we allow the sunset to occur, the revenue change would be 1.4 percent of GDP, and Eric's point that about half of that would be offset by spending, if we accept that for the sake of argument, we're left with a net saving of about .7 percent of GDP. It so happens that that's about the cost of the general revenue transfers under models two and three for the Social Security Commission that Mr. Frenzel served on. So I was wondering, if you only had to choose one, would you make EGTRRA permanent, or would you finance those general revenue transfers? And perhaps you don't accept the choice of having to choose one, but do you see a trade-off there?
WILLIAM FRENZEL: No, I find the hypotheticals obnoxious. And I always try to extend my options well beyond the range proposed by the question. I'd prefer to keep social security taxes the way they are now, and I'm still waiting for some suggestions from others as to how to remedy that situation. Like Congressman Thomas, however, I may wait in vain. But I am not one who believes that the tax on estates should either sunset, nor be reinstated. I believe there is a position in-between someplace. I believe that if the super-rich insist on paying estate taxes, they should be granted that favor. But I don't know whether the 2008 position is a good place to be, or the 2009 position. But I feel confident that Congress is going to attack that problem. But with respect to the year 2010, I would not use whatever savings would occur in that year, I would not designate it for a special purpose at this time.
JIM KLUMPER, House Budget Committee: I had two quick questions for Eric Engen. You said that you had a hard time believing that raising taxes increased growth. Clearly, you believe that lower taxes helped growth. In the late 1990s real growth averaged 4 percent on a real basis, this would have been when real bracket creep would have been having its greatest disincentive effects. How much faster would you guess growth would have been in the late 1990s if we had not raised taxes on upper-income people in '93?
The second question was, you also ventured an estimate that a $1 reduction in taxes resulted in a half a dollar decrease in federal spending. If you run a simple correlation between federal non-interest spending and taxes you see quite a strong relationship between tax increases and spending decreases, and vice versa. Clearly, there is some third or fourth factor going on. What would you identify as the other factors which overwhelmed the 50 cent effect that you hypothesized?
ERIC ENGEN: I guess with respect to your first question on how much higher would growth be had we [not] had the '90 and '93 tax increases, I haven't run through that calculation, so I wouldn't want to say a number right now without actually doing that. I think that the effect would be somewhat higher. I'm not sure exactly what kind of number.
Now, one thing I do want to note and actually answer the question I thought you were going to ask on that one, is that some people say, look, in the nineties we had this experience of the rate increases, particularly in '93, and growth took off. And I think one of the things we need to be careful of is this sort of simple—kind of one snapshot, time series correlation. Those kind of things are oftentimes used on the other side, I think just as incorrectly—I've written on this before. For example, people state that economic growth really took off after the Kennedy tax cuts in the early nineties, and that proves that tax cuts improve growth, or that growth really took off in the early eighties, after the '81 tax cut. And I think both those cases miss a very important and difficult thing to do, and that is, you have to try to control for other things. And so I think these one-time-period kinds of things are difficult to look at.
The other is, on the tax-and-spend relationship, a couple of things. If you run some of the correlations in short enough time periods, say, in the late nineties, you see taxes and spending on level terms go in opposite directions. If you look over the longer time period, say, if I put a spending to GDP graph up that matched the tax one, what you'd see is the general trend of both of those was going up, and so there over a longer frequency you would tend to see a positive correlation.
Without getting into the econometric details, there are various things that you have to do when you have these long-run trends to make the series comparable. And once you do those, and in the analysis I did is that rather than looking at just the trend change, you look at what is the one period to one period change, you then have the appropriate time series properties for those series that you can then do the analysis, and what that shows, regardless of controlling for the other economic factors that are changing, such as GDP and unemployment, and those things, much to my surprise, you get this estimate of $1 in tax change is offset by a half a cent in spending.
JODIE ALLEN: Questions?
RANDY BOVBJERG, Urban Institute: Obviously there is some dislike for hypotheticals, there may be some difficulty resolving differences in econometrics in a forum like this, but I'm looking at two bullets from the first and second presentations from Bill and Eric. The first one says outlays in 2000 were the lowest share of GDP in 34 years. The second one says the tax burden reached a post-World War II high of almost 21 percent of GDP 2000. Could you guys discuss this please?
