|Economist article 2006-0518|
Page 34 , The Economist April 15th 2006
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
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
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,
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).
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,
Add together the recent record in complexity, incentives and progressivity and one conclusions jumps out: