Mrs. Ronald Rotunda

Introduction
Many people assume that lower tax rates means that the Government will collect less in taxes, and that lower progressive rates will benefit "the rich" more than "the poor" because the rich pay at higher progressive rates. Those assumptions are incorrect. First, they are counter-intuitive to our everyday experience. We know that Wal-Mart has increases its profits by lowering prices, not by raising them. If tax rates (or Wal-Mart's prices) are too high, the Government (or Wal-Mart) will collect less, not more. Second, empirical research (the effect of the Bush tax cuts in the first part of this decade) supports what this theory predicts: lowering taxes will increase government revenue by increasing economic growth, gross domestic product, employment and income and by decreasing the use of tax shelters.

Sometimes, to be sure, the Government imposes taxes in order to punish an activity. A higher tax on leaded gasoline than unleaded will encourage people to use less leaded gasoline because it is comparatively more expensive. The tax is supposed to work that way. However, if the purpose of a tax is to raise revenue rather than punish an activity, the Government must not set taxes too high. If tax rates that are too high, the Government will collect less, not more, because people change their behavior and seek out tax shelters.

Earlier this decade, President Bush and Congress decided that taxes were too high. We now have a few years to evaluate the experiment and test its success.

Capital Gains and Dividends
Consider, first, the tax on dividends and capital gains derived from holding or selling stock. If the Government increases the tax on capital gains, holders of stock will have an incentive to hold on to their shares longer, thus postponing the taxable event (and reducing the Government's revenue). The richest of the stock holders (those who have less need to sell the stock to meet their daily expenses) will have the ability to wait even longer between sales. The higher capital gains tax will have the perverse effect of reducing taxes on the truly rich while reducing total government revenue.

Similarly, If the Government imposes a tax on dividends that is higher than the tax on capital gains, people will gravitate towards owning and buying stocks that pay lower (or no) dividends but offer comparatively higher capital gains. The truly rich (those who can afford to wait for the capital gains) will benefit while the ordinary investor (who needs the more predictable income from dividends) will pay higher relative taxes. President Bush proposed tax relief for dividends in 2003. Such a proposal was hardly radical. Many countries with traditions more socialist than ours had already imposed dividend tax relief. For example, Australia, Finland, Mexico, New Zealand, and Norway already fully offset the double taxation of dividends with an individual tax credit.¹

Let us examine what has happened since 2003, when Congress lowered the tax rate on capital gains, and lowered the tax rate on dividends, so that they are, in general treated the same as the tax on capital gains (15%). The Government revenue from tax payments on capital gains increased by 79% and its revenue from dividends increased by 35%, even though the taxable rate fell from 39.6% to 15%.²

If the purpose of taxes is to increase the Government's revenue, the Government increased its revenue substantially by lowering dividend and capital gain rates. As the National Bureau of Economic Research reporter, "After a continuous decline in dividend payments over more than two decades, total regular dividends have grown by nearly 20 percent since the beginning of 2003 - precisely the point at which the lower tax rate was proposed and subsequently applied retroactively."³

What about taxes on "the truly rich"? The Government, after lowering its taxes on dividends and capital gains, increased its revenue from the well-heeled. Between 2002 and 2004, the income tax share of the top 0.1% of earners rose to 17.4% from 15.4%.⁴

Tax Cuts and Tax Revenue Increases
Have the Bush tax cuts lowered government revenue? In 2006, federal tax revenues were 18.4% GDP. The 40-year average has been 18.3%. So, the government may be taking a slightly larger share of the GDP pie after it lowered its tax rates.⁵

And, because the pie is growing, the Government is collecting more in taxes. In 2003, the Federal Government collected $ 1,782.5 billion; by 2006, that figure grew to $2,285.6 billion. It went up, in just three years (after the Bush tax cuts had a chance to jump start the economy), to over $500 billion, or over 28% more. Lowering taxes actually brought in more money - 28% more.