LEONARD BURMAN: We had a big surplus.
ERIC ENGEN: That's exactly correct, that's the facts.
JODIE ALLEN: I think there was another question over here, yes.
BOB LERMAN, Urban Institute: I'm looking at Bill's table, that wasn't in the presentation, but I looked in your paper while you were speaking. And if you look at the distributional effects that you cite, it looks as if—I'm just looking at this for the first time. But, it looks like while it's true that the top 1 percent got a higher percentage reduction in tax payments than the average, much of the other—the groups that seem to have gotten a much lower share than the average were, let's say, the 90 through 95 percent group, which is clearly a high-income group, and then even the group that is 80 to 95 percent, and the 60 to 80 percent group. So I would think that the distributional impact is at least a little more complex than what you were saying.
WILLIAM GALE: All right. The numbers in the report are exactly right, if you acknowledge you haven't looked at the paper. So I'll refer you to the paper and say that the numbers in the paper assume that the AMT is repealed. I mean, that we have a major league AMT problem in 2010. These numbers assume that 35 percent of taxpayers are on the AMT. And so the AMT cuts into the tax cut that the 80th to the 99th percentile would get, for precisely the reason that Len talked about. If you adjusted the AMT downward, you'd see much bigger impacts there. I was unable to do that at the time I wrote this paper, because the AMT model wasn't done. But, the reason—
BOB LERMAN: Then you'd have to pick out an AMT plan of some kind, right?
WILLIAM GALE: Well, essentially current law under the AMT, which you already have... This table is based on the law in 2010, as legislated, all right; under current legislation 35 or 39 million households are going to be on the AMT in 2010, and that's why this is the take back. What you're saying is exactly the take back that Len is talking about.
LEONARD BURMAN: If you hold the AMT constant, the people with income between $50,000 and $500,000 would get three times as big a tax cut. In other words, if the AMT were just frozen at the pre-EGTRRA levels they would get three times as big a tax cut as they actually got, because of the AMT. So you do see a blip. In any table showing the distribution of the income tax cuts from AMT there is a drop in the income range, in the percentage of income that the tax cut reflects.
BERNARD WASOW, Century Foundation: I was struck that apart from Bill Gale, nobody really looked at the long run at all. We are assessing a tax cut a year later—to me it looks an awful lot like Ronald Reagan redux: you come in, you cut taxes, you jack up military spending. If one projects on reasonable assumptions there are huge fiscal deficits down the road. Doesn't that bother Mr. Engen, or Congressman Frenzel, or is that just simply too far into the future to worry about?
ERIC ENGEN: Yes, certainly, but I think it's important, at least in my mind, to keep in order what are the most important things, and I think the size of the economy that the government takes and transfers, and the distortion effects of high marginal rates in order to take those taxes are every bit as important as the deficit effects.
Bill covered deficit effects, and I think in my analysis of the interaction between taxes and spending was sort of my part of that. Certainly, all else being equal, yes, I think it would be better to have lower deficits than higher deficits. But, I don't think that we should so concern ourselves with the size of the deficit that we miss sight of the size of the tax burden in general, and the size and the distortionary effect of marginal rates.
WILLIAM FRENZEL: I am concerned by deficits, and there is time to make adjustments, and I don't know how long military emergencies will last. I do recall the Reagan years, when the president said, "I have to get rid of the Evil Empire," and Congress said, "we'd like to help you, Mr. President, as long as you can take care of our constituents with their highway ramps, and their university grants, and tennis courts." And, as a result, we ramped up both ends of the game.
But I do not believe that surpluses and deficits depend only on the revenue side. I believe it calls for some modest discipline on the spending side. And I do note that after 1988, when we cut defense in every single year, and spent the dividend for other things, that Congress doesn't pay quite as much attention to them. I think the tax cuts have to be accomplished when they can be accomplished, because the congressional pattern is pretty clear.
