Last week, the leftist group Citizens for Tax Justice issued data showing that the top 1 percent of taxpayers would get 45 percent of the benefits of George W. Bush's proposed tax cut. The administration responded that these number were wrong, but produced no numbers of its own to counter CTJ's. This is odd because the Treasury Department has a huge staff of economists who easily produce distributional tables for tax bills far more complicated that Bush's.
Obviously, the problem is that the Treasury economists, all of whom belong to the civil service and cannot be fired, will not produce suitable data regarding the administration's plans. This was a perfectly predictable problem that the Bush administration should have been prepared to deal with on Jan. 20. One of the administration's very first appointments should have been a top-level economist as deputy assistant secretary for tax analysis at the Treasury Department. This person oversees the career economists in Treasury's Office of Tax Analysis (OTA). Yet to this day, no one has been appointed to this critical position.
The liberal media would like to paint this situation as one of David versus Goliath. David, in this story, is represented by the career economists, who seeking only truth and using the best scientific methods, have concluded that Bush's tax plan tilts too much toward the rich. Goliath is the Bush administration political appointees, who want to subvert science and truth, and force these selfless bureaucrats to prostitute themselves by producing incorrect data just to support a political agenda.
This story line is, of course, nonsense. The fact of the matter is that OTA's distributional methodology is based less on science than alchemy. Its economists long ago figured out how to make poor people rich, accomplishing on paper what the ancient alchemists tried to do by turning lead into gold. The economists do this by inflating the incomes of all Americans for analytical purposes. The result is that virtually all tax cuts necessarily benefit the rich by definition.
Understanding why this is the case is a little like watching sausage being made, but following is a brief explanation of what OTA routinely does to calculate the distributional impact of tax changes. A recent paper by economist Julie-Ann Cronin (OTA Paper 85), available on the Treasury Department's website, goes into greater detail for the masochistic.
To begin with, it is important to understand that the measure of income Treasury uses does not correspond even remotely to the income everyone reports on their tax returns. That measure is known as adjusted gross income (AGI), and consists of wages, salaries, rent, dividends, interest, pensions and other familiar forms of income. Any taxpayer can find his AGI on line 33 of the 1040 tax form.
OTA does not use AGI for its analysis, preferring something it calls family economic income. It starts with AGI, but adds to it a great many other forms of income that most Americans don't even know they have. First, it makes up a number for unreported and underreported income and adds it to AGI. Last year, this amounted to $744 billion. Thus, whenever OTA calculates the benefits of a tax cut is it assuming that people who are cheating on their taxes will get a tax cut on the income they are not now reporting.
Next, OTA adds changes in net worth to AGI. Thus, it in effect assumes that everyone sells all their stock every year and pays taxes on the gains, even though they were not realized. Of course, it has always been the case that no one pays capital gains taxes except when assets are sold. Yet OTA pretends that this part of the law simply doesn't apply.
OTA does the same thing in other ways as well, adding to AGI currently nontaxable forms of income such as municipal bond interest; employee contributions to individual retirement accounts, Keogh and 401(k) plans; fringe benefits; Social Security benefits; food stamps; veterans' benefits; workers' compensation; and many other forms of income that people need not report on their tax returns.
Finally, OTA does something that most homeowners will find completely screwy. It adds to their income the "rent" that they pay to themselves as landlords of their own home. This means that every homeowner is richer to the extent that they receive rent from themselves. Thus if it would cost, say, $1,000 to rent a home like yours, you have $12,000 per year of income you didn't know you had. OTA adds this fictitious income to your legitimate income in its distribution tables.
The result of all these adjustments is to inflate AGI by about a third. In other words, every American is 33 percent richer than they think they are, according to OTA. So if someone earning $40,000 wants to know how much taxes they will save by looking at the $40,000 line on a Treasury distribution table, they are looking in the wrong place. They should look at the line for those making $60,000, because that is where OTA puts most people with $40,000 in earnings, owing to the addition of all these other forms of noncash income.
Another thing OTA does in its distributional methodology that is highly questionable is attribute the estate and gift tax to taxpayers according to their annual income. In effect, Treasury assumes that everyone with a taxable estate dies every year and pays estate taxes on top of their income and other taxes. This imputation borders on irresponsibility because, of course, estate taxes are not paid out of incomes, but out of assets. Treating estate taxes as if they are paid annually out of incomes, when in fact they are paid only once, at death, out of assets accumulated over a lifetime, is utterly unjustifiable.
Interestingly, OTA historically did not include the estate tax in its distribution tables precisely because it is inappropriate to do so. It made this change in 1998 as part of the Clinton administration's strategy to counter Republican efforts to abolish the so-called death tax. According to OTA calculations, 91 percent of the estate tax is paid by just the top 5 percent of taxpayers, ranked by annual income. Therefore, 91 percent of the benefits of abolishing the estate tax will accrue to just the richest 5 percent of taxpayers. This is mainly why CTJ got the result it got.
The bottom line is that Treasury's distributional methodology is highly questionable. At a minimum, it does almost nothing to tell taxpayers how they themselves will actually be affected by Bush's tax plans. Treasury Secretary Paul O'Neill should make a strenuous effort to fix this problem. For example, he could insist that tax tables be based only on AGI and include only taxes that are paid annually.