In terms of domestic policy, no issue more clearly defines the presidency of George W. Bush than taxation. Among Democrats, it even exceeds Iraq as the issue that motivates their loathing. Thus, during the recent Democratic primaries, Senator Joseph Lieberman and Representative Richard Gephardt continued to support the invasion of Iraq despite strong opposition from the party's base. But every candidate for the Democratic presidential nomination supported repeal, in whole or in part, of the Bush tax cuts.
It is difficult to think of another period in American history when tax policy was so polarizing an issue. Ronald Reagan pushed a highly controversial cut through Congress during his first year in office, but then he raised taxes almost continuously throughout the balance of his presidency. His tax-reform legislation in 1986 received broad bipartisan support. Bill Clinton's 1993 increase was contentious but rather modest, and by 1997 he had joined congressional Republicans in support of the first major tax cut since 1981.
One reason Bush's tax-cutting has stoked such ire is that he has been so relentless about it. He pushed major legislation through Congress in each of his first three years in office. This alone is a remarkable political achievement, since large cuts have historically occurred only at widespread intervals. The Kennedy tax cut, rammed through Congress by Lyndon Johnson in 1964, was the first major reduction since the 1920's, and it was not until 1981 and then 1997 that taxes were again reduced significantly.
What is still lacking, however, is any clear explanation for Bush's single-mindedness on this issue. John F. Kennedy was motivated to cut taxes by the economic theories of John Maynard Keynes, which were at the pinnacle of their influence in the early 1960's, while Ronald Reagan was strongly influenced by supply-side economics and his desire to reduce the size of government. Bush, by contrast, cites no particular ideology or theory of economics to defend his tax policies. His speeches and statements on the subject consist of disparate arguments, seemingly assembled in an ad-hoc fashion. On tax policy (as on domestic issues in general), this White House seems to go out of its way to avoid serious analysis.
That is a problem, to be sure. But it does not mean that the Democratic critique of the Bush cuts is correct. Indeed, there is a clear and compelling logic to the President's reforms, even if the administration itself has failed to articulate it.
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George W. Bush's initial tax proposal was put forward in late 1999, while he was locked in a struggle for the Republican nomination against Senator John McCain and the magazine publisher Steve Forbes, a favorite of supply-siders whose principal campaign promise was to establish a flat tax. Forbes was able to draw upon the misgivings that many conservatives felt toward Bush because of his father's apostasy on the issue. Bush, Sr. had famously declared, “Read my lips, no new taxes” at the Republican convention in 1988, only to abandon his pledge once in office. As a result, many conservatives stayed at home on election day in 1992 or voted for Ross Perot, making possible Bill Clinton's victory.
There was nothing special about the big tax cut that candidate George W. Bush made the centerpiece of his campaign for the 2000 Republican nomination. Its real purpose seemed to be to allay concerns that he might follow in his father's footsteps and raise taxes. Consisting of recycled bits and pieces of previous Republican initiatives, the Bush proposal dropped the bottom income-tax rate from 15 to 10 percent and the top rate from 39.6 to 33 percent; it also increased the tax credit for children, reduced the so-called marriage penalty, and eliminated the estate tax (dubbed the “death tax”).
An important backdrop to Bush's plan was the budgetary situation. When his proposal was advanced during the campaign, the economy and the stock market were close to the peak of the 1990's boom. Revenues were flooding into the treasury, and vast surpluses were anticipated far into the future. In June 1999, the federal Office of Management and Budget projected a cumulative surplus of almost $5 trillion by 2014.
Conservatives were wary of these predictions, fearing that surpluses would lead to massive new government spending. One goal of Bush's proposal was thus simply to take money out of the hands of Congress and give it back to the taxpayers. This was a version of the “starve-the-beast” theory, according to which the best way to reduce the size of government is, as Ronald Reagan liked to say, to take away its allowance. To Republicans worried about Bush's talk of “compassionate conservatism,” which sounded suspiciously liberal (and potentially expensive), the tax plan shored up the candidate's credentials as a small-government conservative.
