The Bush Tax Bill: Complex, Confusing and Drawn OutPublished: June 06, 2001 in Knowledge@Wharton
Now that Congress has passed President Bush’s $1.35 trillion tax bill, what does it all mean?
Faculty members at Wharton and the Goizueta Business School at Emory University say the bill contains provisions that will provide a modest stimulus to the sluggish economy and allow taxpayers to keep more of their income and sock away more money for retirement. But the bill has so many twists and turns that even London cab drivers, famed for their ability to memorize that city’s Byzantine thoroughfares, would need a map to navigate this legislative maze.
For one thing, substantive tax savings are years down the road because the cuts do not take effect right away. In addition, lawmakers will undoubtedly be compelled to revisit the new law at some point because the measure is set to expire in 10 years. One thing both Republicans and Democrats alike may wish to do is reverse some unintended effects, such as subjecting more taxpayers to the little-known but much-dreaded alternative minimum tax (AMT).
The need to revisit the bill was obvious even before Sen. Jim Jeffords of Vermont bolted from the Republican Party in May. To what degree the bill will be altered even further in years to come is even more tenuous now that Tom Daschle of South Dakota, the new Senate majority leader, has said that Democrats will target some provisions for repeal.
Despite bipartisan support for the bill, Democrats and Republicans disagree more than they agree on overall tax policy. Clearly, the bill does not satisfy everyone, especially those who fear that the projected budget surplus over the next 10 years will not materialize and that the tax cuts are out of line. Some faculty members think the bill does not go far enough; others do not like it at all; and still others find elements to like and dislike.
"Yawn," says Goizueta finance professor Paul Irvine when asked to sum up his response to the bill. Irvine, who supported bigger tax cuts and ultimately favors a flat tax, says passage of the bill was little more than "a symbolic victory" for President Bush. "He said he was going to do it and he got it done. But it will take years for these 1.35 trillion dollars to add up."
Wharton finance professor Jeremy Siegel says: "On the whole I think the bill is moving in the right direction, in the sense that it is lowering marginal tax rates, which increases the efficiency of the economic system." But Siegel, who also is a proponent of a flat tax, says the bill does nothing to move the country toward tax simplification.
Howard Pack, professor of public policy and management at Wharton, calls the entire bill "a bad package because I don’t know that we’re going to have a surplus that the tax cut is assuming is going to be there."
Goizueta accounting professor Paul Simko takes a centrist view. "The bill is more or less a proper reallocation of resources given to the government," he says. "The surplus does belong in the hands of the people. But it might not have the short-term stimulative effect we’re being led to believe it will have, given that it will be spread over a long period of time."
In addition, Simko notes, "My view on the whole tax system is we have a pool of social services to pay for and we’ve got to get the revenue from somewhere."
Cuts in marginal rates
The centerpiece of the bill is its reduction in marginal rates, totaling $875 billion over 10 years. The bill establishes a new 10% bracket for the first $12,000 in taxable income for couples and $6,000 for single taxpayers. Previously, that income has been subject to a tax of 15%. As a result of the new bracket, which is retroactive to January 1, 2000, the federal government in August will begin mailing rebate checks to taxpayers of as much as $300 for singles and $600 for married couples.
Siegel supports lowering the marginal rates. "One of the things that economists know is that [marginal] taxes distort decisions," says Siegel. "If you work harder than you do now and pay higher taxes for it, that’s really not something we ought to promote." Siegel adds that high rates encourage people to cheat on their 1040 forms. "The higher the marginal tax," he says, "the more people try to evade the tax."
The bill also reduces tax rates paid by higher-income taxpayers -- from 39.6% to 35%, from 36% to 33%, from 31% to 28%, and from 28% to 25%. The new rates will be phased in between 2001 and 2006, so it will be five years before taxpayers begin to reap the full benefits of the new brackets.
Siegel says the rebate checks will, to some extent, help the economy. "We want to try and get some fiscal stimulus in the second half of this year," Siegel says. "It will be modest, but every little bit will help during this slowdown. People will either save it or spend it. It’s hard to know what the consumer will do with it. My feeling is that even if he or she saves it, that’s positive because if they weren’t getting the checks they may cut back consumption more and that would be detrimental to the economy. Economists are worried about consumers right now. They’re the only thing standing in the way of a recession."
But Irvine questions whether the amount of the rebate -- about $100 billion, or 0.1%, of a $10-trillion economy -- will do much to boost GDP. "I’m pretty skeptical about its immediate impact," Irvine says. "It might be politically very nice because it’s unusual to get a check back from the government like this. On the one hand, it might increase the desire of the average taxpayer to see more of this, but on the other hand you could argue that taxpayers see rebates every year [in the form of tax refunds]. They don’t seem to realize they pay too much. They treat it like a windfall when all they did was give the IRS an interest-free loan."
A boost for retirement
Another key provision of the bill gradually increases annual contribution limits for IRAs to $5,000 from $2,000 and for 401(k) and 403(b) plans to $15,000 from $10,000, a component that Siegel and Simko applaud.
"You want people to save more," Siegel says. "You want to supplement any Social Security they’re going to have. My feeling is that it should be increased even more, as long as we have the current tax system." Simko says boosting the IRA and 401(k) limits are "long past due" and adds that he would like Congress to index the limits for inflation so that taxpayers could offset inflation risk.
