Taxes and the Economy
We have compiled the list of
questions below based on inquiries that we
receive. This information is generic in
nature regarding tax policy questions and is
intended
to serve as tax advice. We also cannot
provide up-to-date information on any
Administration or Congressional proposals
that may affect the information shown herein.
Any questions regarding specific tax
situations or for help in filling out your
tax return should be directed to your
attorney, accountant or other tax
professional, or to the Internal
Revenue Service. The IRS will not
comment, though, on the legislative merits of
current tax law, or on pending Congressional
action that may change the tax code. Finally,
we make every effort to make certain that the
information contained here is accurate, but
due to the fluid nature of the legislative
process, changes in tax laws may occur that
are not reflected here at the time of
publication. To the best of our knowledge,
this information is accurate.
I earn more than my parents
ever dreamed, yet it seems that I pay so much
in taxes that they were better off
financially. How does my tax bill compare
with those of previous generations?
What are marginal income tax
rates and why was President Bush so adamant
about lowering marginal tax rates in the 2001
tax cut?
What are Capital Gains and
why are they taxed at special rates?
If we think some kinds of
businesses are better or more important than
others, what is wrong with using the tax code
to help out those we think are more
important?
What is a tax expenditure
and what's the difference between a tax
expenditure and a tax loophole?
 There is no one answer to this
question, because tax burdens depend so much
on the individual's personal circumstances.
Also, the tax landscape has changed
dramatically over the years. For example,
income tax rates are much lower today than
they were a generation ago, and yet because
of changes in the definition of taxable
income, individual income tax burdens are
often higher than they were 20 or 30 years
ago. At the same time, payroll taxes, such as
the Social Security and Medicare taxes are
much higher today than they once were.
However, it is possible to give a general
sense of how the tax burdens have changed
over time. One convenient measure is the per
capita tax burden. Adjusting for changes in
the general price level, the per capita tax
burden indicates how much each person in the
country would pay in taxes if everyone paid
the same amount and how this amount differs
today from earlier periods. For example, in
2002 the per capita federal tax burden is
expected to reach $6,765. The per capita tax
burden reached an all-time high in 2000 at
$7,718 (all figures expressed in $2002). In
comparison, in 1990 the per capita tax burden
stood at $5,523. A generation ago it stood at
$4,832. So the per capita tax burden rose by
$1,933, or almost 40 percent in a generation,
and this is after adjusting for
inflation.
As large as it was, the increase in the
per capita tax burden throughout the 1980s
and 1990s was the norm, not the exception for
the century. At the end of the Second World
War, it stood at $2,505, up from less than
$1,000 at the start of the war. So, while the
per capita tax burden has risen 40 percent in
a generation, it has risen over seven-fold in
three generations.
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A marginal income tax rate is the
tax rate levied on a taxpayer's last dollar
of taxable income. This last dollar of income
is often called the marginal dollar of
income. For example, if an individual earns
$25,001 in taxable income, the tax rate
imposed on the marginal dollar of income that
brings him or her from $25,000 to $25,001 is
the marginal tax rate. The federal income tax
employs a progressive tax rate schedule,
meaning that as an individual's income
increases, at certain distinct income levels
there is a jump in the marginal tax rate
facing the marginal dollar of income. The tax
rates are levied on ranges of income, so, for
example, an individual earning $6000 faces a
10 percent rate on the full amount, so her
tax liability is $600. There is a jump in tax
rates as income levels rise about $6,000,
which means that if she earns $6,001, then
she will owe 15 percent on the last dollar of
income. This doesn't mean she owes $900.15 in
tax (15 percent of $6,001). The 15 percent
rate only applies to the last dollar, so her
tax liability is $600.15.
The obvious marginal income tax rates are
those found in the tax law itself. For
example, the tax code for 2002 specifies
marginal tax rates of 10 percent, 15 percent,
27 percent, 30 percent, 35 percent, and 38
percent. One of the complexities of the tax
law, however, is that many tax provisions
phase out as incomes increase. The $600 child
tax credit, for example, phases out at the
rate of $50 for every $1,000 of modified
adjusted gross income over $110,000. The
effect of this phase-out is to create a 5
percent marginal tax rate surcharge over the
specified phase-out range. In other words, a
taxpayer facing a statutory tax rate of 27
percent actually faces an effective marginal
tax rate of 32 percent.