LEONARD BURMAN: Can I make one comment? This idea of this sort of historical ratio of taxes to GDP, and that's the golden era that we should revert to, it might be okay if we had policies that could lead to sustainable spending at that level and also meet social needs. The one thing that happened when I was DAS at Treasury that I was not embarrassed about was this idea that you should save Social Security first. It seemed that there were all these long-running problems, like the AMT, like Social Security, like Medicare, like things Congress of both parties were promising, like prescription drug benefits, that are inevitably going to require either more resources or some other kinds of tax increases. Tax increases to pay for Social Security and Medicare. And to first give the tax cut, and then say, well, these other problems we're going to deal with at some point in the future, seems to be a recipe for disaster.
WILLIAM GALE: I just want to add one comment, too. Bill Frenzel said what sounds to me like a classic Bushism, which was that, yes, we should have a tax cut, but we should have some modest discipline on the spending side, too. If you're trying to close a fiscal gap, and you have modest discipline, that means you're raising taxes and you're lowering spending. And what Bill is saying is, no, we should lower taxes by a lot, and lower spending some. That doesn't get you even in the right direction of closing the fiscal gap. And so, if we're going to have some modest discipline on the spending side, we should have some modest discipline of belt-tightening on the tax cut. But to say we should cut taxes by a lot, and modest discipline on the spending side seems to me to be completely not Orwellian, but at least Bushian sort of logic.
WILLIAM FRENZEL: As a long-time Bushian, I must say that for me this wasn't a tax cut at all. It was just taking down the tax proportion to what it used to be. Taxes were running wild, and they were getting spent.
JODIE ALLEN: But that's the curious thing about the nineties, is that even while we did have a tax increase, domestic spending, including not just defense, but domestic spending, continued to decline, I believe, to postwar low as a percent of GDP. So, you didn't—
WILLIAM GALE: Spending as a share of GDP in 2000, other than net interest, was its lowest share since 1957.
ERIC ENGEN: Primarily because of defense.
WILLIAM GALE: Well, all forms of spending were down, discretionary nondefense spending was down over the decade, defense spending was certainly down, even entitlements were down as a share of GDP. And net interest, of course, was down, if you want to include that.
JODIE ALLEN: And that is the more remarkable because the biggest entitlement, of course, is Social Security, and as the population grows, especially the aging population, it's supposed to increase. So, it must confuse the models.
Yes, this gentleman here in front.
LEE PRICE, Commerce Department: The last page of Bill Gale's paper, figure 3, gives sort of what you've been talking about for the last five minutes. And the notion that the dotted line is—revenues have been averaging for 50 years, 18 percent is the norm. And we should bring down revenues to something like that, and that would be a happy situation is I think puzzling, because if you look at the spending side, the spending side probably for the last 20 years, and we're not going to go back to 1960s kind of spending, we're in the new world: defense, homeland protection, Social Security, Medicare coming up, and that record revenue level of 2000 was not even at the average of the last 20 years' spending. And we can expect more spending.
So I guess my question is, how can you say—surely there were tennis courts and some extra ramps built, but really is it plausible to have spending down to 18 percent given what we know, in the long run we're all dead, but we do have a homeland defense spending plan, we have a defense spending plan. We know there's a demographic shift coming for Social Security and Medicare. Is it plausible to say, well, we really ought to bring revenue down to 18 percent average of 50 years, when the last 20 to 25 years the spending has been above 20 percent, and it's likely to stay above 20 percent for some period of time?
ERIC ENGEN: I guess, first of all, I did not say that taxes should be held at, say, the 17.9 to 18 percent. I was just putting in context what the tax cuts did in terms of their expected effect on the size of the economy. So, in that sense, I don't think there's necessarily a magic number of 18. Obviously, Bill made it more clear that he believes that we should stay around that average.
QUESTION: You did imply it was too high.
ERIC ENGEN: I said it hit a postwar high, and that even with the reductions from the 2001 Tax Act, you were still above the average.
JODIE ALLEN: But the GDP is much bigger in real terms, so the same percentage does yield growth in spending.
ERIC ENGEN: But I do think it raises the question, particularly given that one of the reasons why tax revenues increased a lot was because we had a serious ramp up in the marginal rates. The economic distortion from that were ones that I think are worrisome.
