"Economic Perspective" column reprinted with permission.
Copyright 2001 TAX ANALYSTS
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Tax and expenditure analyses are usually performed as if they were totally independent. Congressional policymaking, too, is divided so that tax bills are addressed at different times and by different committees than are appropriations bills. In many cases, however, the separation either doesn't make sense or is inappropriate for the congressional policy objective being pursued. In part one of this series (see Tax Notes, July 2, 2001, p. 125), I examined this tension when it comes to determining the progressivity of a set of changes. Here I want to turn to the issue of marginal tax rates—broadly defined to mean the share of each additional dollar of income or earnings that goes to the government. Although we normally think of the statutory rate schedule in the income tax when figuring out marginal tax rates, tax rates exist in all sorts of other programs. The phaseouts of various benefits as income increases act just like additional income taxes.
The earned income tax credit has its own rate schedule. At first, as a person earns more, the EITC increases. Then, beyond a plateau (currently around $12,700), the program begins to claw back those benefits. For every dollar earned beyond the plateau, the government takes back 21 cents. This program then provides an effective marginal tax rate of about 21 percent from the end of the plateau until no EITC is left. For a return on which two kids are claimed, this 21 percent rate applied roughly under pre-2001 law from $12,700 to $31,200.
Although the EITC is administered by the IRS, the budget treats most of its costs (those payments that exceed income tax liability) as expenditures or outlays. My purpose here is not to address arcane budget rules. Unlike most expenditure programs, nevertheless, the connection to the IRS and the treatment of some portion of the cost as a tax cut rather than an outlay means that the EITC will be considered in tax bills.
Let's consider for a moment the combined marginal tax rates for the income tax and the EITC for a married couple with two children under the law that prevailed before passage of the 2001 legislation. At a little more than $20,000 of income, the marginal rate jumped-up toward about 36 percent. This combined marginal rate derived from the 21 percent tax rate due to the phaseout of the EITC plus the 15 percent marginal tax rate that used to represent the first bracket of the income tax.
Through a combination of increasing the child credit and creating a 10 percent bracket, the Bush administration deliberately tried to move out the point at which low-income families faced any direct individual income tax rate to just beyond where the EITC phased out. The goal, barely noticed in most press accounts of the tax debate, was clearly to try to reduce the marginal tax rate for these low to moderate income families.
If one is going to take into account the tax rates that derive from outlay programs, however, then food stamps, Medicaid, and housing allowances also come into play. These programs often phase out in the $10,000 to $30,000 income ranges—long after families are off of traditional welfare, typically defined as Temporary Assistance to Needy Families (TANF, a replacement for the older Aid to Families with Dependent Children or AFDC). When these programs are added in, it turns out that a large portion of moderate income families face very high rates, usually about 60 or 70 percent, for each additional dollar of earnings.
In the debate over the 2001 legislation, therefore, a strong and successful effort was made to make the child credit refundable. While much of the push came from an effort simply to get more benefits to lower income individuals, another argument was that some refundability in the child credit could offset the high marginal rates that came from the combination of outlay and tax programs. The positive rate of phase-in of the child credit could offset the negative rate of tax from the phaseout of the other programs.
Was this a tax issue? Well, the refundable portion of the child credit will count in the budget as an outlay (just like the refundable portion of the EITC). So here was an outlay program designed to offset the high tax rates in other outlay programs that was enacted as part of a tax bill!
Could reform have been made simpler by ignoring these outlay issues? Perhaps, but not necessarily better since a pure tax bill could not address the marginal tax rates of many moderate income households, and lowering marginal tax rates was the primary motivation for the bill.
In many ways, combined marginal tax rates and hidden tax systems at the top of the income distribution—due to such crazy provisions as the phaseout of itemized deductions and personal exemptions—has its parallel at the bottom of the income distribution. To say that the former is worth addressing but not the latter is inconsistent, especially since the hidden and multiple rates at the bottom are usually higher.
For some purposes tax and expenditure issues simply cannot be separated. A cleaner bill that also met the goals of the legislation might have been achievable by pulling in more of the outlay programs rather than fewer. In that way, the offsets could be made more directly in those programs themselves. Addressing all the programs in a consistent manner would have been even more ideal. But the current legislative process does not yet know how to make these types of tradeoffs across tax and transfer programs. The major exceptions have tended to be social security and Medicare, in which tax and expenditure issues are often treated simultaneously.
In effect, in a world with multiple transfer and tax programs, one can't solve the issue of how to set tax rates unless the tax and spending sides of the budget are analyzed together and unless phaseouts of various tax and expenditure benefits are considered along with direct statutory income tax rates. We have moved to a world where it is increasingly harder to separate tax and spending issues. The recent debate over the tax bill was often confusing because it was responding to new world issues with old world procedures.
Those concerned with coming up with a cleaner, more efficient, and more administrable tax system, therefore, may need to change strategy. The purist cannot claim to be pure by keeping outlay types of issues off of the table. A long-term strategy—admittedly difficult—might be to figure out some way Congress more easily could consider outlay and tax issues simultaneously when a major tax (or outlay) bill is being considered.