Compare that year to 2000 (the last year of the Clinton Presidency). It was before stocks had entered a prolonged bear market; the economy was not yet in recession, and tax rates were much higher. But federal tax revenues in 2000 were $260 billion lower than tax revenues in 2006.⁶ If the purpose of taxes is to raise revenue, the Bush taxes worked. There was nearly a 15% increase in federal tax receipts in 2005, and another increase of almost 12% in fiscal 2006. That increase in tax revenues reduced the federal budget deficit to 1.8% of GDP, lower the average for the last 25 years.⁷

These tax cuts did not reduce the progressivity of the tax system. IRS data show that U.S. households whose income places them in the bottom 50% in income, paid a smaller share of total income taxes in 2004 (3.3%) than in President Clinton's last year in office (3.9%). The majority of American families with an income below $40,000 pay no income tax at all today. In addition, many of them also receive an Earned Income Tax Credit that effectively offsets much of their payroll taxes. The top half of taxpayers now pay 96.7% of all taxes, the highest in decades.⁸

Forty percent of U.S. households pay no income tax. Compare them with taxpayers whose income placed them in the top 5%. They paid 57.1% of income taxes in 2006. The top 40% pay 99.1% of all income taxes. In 2000 (the last year of the Clinton presidency), the top 5% paid 56.5%. In other words, the percentage of taxes that the richest 5% paid increased in the Bush years compared to the Clinton years.⁹

Income Mobility
We should not forget income mobility. When we talk about the top 1% or the top quintiles (top 20%) or the bottom 20%, we should not assume that those who are in the top quintile in one year one are in the same place a year or two later. There is a fair amount of mobility. People do not stay put in their quintiles over time.

Some of this movement simply occurs through the passing of time. Younger people, just starting to enter the workforce, are more likely to earn more as they gain experience and seniority. And, there is the factor of entrepreneurship and education. People who work harder, who take risks, start businesses, and get an education are more likely to earn more over time.¹⁰

There may have been a modest widening of the income gap in recent decades (regardless of which party controls the White House), probably because of the increased returns on education and skills in the global economy. Americans without a high-school diploma are losing ground compared to those who have college degrees. The statistics shows that this income gap exists not only in the United States but also in Canada, the U.K. and other countries,¹¹ which suggests that the nature of the global economy (not the U.S. tax code) accounts for it.

In addition, some people work more than others do: in 2003, median income for households with two full-time workers was $85,517, but household income was only $15,661 for households in which nobody worked.¹² Households where more people work full-time tend to earn more than those in which no one works.

On the other hand, there is good reason to believe that (other than stock option windfalls during the late-1990s stock-market boom) "there is little evidence of a significant or sustained increase in the inequality of U.S. incomes, wages, consumption, or wealth over the past 20 years."¹³ Income gaps do not mean a reduction in economic mobility.

The United States enjoys a great deal of mobility from one quintile to the next, and that this mobility has been going on for years. For those in the bottom quintile of income tax filers in 1979, 85.8% had left that quintile by 1988. For the next lowest quintile, 71% had left within a decade; for the middle quintile, two-thirds had left during the same period. In the second to the top quintile, 62.5% had left in the same period. And when we turn to the top quintile, 35.3% had left. Some people move up and others move down. If we look to those fortunate few in the top 1%, more than half of them, or 52.7%, had left.¹⁴

Studies that are more recent also show that our economic tradition is economic mobility. Almost three-fifths of those in the lowest income quintile in 1969 were in a higher quintile in 1996, while over three-fifths in the highest income quintile had left to join a lower income quintile during the same period.¹⁵ From 1996 to 1999, almost half (48%) moved to a new income group; more moved up a quintile or more than those who moved down.¹⁶

Safety Net for the Poor
When we look at tax receipts, we also should look at tax outlays. For calendar year 2004 (the latest year for which I have figures), the bottom quintile of households received approximately $8.21 in government spending for each dollar of taxes paid. The middle quintiles received $1.30 per each tax dollar paid, and the highest-earning households receive only $0.41 per tax dollar paid. That should not be surprising because lower income people are more likely to use Medicaid, unemployment compensation, and other programs that offer a safety net. The result is that households in the lowest quintile receive about $31,000 more in total government spending than they pay in government taxes, while households in the top quintile pay about $48,000 more in government taxes than they receive in government spending.¹⁷

Conclusion
We want a safety net for the poor, but we also want a good economy. The question for every tax increase or tax decrease is whether it will increase economic activity and help the economy or not. A separate question is how best to help the poor and create a safety net. If lowering taxes on "the rich" serves to increase economic opportunity and grow the economic pie, the Government can use that revenue to help the poor. The tax cuts that Congress enacted earlier this decade have now had several years to work their way into the economy. The economic result is a happy one, because a rising tide lifts all boats, and the increased tax revenue from the expanding economy has allowed the Government to build a safety net and create new programs to help the less fortunate, such as Medicare Part D prescription program.