On the other hand, say, for example, we went for something that was more revenue neutral, we lowered marginal rates, and broadened the base, I think that would be a good tax change also. I think where taxes should be, obviously, is not just fit in the tax debate, it's got to fit in the overall budget debate, and society has to decide on how much spending they want, also. But I think the high marginal rates are a problem.
JOE MINARIK, House Budget Committee: A question for I guess primarily for Eric. You said that after the tax cuts the projected level of receipts relative to GDP is about 19 percent. In light of the developments of the last few months, do you think that we have any chance of actually attaining that over the next few years?
And, number two, if analysis of the most recent rounds of tax returns were to suggest that the increase in revenues over the late 1990s was largely a technical development driven by the financial market, the buoyance that perhaps is not going to return, do you believe that we ought to reconsider the tax cut in light of the risks that it has of mounting deficits, debt, interest charges, deficits, debt, interest charges, etc.?
ERIC ENGEN: I would say on one thing, I think I agree with your supposition that we know from analysis that we do chalk up some of the rise in tax revenues in the late nineties to these technical factors that probably, in all likelihood, were related to the buoyant stock market. I think that's probably true.
Certainly, some unwinding of that probably is what has been happening this year. I'm not privy to the same numbers and, in fact, since I'm not at the Board anymore, the Reserve Board, I don't have as much of the near-term to know exactly kind of how big those declines were this year relative to expectations. So, I don't know how much of those estimates of CBO—CBO certainly has a better idea than I do at this point.
But I find it hard to believe that it would be, say, large enough to push below the average. And I think, though, if there is further erosion in that, what it means is that policymakers are, in particular, going to have to look at the budget process of setting spending even more seriously than they do right now. I think certainly we're all discouraged with the recent developments in that side, and I think right now we're in one of those, I think at a Brookings conference Richard Coven called it spasms of irresponsibility. I think we're on one of those episodes right now. So, I wouldn't necessarily call for a repeal of the tax cut right at this moment, but we have to see.
JODIE ALLEN: We can take one more question.
VAN OOMS, Committee for Economic Development: This is I guess primarily for Bill, although I'd like comments from anyone else. The conventional wisdom on national saving, growth, and budget deficits has always seemed to argue that a major reason for trying to reduce deficits or, in this context, not to have a very large tax cut, would be to provide for the macroeconomic future when we've got lots and lots of baby boomers retiring, and great pressure on Social Security and Medicare.
Now, Bill, your analysis seems to suggest that after all is said and done, with respect to the tax cut, that there really isn't an awful lot in the growth story on a net basis, that the effects effectively are relatively small, which suggests that we are not going to, even if we were to repeal the tax cut, let's say, it's unlikely that we would have growth effects that were large enough to make any significant difference to the future of the macroeconomy in terms of supporting generationally the Social Security and Medicare issue.
So, is it fair to say that your concerns with the tax cut then are really primarily fiscal and distributional; fiscal in the sense of crowding out other types of programs, such as some kinds of funding for Social Security and Medicare that we might otherwise need to do?
WILLIAM GALE: I'm looking at this paper that I'm reading for the first time. My concerns for the tax cut are that it actually reduces the size of the future economy, raises interest rates, makes taxes more regressive, increases tax complexity, and is fiscally unsustainable even before the economic downturn and the terrorist attacks in 2001.
With respect to growth, cutting taxes to generate more growth to meet the future fiscal responsibilities is a gamble in the sense that you know you're increasing the debt somewhat. You're hoping to get enough growth out of that to not only make up for that, but to increase the size of the economy enough to fund these other programs. My estimates suggest that if you do cut taxes to generate growth, what you'll get is no net increase in growth, because the public saving effect offsets the rate incentive effect, but you will get an increase in fiscal burdens; remember, because you have cut taxes, you now have more public debt at the end of the period.
So, it's true that repealing the tax cut will help growth, but it's also true that it would reduce the fiscal burden. So, in that it would be a net gain in helping us deal with these long-term problems aside from the political economy of spending issues that Bill and Eric have raised.
JODIE ALLEN: Well, I know we can go on taking questions. I know I have a bunch I'd love to ask, too, but we've come to the end of our time, and I want to thank our four panelists who I think have done a wonderful job.
(Applause and end of event.)
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