Taxpayers responded to President Bush's tax cuts in 2001 and 2003 by generating greater taxable income, according to a new paper to be published this fall in the National Tax Journal. In fact, taxpayers reported so much more income than was anticipated, it likely offset as much as 40% of the revenue that was lost by lowering the top two tax brackets, the paper, authored by a vice president for economic policy at the Tax Foundation, Robert Carroll, and economists Gerald Auten and Geoffrey Gee of the Department of the Treasury, found.
"This research illustrates that, while the lower tax rates have not paid for themselves, they do provide important economic benefits and can expand the tax base to such an extent that they cost the federal government substantially less revenue than the casual observer might think," Mr. Carroll, who was previously the deputy assistant secretary for tax analysis in the Office of Tax Policy at the Treasury, wrote.
As the Bush tax cuts are scheduled to sunset at the end of 2010, and the presidential candidates are busy finalizing their tax plans, understanding the effects of Bush's tax policy is critical. This paper, "The 2001 and 2003 Tax Rate Reductions: An Overview and Estimate of the Taxable Income Response," contends that lower taxes create a behavioral response in taxpayers, including working longer hours or taking higher-paying jobs, that generate greater taxable income.
This behavioral response, however, also means that when taxes are raised, there is a shift in behavior, and the tax increases often generate less revenue than anticipated.
"This is an important point, one that Obama is not taking into consideration," a resident scholar at the American Enterprise Institute, Alan Viard, said. "The Obama campaign is not taking into consideration any behavioral reaction, which means that the revenue gain that Obama is predicting from his tax increase is not going to be as large as they say."
Senator Obama's economic policy director, Jason Furman, disputes this, saying that the presidential candidate does take into consideration some behavioral response, or so-called elasticity.
"The conservative estimate we use for budget purposes comes from the Tax Policy Center, and it does take into consideration some elasticity," Mr. Furman said.
Some other economic analysts also took issue with the paper.
"Even taking the 40% response at face value, that's a long way from 'tax cuts paying for themselves,'" a senior fellow at the Brookings Institution, Douglas Elmendorf, said. "That is, McCain needs serious spending cuts to pay for his tax cuts, and he doesn't have any."
The paper examined more than 168,000 tax returns between 1999 and 2005 from taxpayers earning $50,000 or more. Looking at the change in taxable income as reported on their tax forms and the change in their tax rates, and after controlling for a number of factors, such as age and marital status, the researchers found that every 1% increase in a taxpayer's after-tax share ó if the tax rate is 35%, the after-tax share is 65% ó results in a 0.4% increase in reported taxable income.
A taxpayer who reported $500,000 in taxable income saw the tax rate drop from 39.6% to 35%, saving the taxpayer around $12,300 in taxes.
The tax cut increased the taxpayer's after-tax share from 60.4% to 65%, or an additional 7.6%. Multiplying 7.6% by 0.4% leads to an increase in taxable income of 3.04%. That means the taxpayer would have an increase in taxable income of $15,200. Taxed at the 35% rate, this translates into an extra tax payment of $5,320. Therefore, the behavioral response offsets about 43% of the $12,300 in revenue that was lost.
The paper also notes that the 0.4% increase in taxable income is based on the behavioral response of all taxpayers earning more than $50,000, not just those subject to the top two tax rates. It is widely acknowledged that taxpayers in the top brackets have a larger behavioral response than those in the lower tax brackets because they have more discretionary income. So, it is likely that responsiveness for high-income taxpayers is greater than 0.4%.
"There is uncertainty about the impact of the behavioral response to tax cuts, but this research is certainly well within the range of possibility, and is a very serious estimate," Mr. Viard said.