In a recent meeting with Sen. Don Nickles, Republican of Oklahoma and incoming chairman of the Senate Budget Committee, I asked him how he planned to deal with the distributional problem in President Bush's proposed tax cut.
While the details of this plan are not yet known, the outlines seem clear. President Bush will push for making permanent the tax cut enacted last year -- due to obscure budget rules, the whole thing disappears in 2011. He may also ask for the tax cut to be speeded up -- its provisions are mostly phased-in over a 10-year period. And he will likely ask for some relief from the double taxation of corporate profits and an expansion of business depreciation allowances in order to stimulate investment.
While I support all these provisions, there is no question that the distribution of such a tax plan will be heavily tilted toward the wealthy. That is, the tables routinely produced by the Treasury Department and Joint Committee on Taxation will show that the bulk of the benefits will accrue mainly to those with upper incomes.
This fact is preordained by their standard methodology, which basically assumes that nothing changes in terms of people's income except their tax rate. Thus, for example, if the capital gains tax rate is reduced, the distribution tables will assume that there will be no change in the number or size of gains realized in the future. All that changes is that the government collects less capital gains revenue at the lower rate.
Under these circumstances, virtually all tax cuts primarily benefit the wealthy. Given that the top 10 percent of taxpayers pay more than two-thirds of all federal income taxes, there is no way this cannot be the case. When one looks at ownership of corporate stock, an even higher percentage of the wealthy would benefit from any reduction in corporate taxes. Thus, there is simply no way that the Bush administration's tax plan will not appear to mainly benefit the wealthy, given current methodology.
Nickles was outraged by my suggestion and berated me for making it. He said that tax policy should be based on what is good for the economy as a whole, without regard for the narrow distributional effects.
While I agree with the good senator that this is the way policy should be made, it is not the way policy is made. Nor is there any reason to suppose that the situation has changed. Therefore, distributional questions will largely determine the outcome of next year's tax debate.
Bush administration economists are well aware that this is the case. So in order to ease passage of its new tax stimulus plan, they have lately been criticizing current tax distribution methods. On Dec. 10, two of them spoke on the subject at the American Enterprise Institute.
The first was Larry Lindsey, outgoing director of the White House National Economic Council. He made the point that standard tax distribution tables often include Social Security taxes. This is wrong, he said, because most of what such taxes pay for comes back to the taxpayer in the form of specific cash benefits. By contrast, little, if any, income taxes come back to the taxpayer who paid them.
Therefore, Social Security taxes are not really taxes in a meaningful sense of the term. True, they take money out of one's paycheck, but so do deductions for health insurance, life insurance and other things. Yet we do not view the latter as taxes because we are getting something specific in return. So, too, with Social Security, which is why its supporters have always referred to its payments as "contributions," rather than taxes.
An honest appraisal of the distributional effects of Social Security would not only look at taxes paid, but also benefits received. Because the benefit formula is highly progressive -- mainly benefiting those with low incomes -- it offsets the regressivity of the tax. But this fact is not reflected in tax distribution methodology.
Council of Economic Advisers Chairman Glenn Hubbard spoke at the same event. He made the point that standard distributional tables are flawed by being "snap shots" of a particular moment in time, with no regard to age, changes in economic behavior or economic growth. Hubbard pointed out that tax rates necessarily change over one's "life cycle," rising as one ages and increases income, and falling as one moves into old age. Therefore, one may be in a low tax bracket at one point in life and a much higher bracket at another point.
One's tax bracket may also change if one responds to a cut in tax rates by working or investing more, or if economic growth rises due to the tax cut, which will increase employment and wages. But, again, these factors are not considered currently.
The Bush administration is right to question the current methodology for tax distribution. Its main purpose is to prevent taxes from ever being cut.