President Bush made reducing marginal
income tax rates the centerpiece of his tax
program in 2001. The 2001 Economic Growth and
Tax Relief Reconciliation Act of 2001 will
eventually reduce the top tax rate from 39.6
percent to 33 percent, while reducing other
tax brackets by similar proportions. As a
historical comparison, these rates remain
slightly higher than were enacted in the 1986
Tax Reform Act, and slightly lower than were
enacted in the 1981 Economic Recovery Tax
Act.
President Bush insisted on lowering
marginal tax rates because this is a sure way
to strengthen the economy today and into the
future. Lower marginal tax rates help to
minimize the discouraging effects of the
income tax on investment, saving, work
effort, and on attaining the American dream
generally.
Lower marginal tax rates also reduce the
tax barrier to the kinds of economic risk
taking, like starting a new business, that
produce new jobs and new technologies. When
marginal tax rates are relatively high,
individuals with a new idea, individuals with
a desire to build an economic future for
themselves, individuals who want the
challenges and rewards of being their own
boss, may be discouraged from taking the
risks and making the necessary investments.
Facing high marginal tax rates they know that
even if they succeed, the government will end
up taking a greater share of the rewards of
their efforts.
The decision to save provides another
example of the deleterious effects of high
marginal tax rates. There are many reasons to
save - for retirement, to build a "rainy day"
fund, in anticipation of known future
expenses like college tuition or to have a
downpayment for a house. Each of these
options represents future consumption, so the
act of saving today is really the
postponement of consumption today.
Most people want to save and most of the
time they will have some discretion regarding
their level of saving. The amount they save
will depend in part on their expected future
needs and in part on the return they expect
to earn on their saving. If they get a higher
return, they are more likely to save more.
When marginal tax rates are relatively high,
the after-tax return to saving is relatively
low, and so the tax code presents a more
serious disincentive to save.
High marginal tax rates drain vitality
from an economy by reducing the incentives to
create, to build, to learn, to work, to save,
and to invest. Individuals and businesses
respond to opportunities when they are not
unduly discouraged. High marginal tax rates
discourage these activities; low marginal tax
rates unleash the strengths of the economy to
generate jobs and prosperity. This is why
President Bush and Secretary O'Neil feel so
strongly about reducing marginal tax
rates.
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A capital gain arises whenever the
price of an asset such as a house or shares
in a corporation or mutual fund exceeds the
asset's purchase price. In other words, if
you buy as asset for $100 and sell it
sometime later for $150, then your investment
has generated a $50 capital gain. Thus,
capital gains differ from income in that
income represents the return to the use of
factors of production such as capital and
labor, whereas capital gains represent
changes in the market value of capital.
The price of an asset reflects the
market's determination of the discounted
after-tax stream of income or services the
asset is expected to generate over its
lifetime. The market price of a house, for
example, is determined by the value of the
housing services it is expected to provide,
after tax and net of operating costs such as
electricity costs, and net of maintenance
costs. However, because of the time value of
money, the value of these future services
must be discounted appropriately, in effect,
assuring a proper "apples to apples"
comparison.
Capital gains arise from many sources.
When the general price level increases, for
example, asset prices tend to rise by the
same amount, giving rise to what are called
"inflationary gains". When a corporation
earns and accumulates net income prior to
distribution as a dividend, share prices
increase reflecting these earnings. Asset
prices can rise due to a relative scarcity of
that type of asset. For example, if a
particular neighborhood is desirable and
opportunities to build new homes are few,
then home prices in that neighborhood are
likely to increase.
Capital gains can also arise when
individuals and businesses undertake risky
investments and those investments succeed,
giving rise to what are often called
"speculative" gains. Such speculative gains
reflect extraordinary returns as might arise,
for example, when an individual or group of
individuals form a new business to take
advantage of a new technology or a new market
opportunity.