Unfortunately, the protracted election recount in 2000 threw a monkey wrench into policy-planning. Deprived of a normal transition period between the election and inauguration day, and hampered in the recruitment of key officials, the Bush people had to scramble to get a program together once in office. Consequently, rather than rethinking their campaign tax plan in light of changed circumstances—the economy was now on the brink of a recession, and much of the budget surplus had already vanished—they decided to stick with it unchanged.
Having been designed with very different circumstances in mind, the tax cut was now presented primarily as an anti-recession measure. In fact, the President began promoting the plan on Keynesian grounds—as a way to spark consumption and, he argued, economic expansion. But this made it more difficult for the administration to explain why it wanted to cut tax rates for the rich, who spend a smaller portion of their income than the poor, or to abolish the estate tax, which is paid only by the richest 2 percent of families. These were defensible policy actions—but not on Keynesian grounds. Indeed, if job creation, which had become the administration's mantra, were the principal goal, even supply-siders would have suggested alternative policies.
Nevertheless, Bush plowed ahead as if nothing had changed between the early days of his campaign and his first months in office. The administration's supplementary budget message to Congress in February 2001 offered just five pages on tax policy, most of them taken up with graphics. Eager to give Bush a victory with his first big legislative initiative—and to show their own power as, for the first time in 50 years, the party in control of the White House and both houses of Congress—Republicans on Capitol Hill asked few questions about the proposals. The cut was quickly passed, and the President signed it into law in June 2001.
There was one principal innovation in the final legislation: an immediate tax rebate that was, in effect, an advance on the following year's tax cut. This too was promoted as a way of pumping up spending and thereby stimulating growth. Although economists pointed out on the basis of both theory and experience that almost all of the rebate would likely be saved in the short run—a similar measure had been tried in 1975—the pressure to do “something” for the economy quickly won the day1
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Then came the attacks of 9/11, which occurred just as the economy was struggling to recover from the recession that had begun early in the year. The result was negative growth of 1.3 percent in gross domestic product for the third quarter of 2001. Forced to put its longer-term tax plans on hold, the administration now tried to shore up the battered economy.
The President quickly proposed giving businesses a larger depreciation allowance for purchases of capital equipment. Since depreciation—that is, the estimated cost of “using up” buildings and machinery—is deducted from business earnings, a policy of allowing more of it will lower taxable income and leave more money for investment, which was viewed as the economy's principal weak spot. Despite the fact that the Senate was now under Democratic control (due to the switch of Vermont Senator James Jeffords from Republican to Independent), Congress delivered this second Bush tax cut with amazing speed, and it was signed into law in March 2002.
At this point, some in the administration—especially Secretary of the Treasury Paul O'Neill-began to counsel tax restraint. The deterioration of the economy plus the additional spending required for homeland security had virtually wiped out projected budget surpluses. In January 2002, the Congressional Budget Office (CBO) estimated that the cumulative surplus by 2011 would be $1.6 trillion rather than the $5.6 trillion projected a year earlier.
Although the recession ended officially in November 2001 and growth rebounded in 2002, unemployment continued to rise. By midyear, Glenn Hubbard (chairman of Bush's Council of Economic Advisers) and Lawrence Lindsay (director of Bush's National Economic Council) were pressing for yet another big tax cut. O'Neill, however, had concluded that at this point the economy was recovering well enough without further stimulus, and he considered the budget deficit a more pressing problem. In August of that year, the CBO revised the long-term fiscal picture yet again, projecting deficits through 2005 and a total surplus of just $1 trillion through 2012.
O'Neill was fired for his recalcitrance in December 2002; Lindsay was let go as well, apparently not because he disagreed with the tax program but for poor managerial skills. This left Glenn Hubbard alone among Bush's top economic aides. Hubbard quickly pressed for eliminating taxes on stock dividends as a step toward abolishing the double levy on corporate profits, which are taxed once at the corporate level and a second time through the individual income taxes paid by shareholders. Reducing taxes on dividends would have the added advantage, Hubbard argued, of responding to concerns raised by the collapse of Enron and the ensuing Wall Street scandals, which were caused in part by excessively aggressive efforts by a number of companies to reduce their tax burden. Forcing firms to pay out more of their profits in dividends would also make it harder for them to give obscenely large—and increasingly controversial—pay packages to their top managers.
