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The tax-pain threshold
It's not clear how much the economy would be affected if taxes go up in a bid to reduce the deficit.
December 6, 2005: 10:35 AM EST
By Jeanne Sahadi, senior writer

NEW YORK ( Tax reform reportedly has been pushed into the slow lane for now, but not so the tax debate.

This week, President Bush once again called for his tax cuts to be made permanent. And Congress is set to debate a bill that calls for a two-year extension of the reduced capital gains and dividend rates, which expire in 2008.

Lawmakers on both sides of the aisle, meanwhile, are calling for fiscal restraint to rein in the deficit. Just last week, Federal Reserve Chairman Alan Greenspan warned that the United States' "budget position will substantially worsen in the coming years unless major deficit-reducing actions are taken."

Just how to reduce it is a source of contention. Raising taxes and cutting spending are the two major cures. Both can be painful and politically unpopular.

Most economists, whatever their political leanings, agree that at some point if you raise taxes too much, it can harm economic growth.

But it's highly debatable as to just where that pain threshold is.

Taxes up, revenue down?

There is general agreement that taxes affect economic behavior. But evidence for exactly how (and how much) is far from conclusive.

For instance, some studies suggest that higher income taxes will discourage people from working or encourage them to reduce their taxable income (e.g., by taking jobs that pay less in wages but pays more in nontaxable benefits).

But studies that focus on labor income as measured by hours worked don't account for the fact that high-income taxpayers also draw some of their income from investments and are more likely to be salaried, so they would get paid the same regardless of how many hours they worked, said Austin Nichols, a research associate at the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution.

On the other hand, higher tax rates may reduce total labor hours because lower-earning spouses are more likely to drop out of the work force if they determine their after-tax pay isn't sufficient to pay for child care, said Patrick Fleenor, chief economist at the Tax Foundation, which advocates for lower taxes.

It's also possible that some workers may log more hours after a tax increase if they wish to maintain the same level of take-home pay as they had before, Fleenor said. Or they may work the same number of hours but reduce the intensity of how they work if they know their net take-home pay will be less than before.

While some studies show that a tax increase can have a large effect on tax revenue intake, others show a lesser effect, Nichols said. "I don't think anyone believes there would be no effect. In general, a higher rate might have some discouraging effect (on taxpayers' decision to work), but it might be so small as to be negligible."

Stick to the plan, Stan

Or it may not be so negligible.

But the effect on tax revenue after a rate increase may have less to do with the level of the increase, than with the timing of the change, Nichols said.

If revenue falls after an announced change in rates or revenue goes up but not by nearly as much as expected, he said, that may be because people will try to generate more income in the low tax years and generate less in the anticipated higher-tax years.

Most tax experts, whatever their political leanings, would agree that permanency in tax policy whether cuts, increases or other measures makes for far better policy than temporary provisions because it allows for more rational tax planning and makes revenue estimates more reliable.

But temporary provisions have been a hallmark of the federal tax code. Nichols estimates that U.S. tax rates change every five years or so.

Pain now or later?

If the tax cuts are allowed to expire, the Congressional Budget Office projects that the cumulative deficit from 2006 through 2015 would be 1.3 percent of GDP and the debt held by the public would be 34.6 percent of GDP by 2015.

If the cuts are extended, the CBO projects the deficit would rise to 2.4 percent of GDP, and the debt held by the public would jump to 44 percent of GDP.

Beyond the cost of the tax cuts and the interest to pay off debt-financed spending -- the CBO has said that economic growth alone (whether spurred by tax cuts or other measures) won't alleviate the budgetary pressures that will be brought to bear in the coming decades by the growth in Social Security and Medicare spending to meet the needs of retired Baby Boomers and their rising health care costs.

That's why the Concord Coalition, a bipartisan nonprofit that analyzes the causes and consequences of federal budget deficits, is advocating that lawmakers both those who support and those who oppose tax cuts make deficit reduction a top goal, put all elements on the table and negotiate trade-offs.

Some tax cuts may be deemed useful and worth continuing, but if they're kept the Concord Coalition suggests they should be offset or made part of a broader revenue-neutral tax reform package.

And the sooner the changes are made, the less painful they'll be, said policy director Ed Lorenzen. "It's a matter of taking a small amount of pain now or a large, continuous and growing amount of pain in the future."  Top of page

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