Having lost the battle to George W. Bush over whether there should be a big tax cut this year, Democrats are now fighting specific provisions of his plan. In particular, they are making every possible effort to stop the top income-tax rate from being reduced to 33 percent from 39.6 percent, as he wants.
Bush has responded that he intends to fight for his proposal, saying that it is essential to lower the top rate in order to "encourage entrepreneurial growth in America." He notes that many small businesses are not organized as corporations and report their profits on individual tax returns. Thus, the top rate reduction is, to a large extent, a small business tax cut. According to the Treasury Department, 63 percent of those benefiting from a 33 percent top rate are small business owners.
As good as this argument is, however, it will not be enough to sell a top rate cut to hostile Democrats and squishy Republicans. They are going to have to see some evidence that the American people support the reduction of a tax rate most of them will never pay. It can be done, but it is going to take a serious education effort to explain why a lower top rate is not only good for the economy, but fair as well.
For starters, Bush needs to re-emphasize the fundamental unfairness of taking more than a third of anyone's income, no matter how rich. This is an argument that actually resonates with average Americans. In March, Fox News and Opinion Dynamics asked registered voters what is the highest tax rate anybody should have to pay? Amazingly, 52 percent said that no one should have to pay more than 20 percent in combined federal, state and local taxes. Another 27 percent said that the most anyone should pay is 30 percent. Thus, almost 80 percent of Americans implicitly favor a lower top rate than Bush is proposing.
A 1995 Roper poll asked what was the most that a family making $200,000 ought to pay. The median answer was 25 percent. In fact, those with such an income were -- and still are -- paying 36 percent out of each additional dollar earned to the federal government alone, with state taxes on top.
One reason for this result may be that people generally don't know how high taxes really are. Studies show that most greatly underestimate how much they pay in taxes. One found that twice as many people underestimated their taxes as overestimated them. A key reason may be the tendency for people to think of their taxes mainly in terms of the checks they send to the Treasury for underwithholding. They forget that the withheld portion is also part of their tax burden, as are many taxes other than those on incomes.
People also underestimate how much taxes others pay, especially the rich. A 1986 Roper poll asked people how much they thought a family making $200,000 per year paid in taxes. The median estimate was only $15,000, or 7.5 percent, when such a family was actually paying 21 percent on average. A 1987 survey found that people believe almost half of all millionaires pay no income taxes whatsoever. In reality, according to IRS data, fewer than 2 percent of millionaires pay no income taxes.
This suggests that Bush can help his cause a great deal simply by publicizing just how much everyone is paying in taxes now. According to a May 4 report from Congress' Joint Committee on Taxation, the average federal tax rate is 21.5 percent, rising from 9.2 percent on those with incomes below $10,000 to 27.9 percent on those over $200,000. Without any legislative action, by 2006 these figures will rise to 10.4 percent and 28.3 percent, respectively.
Furthermore, the JCT report proves that the Bush tax cut is not overly generous to the wealthy, but cuts taxes roughly in proportion to the taxes people pay. This is proven by the fact that there is essentially no change in the distribution of total federal taxes before and after the Bush plan takes effect. In 2006, those making over $200,000 will pay 32.1 percent of all taxes in the absence of a tax cut, and 32.2 percent with the tax cut.
But even if tax awareness becomes much greater, Bush is still going to need to do more to justify a cut in the top rate, given the hostility of his enemies. One concern he must address better is the issue of lost revenue. According to the liberal Center on Budget and Policy Priorities, lowering the top rate to 33 percent will "cost" the Treasury $237 billion over 10 years.
In truth, it probably won't cost anything in terms of lost revenue. As University of Michigan economist Joel Slemrod points out, economic theory says that the optimum marginal tax rate on those with the highest incomes is actually zero! That is because they have the greatest flexibility in terms of work hours, when and how they receive income, and in what form. As a result, raising the top rate yields no net revenue at all. Therefore, cutting the top rate will more than likely pay for itself.
This prediction is borne out by experience. When Ronald Reagan proposed cutting the top tax rate from 70 percent to 50 percent, the same dire warnings about lost revenue were made by the same "Chicken Littles." However, a careful study by the Congressional Budget Office in 1987 showed that among the top 1 percent of taxpayers, 60 percent of the static revenue loss was recouped through behavioral effects alone. And the estimate left out any impact on the overall economy, which certainly would have raised the feedback to over 100 percent.
"The data show considerable evidence of a very significant revenue response among taxpayers at the very highest income levels. This finding of a strong revenue response in the top income group holds true for both projection methodologies and all target years," the CBO concluded.
Like it or not, Bush is going to have to fight the battle of the Reagan tax cut all over again. Fortunately, it was successful, and we now have the data and experience from that initiative to prove it. Bush should not be shy about entering this arena. His top economist, Larry Lindsey, literally wrote the book on it: "The Growth Experiment: How the New Tax Policy is Transforming the U.S. Economy" (Basic Books, 1990).
Chart data: Share of Total Federal Taxes Before and After Bush Tax Cut
Income Class* ---- Before** ---- After**
Under 50 ---- 14.3 ---- 14.1
50 - 75 ---- 14.0 ---- 14.0
75 - 100 ---- 13.3 ---- 13.3
100 - 200 ---- 26.3 ---- 26.5
Over 200 ---- 32.1 ---- 32.2
* Thousands of dollars ** Percent
Source: Joint Committee on Taxation