At the beginning of 2003, Bush announced his third major tax proposal. In addition to eliminating the double tax on stock dividends, this included an acceleration of some previously enacted cuts and the permanent establishment of others that were scheduled to expire. But this time, Congress did not act with dispatch. Owing mainly to concerns about the deficit, action in the Senate was protracted. Still, the administration got most of what it asked for. Although the tax on dividends was not eliminated, the top rate was reduced to just 15 percent. President Bush signed the tax cut into law in May 2003.
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Because the administration has offered no coherent rationale for its tax policies, critics have been able to charge that these policies have been driven principally by a desire to reward the President's wealthy supporters and to deprive the federal government of resources. Others blame the tax cuts for our mounting deficits and point to a fiscal train wreck ahead.
The “starve-the-beast” argument is easily dismissed. Unlike Ronald Reagan, who did use tax cuts to force reductions in spending, George W. Bush has made no effort at all to restrain the growth of federal outlays. He has vetoed not a single spending bill, no matter how pork-laden. To the contrary, he has initiated the largest new social program in decades by adding an expensive prescription-drug benefit to Medicare. Within a few years, the new program is expected to increase Medicare spending, already widely viewed as out of control, by one third.
As for the deficit, independent analyses by the CBO and others have consistently shown that the tax cuts are responsible only for about a third of the deterioration in the surplus since 2000. The recession accounts for the bulk of it. Liberal critics, such as the Center on Budget and Policy Priorities, balloon this percentage by ignoring the stimulative effect of the tax cuts, assuming that pre-recession revenues would have been collected in the absence of the tax cuts, and treating proposed future tax cuts as if they were part of current law.
Others argue that, irrespective of what causes them, future deficits will negate any positive effects of the tax cuts. But these analyses assume that deficits will have a large impact on interest rates because of increased government borrowing—an assumption that is not justified by experience. In recent years, interest rates have risen as deficits have fallen and fallen as deficits have risen. The truth is that interest rates are determined by so many different factors—Federal Reserve policy, expected inflation, foreign purchases of Treasury bonds—that it is absurd to think that the deficit is the overriding influence.
The question of fairness is harder to answer, but not for the reasons assumed by the critics. The fundamental problem is that, over the years, we have virtually eliminated income taxes for anyone who could remotely be considered poor and for much of the middle class as well. According to a recent study by Congress's Joint Committee on Taxation, 40 percent of all federal income-tax returns now report no tax liability at all. Indeed, because of refunds under programs like the Earned Income Tax Credit (EITC), scarcely anyone with an income below $30,000 pays federal income taxes, and many receive checks from the government in lieu of payments.
As a consequence, a huge percentage of the federal income tax is now paid by the wealthy. According to the Internal Revenue Service, in the year 2000 (the latest for which figures are available), more than 37 percent of all federal income taxes were paid by just the top 1 percent of taxpayers, namely, those with adjusted gross incomes above $313,000. More than half of all federal income taxes were paid by the top 10 percent of earners (those with adjusted gross incomes over $92,000), and 94 percent were paid by the top half of earners. The bottom 50 percent of taxpayers paid just 6 percent of all federal income taxes.
Liberals often criticize these data for excluding the Social Security payroll tax. But including the payroll tax does not change the basic picture. According to an IRS study, the top 20 percent of taxpayers paid more than two-thirds of the combined income-and payroll-tax burden in 1999. Moreover, liberals often conveniently forget that the EITC was made refundable precisely in order to offset the payroll tax for low-income workers.
With the tax burden skewed so heavily toward the rich, it is simply impossible to reduce that burden in a way that is not similarly skewed toward the rich. If the Bush cuts appear unfair to some people, that is because they imagine the government mailing large checks to people who are already wealthy. But there is a world of difference between receiving an actual government handout and being allowed to keep more of one's own income.
