How an Invisible Hand Pushes U.S. Taxes Higher
Oct. 22 (Bloomberg) -- Federal tax rates on higher incomes were raised at the start of the year. Meanwhile, the Internal Revenue Service has increased its audits of wealthy taxpayers and is pressing small-business owners over unreported income. And tax collectors are pursuing would-be tax dodgers who hold Swiss and other offshore investment accounts.
This is all being done in the name of raising federal revenue to combat huge annual deficits and to punish the Wall Street bankers who President Barack Obama has criticized, right? Well, partly, but that’s not the full story.
An invisible hand seems to guide effective personal tax rates. In his seminal 1776 book, “The Wealth of Nations,” Adam Smith described how, in free markets, the invisible hand leads individuals to promote the common good, even as they act in their own best interests. Competition between buyers and sellers, driven by the profit motive, results in better products at lower prices.
When it comes to tax rates, the invisible hand isn’t always benevolent. Yet, regardless of the specific intent of Congress and the president, it has maintained the effective tax rate on personal income at a remarkably steady average of 12.3 percent, according to data that started to be collected in January 1967.
Whenever the rate has climbed well above 12.3 percent, something happens in the economy to knock it down -- for example, the dot-com collapse in 2000 after the 1990s bubble. Otherwise, the government acts by cutting tax rates, reducing the number of audits or creating more loopholes. Conversely, when the effective rate drops distinctly below 12.3 percent, loopholes are closed, tax rates rise and audits increase, as has been the case recently.
There are examples of the invisible hand at work throughout history. In 1964, individual tax rates were cut, with the top rate dropping to 70 percent from 91 percent. Of course, the 91 percent rate applied only to incomes of more than $400,000; 501 taxpayers out of 64 million were affected. Also, the minimum standard deduction of $300 plus $100 per exemption - - for a maximum total of $1,000 -- was instituted in 1964. In addition, the top corporate rate was lowered to 48 percent from 52 percent.
Partly as a result, the personal-taxes-to-personal-income ratio dropped below 12.3 percent. Not surprisingly, in 1968, temporary tax surcharges of 10 percent were enacted on individual and corporate incomes. Also at work were the huge government outlays for the Vietnam War and the “war on poverty,” which widened the federal deficit to 2.9 percent of gross domestic product in 1968 from 0.2 percent in 1965.
The taxes-to-income ratio jumped, and in 1969, as a recession loomed, the personal exemption was raised to $750 from $600, the minimum standard deduction went to $1,000 from $300 and the tax surcharge dropped to 5 percent.
The 1973-1975 recession, at the time the steepest since the 1930s, spawned the Tax Reduction Act of 1975. It provided a 10 percent rebate of 1974 tax liability, created a temporary $30 general tax credit for each taxpayer and dependent, pushed the minimum standard deduction on a temporary basis to $1,900 from $1,300 and increased the percentage standard deduction to 16 percent from 1 percent, but just for 1975.
In 1976, the temporary general tax credit and standard deduction increase were extended. The tax rate fell to zero for low-income taxpayers. The taxes-to-income ratio dropped sharply, but moved back above 12.3 percent with the recovery.
Under the Revenue Act of 1978, individual taxes were reduced by widening the tax brackets and reducing their number. The personal exemption rose to $1,000 from $750, the standard deduction climbed to $3,400 for joint filers from $3,200, and the capital-gains exclusion increased to 60 percent from 59 percent. The top corporate tax rate was cut to 46 percent from 48 percent.
With the taxes-to-income ratio at about 13.5 percent in 1981, big cuts were enacted. Marginal tax rates were reduced by 23 percent over three years, and the maximum rate was cut to 50 percent from 70 percent; the top capital-gains rate fell to 20 percent. Eligibility for participation in individual retirement accounts was expanded, the annual contribution limit to Keogh plans was raised to $15,000 and estate taxes were cut, with the top rate dropping to 50 percent from 70 percent.
Not surprisingly, this government largesse narrowed the tax-to-income ratio, and officials in Washington soon realized they had overdone the tax cuts. So a year later, in 1982, Congress imposed withholding on interest and dividends, accelerated corporate tax payments, strengthened the individual minimum tax and tightened depreciation allowances. Excise taxes were raised on airline tickets, cigarettes and telephone bills.