Capital gains, especially "long-term"
capital gains, i.e. those arising from assets
held for more than one year, have
traditionally been taxed more lightly than
income. For example, partly for policy
reasons and partly for administrative
reasons, capital gains generally have been
subject to tax when they are realized, i.e.
upon the sale of the asset, rather than as
they are accrued. Also, taxpayers have
generally been restricted in the amount of
capital losses they can apply against taxable
income. Further, while most areas of the tax
system protect taxpayers from the effects of
inflation, taxpayers must pay capital gains
tax, or forego capital loss, due to changes
in the general price level. Finally, capital
gains have traditionally been subject to
lower tax rates than regular income.
The lower tax rate on capital gains is
justified on many grounds. To begin, capital
gains are generally not income in the
economic sense of the word, so there is no
reason to presume they would be subject to
the same rate of tax. Income is the return to
the use of factors of production such as
capital and labor. In other words, it
represents a flow of value to its owner. A
capital gain is a change in the value of a
stock of an asset. Also, a lower tax rate is
intended to provide some relief to the lack
of protection against purely inflationary
gains.
Third, non-inflationary capital gains
often reflect an increase in the future
after-tax income accruing to the asset. When
the increase in after-tax income is due not
to a reduction in the income tax burden but
rather to an increase in pre-tax income, the
increase in income will result in an increase
in income tax liability. For example, suppose
an asset is expected to yield $100 annually
and indefinitely on a pre-tax basis. If the
taxpayer faces a 25 percent tax rate and the
discount rate is 7 percent, the asset will
give rise to a $25 annual tax liability and
the price of the asset will be $1070. Suppose
there was a change in the market resulting in
an increase in the asset's yield to $120
annually. In this case, the income tax
liability will increase to $30 annually, and
the price of the asset will increase to
$1284. Thus, in those instances where the
asset owner really has enjoyed an economic
gain, the capital gains tax clearly
represents a second level of tax.
Finally, it is generally recognized that a
critical source of economic vibrancy that
distinguishes the U.S. economy is the ability
and willingness of individuals to take
economic risks. Part of the willingness to
take on these risks is the prospect of
enjoying the economic benefits that follow
success. These benefits generally manifest
themselves in the form of capital gains. The
lower the capital gains tax rate, the more
the entrepreneurs and inventors of America
will apply their energies and talents. Thus,
a low capital gains tax rate is vital to
maintaining the strength of the economy into
the future.
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The one inescapable feature of a
modern economy is that every company and
every industry operates as part of a complex
web of economic relationships. When one
industry grows rapidly, it brings along
related industries in the chain of
production. And when an industry suffers, it
pulls down those industries that supply
it.
For example, the rapid growth in
information technologies (IT) and their
powerful effects on raising productivity
growth may suggest that computer
manufacturers and software and
telecommunications companies deserve a
special place in our economic policies,
including tax policy. However, as important
as these industries have become, where would
they be without the manufacturers that make
the components that go into these
technological marvels? How would the
manufacturers produce without the machine
tool industry and other suppliers that create
the machines that make the components? Where
would they be without the transportation
industry that brings parts and people
together and then brings product to
consumers? And where would any of them be
without the energy industry provided the gas
and oil and coal and electricity to run the
plants, heat the offices, and move the
goods?
The point is that it is very difficult to
hold one industry or business sector up as
more important than another because they are
all so interdependent. It may seem that
agriculture is more important than
entertainment, and in many poorer countries
it obviously is. But in a modern economy such
as the U.S. economy, where most citizens can
look beyond subsistence and survival to a
higher quality of life, entertainment becomes
an important feature of the economy.
Government has an important role to play
in the economy, but history has shown that
when government's role goes from ensuring the
strength of economic institutions to director
of activities and resources that the results
are too often undesirable. When applied to
tax policy, this suggests the general rule
that taxes should be as neutral as possible
with respect to all manner of economic
decisions and explicitly should not be tasked
with directing economic activity.
