Page 34 , The Economist April 15^th 2006

Taxes

April’s hard truths

EVERY year, as millions of Americans scramble to file their tax returns by the statutory deadline of April 15th (techni­cally April 17th this year, as the 15th falls on a Saturday), the spotlight focuses on Amer­ica’s tax code. For George Bush, the result is embarrassing. Quite apart from the reck­lessness of a fiscal strategy based on cut­ting taxes and boosting spending, the man who promised to devote his second term to making America’s tax system simpler, fairer and more pro-growth has presided over something rather different. During the past five years America’s tax code has become far more complex, somewhat less progressive, and has done less to improve incentives to work and save than first ap­pearances suggest. Of course, it is not all Mr Bush’s fault; Congress has done plenty to help. But Congress never said it would improve matters.

The tax code’s complexity is notorious. Overall, Americans spend around 3.5 bil­lion hours doing their taxes, an average of about 26 hours per household. Around $140 billion is spent on tax preparation and compliance every year, according to Joel Slemrod of the University of Michi­gan, as desperate households seek profes­sional help. Tax rules were horribly com­plicated, of course, long before the Bush presidency, but during the past five years things have got much worse. The number of pages of federal tax regulations has risen by over 40%, from 46,900 in 2000 to 66,498 this year, according to Chris Ed­wards of the Cab Institute. The number of different tax forms issued by the Internal Revenue Service has soared from 475 in 2000 to 582.

Part of the headache for individuals is caused by the rise of the fiendishly tricky Alternative Minimum Tax (AMT). This par­allel income tax, originally designed to stop rich people claiming too many deduc­tions, is now ensnaring middle-class fam­ilies. But most of the new paperwork has to do with recent tax-policy decisions.

Both the Bush team and, especially, Congress have used the tax code as a tool of social policy and source of patronage, pushing endless tax incentives for fa­voured groups or activities. There are now 16 separate tax breaks for education costs, up from seven a decade ago. The number of energy tax breaks has more than dou­bled since 1995. Thanks to this labyrinth of targeted (and often temporary) tax breaks, the Bush administration has done less to improve the tax code’s incentives than it likes to think.

As disenchanted supply-siders point out, many of Mr Bush’s tax cuts, such as the doubling of the child tax credit, have done little to improve incentives at the margin. Often such tax breaks produce high marginal rates as the exemptions phase out. Families with incomes above $110,000, for instance, have seen their marginal income-tax rates rise as their child tax credit gradually disappears.

Nonetheless, Team Bush did push through some clear cuts in marginal rates, notably the 2001 income-tax cuts and the big cuts in the taxation of dividends and capital gains in 2003. These cuts have im­proved incentives to work and save (thoughJohn Snow, the treasury secretary, is prone to overstate by just how much; even in theory, the link between lower dividend taxes and higher investment is ambiguous). The problem is that Mr Bush’s failure to cut spending at the same time makes it less likely that these tax cuts will be permanent. (Republican leaders in the House failed to achieve a two-year ex­tension before leaving for their Easter break). That uncertainty does not improve the tax code’s efficiency.

Politically, the most contentious issue is whether Mr Bush’s tax cuts have made the code more or less fair. The White House likes to argue that its tax cuts have in­creased the progressivity of the federal tax system, usually by pointing out that the share of taxes paid by richer Americans has risen since 2001.

The trouble is that this is not a good measure of progressivity. The share of taxes paid by different income groups can vary dramatically for reasons that have nothing to do with changes in the tax code. In 2001, for instance, the share of taxes paid by the richest fifth of Americans fell because of the large drop in the stockmark­et. In the long term, America’s income dis­tribution has widened dramatically; since 1979 the share of income going to the top

1% of Americans has risen by over 50%, from 9% to 14%. Even with no change in tax rates, that implies a large increase in the share of income tax paid by the rich.

A better measure of tax progressivity is how the average tax rate varies across in­come groups (although that, too, can be af­fected by changes in income distribution). In a progressive tax system, richer people should pay tax at a higher average rate than poorer ones. Tax cuts are progressive if they reduce average tax burdens more at the bottom than the top.

Tending to regress

Chart 1 shows average effective federal tax rates for American households at different levels of income distribution. This is an overall measure: it includes payroll taxes (which disproportionately hit the bottom level) as well as corporate income taxes (whose burden is assumed to fall on richer people since they hold most shares). America’s tax system is clearly progressive; richer people have a higher average tax rate than poorer ones. But, by some mea­sures, the Bush tax cuts have made it mod­erately less so. Calculations by the Tax Pol­icy Centre show that the Bush tax cuts reduced average tax rates more for richer Americans than poorer ones. Assuming Congress patches up the AMT, the average tax rate in 2006 for the richest 0.1% of Americans is 3.8 percentage points lower than without the tax cuts. For the bottom 20%, the average tax rate has fallen by 0.3%. ~

It is hard to avoid this outcome, how­ever, if you are cutting income taxes. Thanks both to widening income inequal­ity and improvements in progressivity over the past two decades, America’s in­come tax is increasingly paid by the rich (see chart 2). In 1980 the poorest 60% of Americans paid 15.1% of all income taxes, compared with 17.4% paid by the richest 1%. By 2003 the bottom 60% paid a mere 0.6% of all income taxes. The Earned In­come Tax Credit, a kind of negative income tax that has been expanded several times in the past 20 years, means that the poorest Americans receive money from the federal tax system. Mr Bush’s refundable child credit enhanced the trend. The poorest 20% of Americans had an average income tax rate of -6% in 2003; -10% for house­holds with children. Of the 136m Ameri­cans who file federal tax returns, 43.4m or 32% have zero or negative tax liabilities. Twenty years ago, that share was below 20%. For most Americans the income tax is much less important than the payroll tax.

Add together the recent record in complexity, incentives and progressivity and one conclusions jumps out: America needs a comprehensive tax reform that in­cludes all types of federal taxation, rather than the current approach of piecemeal re­form via tax cuts. Mr Bush had the right goal for his second term. Too bad that he now has neither the courage nor the politi­cal capital to achieve it. •