In 1986, the tax-to-income ratio was running close to its long-run 12.3 percent average, but the tax code had become too complicated. The result was the Tax Reform Act of 1986, which reduced the number of individual tax brackets from 15 to two in 1988 and dropped the top bracket to 28 percent from 50 percent. The bottom bracket shifted to 15 percent from 11 percent. This was the first time in the history of the federal income tax, starting in 1862, that the top rate was reduced as the bottom bracket was raised. Capital gains were taxed at the same rates as ordinary income.
State and local tax deductions were repealed as was the break for interest on consumer loans such as credit-card debt. So was income averaging, which helped those with a recent sudden jump in income. Full medical expense deductions and full deductions for business meals and entertainment also disappeared. IRA contributions were restructured, and the depreciable lifespans for capital equipment and structures were lengthened. Defined-benefit pension contributions were indexed for inflation and reduced to a $7,000 maximum from $30,000.
From 1986 through the early 1990s, the tax-to-income ratio remained close to its long-run average, even though the top individual rate was raised in 1990 to 31 percent from 28 percent and the alternative minimum tax increased to 24 percent from 21 percent. Meanwhile, itemized deductions for high-income taxpayers were reduced. In 1993, new top tax rates of 36 percent and 39.6 percent took effect. The taxable portion of Social Security benefits rose to 85 percent from 50 percent.
Many of these increases were probably a response to worsening income polarization. Only those in the top 20 percent of income have seen their share of the total rise continually since 1967; the share of the remaining four quintiles has shrunk. As a reflection of the concern about income polarization, the bottom tax rate remained at the 1986 level of 15 percent in the 1990s.
The booming economy, aided and abetted by the dot-com bubble, pushed up the tax-to-income ratio in the 1990s. It reached 14.6 percent in early 2001. Then, despite concern about income inequality, tax rates were cut. In 1997, the estate tax exemption was gradually raised to $1 million from $600,000 per person. The $10,000 annual gift exclusion was indexed for inflation. Capital-gains rates were dropped from 28 percent to 20 percent and from 15 percent to 10 percent.
There were further cuts in 2001, induced by the recession that year. A 10 percent bracket for low-income taxpayers was introduced, and made retroactive, resulting in $600 refund checks for couples. Higher-bracket rates were cut, the phase-out of the itemized deduction and personal exemption was repealed, the child tax credit was doubled to $1,000, and the child and dependent care tax credit was increased.
The estate and gift tax rate was cut, and the exemption raised from $1 million in 2002 to $3.5 million in 2009 and eliminated in 2010. IRA contribution limits were raised from $10,000 to $15,000, with catch-ups for those more than 50. Education tax credits and deductions were expanded.
Even though all these tax cuts and the weak economy were pushing the tax-to-income ratio well below the 12.3 percent average, further tax rate cuts were enacted in 2003. Lower brackets were adjusted; for the upper end, capital gains and dividend tax rates were set at 15 percent for 2003-2007, with a 5 percent rate for lower-income taxpayers.
The recession began in December 2007, and by early 2008, it was clear the economy was in trouble. The response was the Economic Stimulus Act of 2008, with tax rebates of $600 per couple and $300 per child. Depreciation of business investment was also eased. Then, in reaction to the collapsing housing market, the Housing Assistance Tax Act of 2008 provided credits for new homeowners as well as increases and simplification of the low-income housing credit to spur new construction.
In 2009, as the recession deepened, Congress cut taxes for individuals and business further. And in 2010, scheduled increases in individual as well as capital-gains and dividend rates were postponed. Also, for employees, the Social Security tax rate was dropped to 4.2 percent from 6.2 percent. At the same time, the inheritance tax exclusion went from zero to $5 million for 2010-2012, with a 35 percent tax rate on average. The Medicare tax rose 0.9 percent, to 3.8 percent, for high incomes. The first-time homebuyer tax credit was introduced, with a limit of 10 percent of the purchase price, with an $8,000 maximum.
The result of all of these tax cuts was that the tax-to-income ratio approached 9 percent, the lowest in more than three decades.
(A. Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the first in a three-part series. Read Part 2 and Part 3.)
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