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  From last wks



Should the President's Tax Cuts be Made Permanent?

William G. Gale, Peter Orszag

Published: March 08, 2004
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The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

© TAX ANALYSTS. Reprinted with permission.

Note: This report is available in its entirety in the Portable Document Format (PDF).

The 2001, 2002, and 2003 tax cuts were signature items in the Bush administration's fiscal policy. All of the provisions of those tax cuts, however, expire by the end of 2010 and some expire earlier, including several that terminate at the end of this year. A prominent feature of the president's most recent budget is the proposal to make almost all the provisions of the 2001 and 2003 tax cuts permanent. This article evaluates the administration's proposal, with the following conclusions:

  • The role of expiring tax provisions has changed dramatically over time. Expiring tax provisions (or "sunsets") have long been a feature of the tax code, but they have traditionally involved relatively minor provisions. Beginning with the 2001 tax cut, however, the use of sunsets grew explosively. As a result, whether expiring provisions in general, and the administration's tax cuts in particular, are extended has become one of the central fiscal issues facing the nation.
  • No permanent tax cut proposal can be sensibly discussed without addressing the alternative minimum tax. Under the administration's budget, which does not address the long-term AMT problem, 30 million households will face the AMT by 2009 (up from three million today). By 2014, 44 million households will face the tax and the AMT would take back 40 percent of the ostensible tax cuts from making the 2001 and 2003 laws permanent. Fixing the AMT is not only necessary to avoid further complexity in the tax code, but would substantially raise the cost of making the tax cuts permanent.
  • Making the 2001 and 2003 tax cuts permanent would generate large, backloaded revenue losses over the next 10 years. Combined with a minimal AMT fix, described below, making the tax cuts permanent would reduce revenues by almost $1.8 trillion over 10 years. By 2014, the annual revenue loss would amount to $400 billion, more than 2 percent of gross domestic product.
  • Paying for the tax cuts would require monumental reductions in other spending or increases in other taxes. To cover the revenue loss in 2014 would require a 48 percent reduction in Social Security benefits, complete elimination of the federal component of Medicaid, a 80 percent reduction in domestic discretionary spending, a 34 percent increase in payroll taxes, a 124 percent increase in corporate taxes, or changes of a similar magnitude. Even many of those who advocate making the tax cuts permanent, such as Federal Reserve chair Alan Greenspan, stipulate that a permanent tax cut is only appropriate if it is financed by other offsetting pol icy changes. Yet we know of no policymaker who would endorse the spending or tax changes noted above. In the absence of those policy changes, making the tax cuts permanent would create large, sustained deficits, that have potentially devastating long-term consequences.
  • Measured over a 75-year horizon, making the tax cuts permanent would cost as much as the combined shortfalls in the Social Security and Medicare trust funds. Over the next 75 years, extending the tax cuts would reduce revenues by an average of 1.8 percent of GDP, which is equal to the combined shortfalls in the Social Security and Medicare hospital insurance trust funds over the same period. (The overall cost of the tax cuts is larger than 1.8 percent of GDP if the revenue reduction before the sunsets take effect is also taken into account.) Thus, to the extent that Social Security and Medicare's hospital insurance program are considered major long-term fiscal problems facing the nation, making the tax cuts permanent should be seen as creating a fiscal problem of an equivalent order of magnitude.
  • Making the tax cuts permanent would be regressive. After-tax income would increase by more than 9 percent for households in the top 1 percent of the income distribution, between 2 and 3 percent for households in the middle 60 percent, and only 0.1 percent for households in the bottom quintile. Also, the share of the tax cut accruing to high-income taxpayers would exceed their share of federal tax payments, so their share of the federal tax burden would decline. The annual tax cut among households with income above $1,000,000 would equal $144,000 (in 2004 dollars), which exceeds the total income of 94 percent of households. Moreover, to the extent that the tax cut would be financed by spending cuts or tax increases that are less progressive than the income and estate taxes being reduced, the overall effects will be even more regressive, and low- and moderate-income households may actually end up worse off, rather than simply obtaining relatively small tax cuts.
  • Making the tax cuts permanent is likely to reduce, not increase, the size of the economy in the longterm. Studies from researchers in academia, the Federal Reserve, the Congressional Budget Office (CBO), and the Joint Committee on Taxation (JCT), as well as our own research, indicate that making the tax cuts permanent could increase the size of the economy slightly for a temporary period but would reduce the size of the economy in the longterm.
  • Making the tax cuts permanent would not reduce uncertainty. Making the tax cuts permanent would raise the underlying fiscal gap — the difference between projected revenue and spending — and hence raise uncertainty about how the gap will eventually be closed. Also, making the tax cuts permanent would likely harm short-term economic activity.
  • By the standards applied to recent tax cuts, making the tax cuts permanent is not affordable. Despite projections of large and growing surpluses at the time, even the 2001 tax cuts were made temporary, due in part to concerns that they would not ultimately be affordable. Since then, current and projected future budgets deficits have grown dramatically.

Section I provides background information on expiring tax provisions, why the recent tax cuts were temporary, and the administration's proposal. Section II examines the 10-year revenue and budget costs of the proposal. Section III shows what other spending or tax changes would be needed to pay for the tax cuts. Section IV compares the long-term costs of the tax cuts to the actuarial shortfalls in the Social Security and Medicare trust funds. Section V examines the distributional effects. Section VI discusses the impact on economic growth. Section VII concludes.

Note: This report is available in its entirety in the Portable Document Format (PDF).