Pack cautions, however, there is little evidence showing that the nation’s savings rate can be increased significantly by allowing people to make larger tax-deductible contributions to retirement plans. Usually, he says, taxpayers simply take money they have already saved and shift it to a retirement account.
Another major part of the bill deals with the estate tax, which affects the wealthiest 2% of Americans who owe taxes on their assets when they die. Under the legislation, the top estate-tax rate, which is now 55%, will be lowered to 50% in 2002 and 45% in 2007. In addition, the amount exempted from the tax will be increased from $1 million in 2002 to $3.5 million in 2009. In 2010, the estate tax would be repealed and capital-gains taxes would be assessed on various inherited assets.
What is confusing for people trying to engage in estate planning is that the estate tax would not apply to people who die in 2010. But the tax would again become effective in 2011. That same year, the exempt amount will go back down to $675,000, which is the current amount, and the top tax rate will revert to 55%. Presumably, Congress will revisit this issue before 2010, but observers point out that it is impossible to say for certain what will happen over the next 10 years.
In any event, Siegel opposes repeal of the estate tax. "I don’t think it’s good for society for huge amounts of wealth to be transferred to children untaxed," he says. "Republicans say that if you’ve already paid tax on it once, why should you pay tax again. That’s wrong. Most estates are built on capital gains that have never been taxed."
Pack opposes the estate tax. But he notes that the tax, in and of itself, is "no big deal either way" when it comes to addressing the broader issue of income inequality, which he says is affected by much more than the estate tax.
Simko favors repealing the estate tax. "There’s inordinate unfairness there. Someone who has built a business over a lifetime shouldn’t be forced to liquidate that business to pay the tax," he explains. "Unfortunately I think it’s also much too complicated to codify rules that would equitably account for these types of individual inequities." Still, Simko shares Pack’s concerns about the tax bill harming the government’s ability to pay for all the programs it wants to include in future budgets. "My concern is the Bush plan has so much additional spending for defense and education, and we’re going to have to get the funds from somewhere," Simko says.
Irvine and Siegel complain that the new bill does nothing to simplify the tax code. Supporters of a flat tax "generally think that the problem with taxes is they never go down, and they distort economic activity," says Irvine. "With this bill, there seems to be no movement toward tax simplification. We have a huge industry and a lot of activity going into tax avoidance, tax planning and estate planning, and I find it very wasteful."
Pack adamantly opposes a flat tax, however. Overall, he is highly critical of Bush’s plan. Pack says there are two reasons to believe that the projected budget surpluses that the administration is counting on to offset the tax cuts will not materialize and that Washington will, therefore, be hard-pressed to fund Medicare and other programs.
"First, a lot of the tax receipts [that have led to the surplus in recent years] have been based on capital gains, so those may disappear if the stock market goes down," Pack notes. "Second, there has been unusual growth in productivity in recent years and we don’t know if that is going to continue."
A major quirk
One of the bill’s major quirks has to do with the AMT. This tax became law some 30 years ago as Congress sought to prevent the wealthy from using deductions and exemptions to such an extent that they owed no tax. But Congress never changed the AMT to account for rising incomes over the last several decades, so the tax today is more apt to apply to millions of Americans who are nowhere near as rich as those targeted by the original law. And those numbers are expected to grow sharply under the new bill. Hence, it may be in the interest of both Democrats and Republicans to take another look at the AMT to avoid the wrath of taxpayers who may unknowingly find themselves defined as wealthy and in line to pay this tax, says Alan Abramowitz, an Emory political science professor.
More generally, Abramowitz notes that passage of the bill, which was supported by more than a few Democrats, is allowing the president to revel in a political victory early in his first term. But he adds that most Americans, while happy to see their taxes decline, have little understanding of the complexity of the bill. What is more, he says, polls show that a tax cut was never high on their list of priorities to begin with.
"When you present people with a trade-off between cutting taxes and using a larger proportion of the surplus to provide additional spending on Social Security, prescription-drug benefits for seniors or education, tax cuts come out behind these other priorities," Abramowitz says.
In addition, Abramowitz points out that citizens might never come to fully understand the effects of the tax cuts -- and perhaps will not even notice them to a large extent -- because of the "fiscal legerdemain" inherent in the bill. For instance, the bill’s provisions are to expire in 2010. Why? This gave Congress the leeway it needed to avoid having to take into account revenue that will be lost beginning in 2011 when the full effect of the cuts kicks in. "It’s not unusual to have some gimmicks to shift dates on when some provisions expire, but this bill is loaded with those," Abramowitz says. "It strikes me as being very misleading."
Only time will tell whether cutting taxes was a good idea or a bad one. Abramowitz says. "The spin by supporters was, ‘We’ll have enough surplus left over to deal with these other priorities.’ Two or three or four years from now we’ll see if that’s really true."
What does Abramowitz have to say to his academic colleagues who support a flat tax? "It’s not going to happen. The tax would have to be so high [to bring in current levels of revenue] that the large majority of taxpayers would be paying a lot more [than they are now]. I think it would be grossly unfair. You already have regressive taxes like sales and property taxes that fall on people on the lower end of the income scale. It’s hard to see how you could have a flat tax and maintain these other taxes." Plus, he says, remember how far Steve Forbes’ campaign got by pushing for a flat tax.