Given the proper institutional framework,
such as a restrained regulatory environment,
flexible labor markets, and ready access to
capital, industries that are deemed
particularly important or poised for rapid
growth will be able to garner the resources
to meet opportunity. It is very rare for a
government to define such an opportunity
before the market can, and virtually unheard
of for government to respond more rapidly or
more effectively than the market. Further,
once a government has become involved in the
success of an industry, it is very difficult
for the government to know when to pull back
again, and even harder as a political matter
for government's involvement to cease.
There are, however, certain instances in
which a more activist policy is appropriate.
This arises, for example, when there is some
feature of the marketplace that causes some
businesses to operate at suboptimal levels
while others receive too much of our national
resources. A good example is research and
development (R&D). The nation prospers
most when there is a free and ready exchange
of information and ideas. A problem arises,
however, when an individual or business
invests in R&D, because if valuable new
information results, such as a new
manufacturing process, he or she can usually
only reap the value of the new information
through its exclusive use. If the results of
his investment in R&D are valuable and
immediately disseminated, then others will
apply the new process and the economic
advantage will be lost to its developer. This
would be good for society and the economy,
but bad for the individual who made the
investment. Knowing this could be the
outcome, the potential investor may well
choose not to invest in the R&D in the
first place, which means everyone loses
out.
Patent and copyright protections were
created to protect the proprietary control
over new information, and thus they help to
address the problems with R&D. However,
because information is valuable and easily
disseminated, it is impossible and
inappropriate to try to preserve its full
value to the individual making the original
investment. There is, therefore, a conflict
between preserving the economic incentive to
invest in new R&D and establishing the
economically optimal level of information
dissemination. One resolution of the problem
through the tax system is the R&D tax
credit, which seeks in effect to compensate
those who would invest in R&D for the
dissemination of the results of their
investment throughout the economy. Thus, the
R&D tax credit, which on its face looks
to subsidize an economically preferred
activity, actually is a tax policy response
to a shortcoming in the marketplace.
^ TOP
In general, a tax expenditure is the
revenue foregone because a provision of the
tax code allows certain taxpayers to pay less
tax than they would pay under a specified
baseline tax system. In effect, these
taxpayers receive a special discount on their
tax burdens and the cumulative amount of the
discount over all such taxpayers is the tax
expenditure.
The Congressional Budget Act of 1974
(Public Law 93-344) defines tax expenditures
as:
revenue losses attributable to provisions
of the Federal tax laws which allow a
special exclusion, exemption, or deduction
from gross income or which provide a
special credit, a preferential rate of tax,
or a deferral of liability.
Tax expenditures are easy to imagine
conceptually, but it is far more difficult to
define them rigorously and then to make the
definition operational so as to estimate
them. The problem lies in that tax
expenditures are essentially negative
deviations from a baseline tax, but the
baseline tax is itself undefined. Moreover,
assuming the baseline tax is some form of
modern income tax, there are a plethora of
conceptual issues that make defining a modern
income tax baseline problematic.
In contrast to tax expenditures, where
there is at least a modicum of theoretical
substance to the concept, there is no
comparable substantive definition of a "tax
loophole". In common parlance, a tax loophole
generally refers to any tax provision that
allows some taxpayer or group of taxpayers to
pay less tax than the speaker believes is
appropriate. Like the problem with defining
tax expenditures, it is impossible to define
a tax loophole with any rigor without first
defining the baseline tax system.
Tax expenditures and tax loopholes do have
some aspects in common. For example, they
both represent a reduction in the amount of
tax that would otherwise be collected from a
given taxpayer or group of taxpayers.
Further, to the extent that each is a
negative deviation from a baseline tax
system, a tax provision that is labeled a tax
expenditure may well be labeled a tax
loophole, as well. Finally, both tax
expenditures and tax loopholes, however they
are defined and however they are calculated,
represent decisions by the Congress to
express and effect some public policy through
the tax code.
^ TOP
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I earn
more than my parents ever dreamed, yet it
seems that I pay so much in taxes that they
were better off financially. How does my tax
bill compare with those of previous
generations?