In any case, even the large cuts of 2001 and 2003 did little to change the basic distribution of taxation. According to an IRS study, if one compares these recent cuts with the 1999 tax distribution, they reduce only fractionally—from 68.17 to 67.47 percent—the share of total income and payroll taxes paid by the top 20 percent of earners.2
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It is hard to know what direction tax policy would have taken in the absence of the attacks of September 11, 2001. Treasury Secretary Paul O'Neill was keen on the idea of fundamental tax reform; it was one area where he saw eye-to-eye with the other key members of the Bush economic team. Like a number of Republican reformers since the mid-1970's, O'Neill wanted to see the U.S. move toward a consumption-based tax system with a flatter rate structure. Under a classic system of this kind, no taxes at all would fall on saving or investment; levies would fall instead on consumer spending, through sales or value-added taxes.
But a consumption-based tax system can also be brought into being more indirectly, without replacing the existing income tax. To do so, it is only necessary to eliminate taxes on capital, as we do already with IRA's and 401(k) accounts. If this were done systematically, we would be left at the end of the day with a consumption tax. The reason is simple. There are only two things that can be done with income: it must be either saved or consumed. Absent a tax on saving or investment, the full burden of taxation must logically fall on consumption.
Secretary O'Neill wanted to start the process by eliminating the corporate income tax. Virtually all tax theorists, from Milton Friedman on the Right to Lester Thurow on the Left, have decried this tax for years, on the grounds that, as we have seen, it taxes the same income twice. In a sole proprietorship or partnership, by contrast, profits are taxed only once—an arrangement that most economists consider rational and productive.
To its credit, the Bush administration has made some progress toward a flat-rate consumption tax. Statutory rates have been cut across the board, with substantial reductions in assessments on capital gains and dividends; the estate tax is being phased out of existence; and depreciation allowances are now close to equaling a full and immediate deduction for capital investments (the economists' term for this is “expensing”). A further step would be to allow greater tax-free savings by individuals, a measure the administration has proposed but has not pressed.
If the return on savings were indeed made tax-free, Americans would save a good deal more. Today, most people do not have nearly enough money set aside for a comfortable retirement, especially given increasing life spans. And the nation as a whole does not save enough to finance domestic investment, as is shown by our ongoing reliance on large inflows of foreign capital. In the long run, more domestic saving leads to more domestic investment, which in turn increases productivity and raises the standard of living.
A more complete consumption-based tax system would also lead to significant simplification. Among the most complex features of the current tax code are those related to capital gains and losses. In theory, a consumption-based tax system would sweep all of this away, giving people a postcard-sized form to fill out. Not only would it save millions of hours per year now spent filling out tax forms, but it would rationalize investment and eliminate the demand for wasteful tax shelters and the like.
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The great mystery is why the President has failed so conspicuously in setting out the rationale for such a tax system. When questioned about this, administration officials have said that they are guided by what will work to gain support at a given moment—that is, by political expediency. There is nothing necessarily wrong with such a laundry-list approach to achieving desirable ends, but in this case it has made the goals of the White House unclear even to many of its supporters.
Whether this intellectual disarray will cost Bush in the 2004 election remains to be seen. John Kerry is already hammering away at the administration's record on taxes, and his views may well gain political traction as a result of continued slow employment growth and the furor over the “outsourcing” of jobs to foreign countries. One can only hope that political necessity will force the President to do what he should have been doing all along: explaining to the country how a simpler, more growth-oriented tax system stands to benefit all Americans.
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1 Subsequent research by Joel Slemrod of the University of Michigan shows that the economists were right: the rebate added little to aggregate spending.
2 According to the Congressional Budget Office, the effective rate of taxation—taxes as a share of income—has risen slightly over time for those with high incomes while falling dramatically for those with low incomes. In 1984, those in the top 20 percent of households paid 24.3 percent of their income in combined federal income and payroll taxes; in 2001, they paid 26.8 percent. By contrast, those in the bottom quintile saw their effective tax rate fall from 10.2 percent to 5.4 percent.
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