Thursday, March 28, 2013

Bush Tax Cuts myths: War on the Middle Class


3. The Bush Tax cuts hurt the middle class and were only a benefit to the rich

Another common criticism of the Bush Tax cuts was that they were a sort of kick back to the rich from the administration.  The US uses a progressive income tax system where the income tax you pay is determined by the last dollar you make in the year.  There are levels or brackets that determine the tax rate that an individual pays.  for example, if you make 0 to $7,000 in a year you pay only 10 percent on your income.  If you make between $7,000 and $28,000 you pay 10 percent on your first $14,000  and 15 percent on the next $13,000.  Each tax bracket is defined by these income thresholds and tax rate and they are subject to change when the tax code is amended.  This analysis focuses on the individual brackets because the married brackets follow the same patterns and the dependent deductions are too individual specific for this analysis.


Below is a graphic of the tax rates prior to the bush Tax Cuts:





The following are the tax brackets after the Bush Tax Cuts took effect:





The most obvious benefit that could have existed is  a direct reduction of the tax rates for a particular group.  For it to help only the rich the reductions must either only apply to the rich or are much larger for the rich.   The definition of the rich needs to be determined.  Because tax brackets are being examined, the rich will be determined to be anyone with earnings that qualify for the top bracket.  Prior to the Bush Tax cuts, The top rate was 39.1 percent for incomes over $297,000.  After the tax cuts the rate was decreased to 35 percent for incomes over $311,000.  Everyone making over $311,000 realized a 4 percent decrease in their top tax rate while everyone with an income between 297,000 and $311,000 realized a 6 percent decrease because they were dropped in to a lower top tax bracket. 

 Prior to the cuts, the second highest bracket rate was 35.5 percent on incomes of $136,000 to $297,000.  After the tax cuts, the rate for this bracket also decreased to 33 percent and the income threshold was increased to $143,000 to $311,000.  Again, this bracket had a 2.5 percent rate reduction and an increase in the income threshold, both of which lowers the tax liability for individuals in this bracket.  The key here is for individuals making between $134,000 to $143,000 who before the tax cuts were paying 35.5 percent, but now are dropped in to the next lowest bracket with a 28 percent tax rate.  These individuals experienced a 7 percent decrease (rest of the bracket with a 2.5 percent decreased), much greater than the 4 percent realized by the highest bracket. 

The third highest tax bracket was between $65,000 and $136,000 with a tax rate of 30 percent prior to the tax cuts.  After the tax cuts, this bracket was between $68,000 and $143,000 with a tax rate of 28 percent.  Most of the individuals in this tax bracket realized a 2 percent tax rate reduction, but those making between $65,000 and $68,000 were dropped in to a lower bracket with a tax rate of 25 percent (a 5 percent reduction).  

The forth bracket was between $27,000 and $65,000 with a tax rate of 27.5 percent.  After the tax cuts, the new bracket was between 28,000 and 68,000 with a tax rate of 25 percent.  Like the previous changes, most of the individuals realized a tax rate deduction of 2.5 percent but those making between 27,000 and 28,000 were dropped to the next lowest bracket which had a new tax rate of 15 percent.  These individuals realized a tax rate reduction of 10 percent.


Prior to the Bush Tax Cuts, there was only one more tax bracket that existed.  This bracket was between $0 and $27,000 with a tax rate of 15 percent.  After the tax cuts, individuals making between $7,000 and $28,000 were subject to a 15 percent rate like before, but those with an income from $0 to $7,000 were dropped in to a new lower bracket with a 10 percent tax rate.  Those making between $7,000 to $28,000 had no reduction to their tax rate but individuals making less than $7,000 realized a 5 percent tax rate reduction. 

Based on these calculations the biggest beneficiaries of the Bush Tax Cuts were those at the margins between the brackets and not the rich as the critics may have you believe.  Individuals with incomes in the top bracket saw their top tax rate lowered by 4.1 percent.  Individuals making between $134,000 and $143,000 experienced a 7 percent decrease, individuals making between $65,000 and $68,000 experienced a 5 percent reduction, individuals making between $27,000 and $28,000 experienced a 10 percent reduction, and those making less than $7,000 also experienced a 10 percent rate reduction.  The mechanics of the tax code changes reveals the truth, which is that most tax payers experienced a benefit from the tax code changes.

As part of the tax cuts, a number of tax credits and deductions were expanded.  Each deduction's amount was either increased or the eligibility was expanded.  The higher income that an individual has, the fewer credits and deductions they are eligible for.  The lower an individuals income, the more credits and deductions they are eligible for.  When tax credits and deductions are expanded it shields more of the income of low income earners and middle class.  As a result, over the course of the Bush administration, fewer tax returns as a percentage of the total tax returns, had a tax liability.  






Over time as tax credits become more expansive it begins to erode the revenue gains to the government.  More people are encouraged to file tax returns in order to receive the benefits of the credits.  What this means is that a larger majority of the taxes paid to the government was paid by the higher ends of the income scale.  This is normal for a progressive tax structure but the imbalance increased due to the tax credits on top of the ones already in place.  From this aspect, more of the tax burden is paid by the rich as compared to the lower income tax brackets.


If the rich were benefiting from the tax cuts, the share of the total taxes they paid would decrease, not increase as the critics may believe. After the Bush Tax cuts went in to effect, the share of total income taxes that were paid by the rich (income above $200,000) increased from 41.9 percent in 2003 to a peak of 54.6 in 2007 and 52 percent in 2008.  The following graphic shows the percentage of income taxes that the high earners paid:

 

If the income taxes were a favor to the rich, it failed because a greater percentage of the taxes were paid by the high earners after 2003.  If high earners are paying a greater share of the income taxes, than the middle class and lower earners must be paying a smaller share.  This reality benefits the middle class not the high earners.  As a result the bottom 50 percent of all tax payers have steadily paid a smaller share of the overall taxes:


As you can see, the share of all income taxes paid by the bottom 50 percent of tax payers has steadily declined over time.  In 2003, the bottom 50 percent was paying 4.07 percent of the taxes while in 2010 they were paying 2.46 percent.  It is clear that the tax changes were not punitive to the tax payers.  All tax payers saw a decrease in their taxes and some of the biggest tax breaks came to those residing in the middle class.

Critics often point to the other tax cuts as the major benefactor to the rich.  The Bush Tax Cuts reduced the capital gains and the gift/estate taxes.  People with greater assets are more affected by these taxes because it takes significant capital to invest and earn taxable capital gains, or considerable assets to be taxable when gifted to someone.  It is true that the highest earners earn more of their income via capital gains as opposed to traditional wages and sales.  On average about 16 percent of a high earner's income comes from capital gains as opposed to lower brackets where less than 5 percent of their income is earn in this manner.  A decrease in the capital gains rate does disproportionately benefit those who earn more money through capital gains, but these are also the individuals who own most of the small businesses that employ a large percentage of the workforce.  A lower capital gains rate also provides an incentive to invest and engage in productive economic activity.  When individuals chose to invest their money, either in the market or through tangible assets, they generate income for others through commissions, direct sales, and capital loaned for business expansion to name a few.   This allows small businesses more options when they grow to invest without punitive taxes to discourage productive economic decisions.  The net effect of lower capital gains taxes is complex because the benefits to the middle class who do not invest and earn capital gains is less obvious.

The middle class benefits from the expanding economic activity that is encouraged by lower taxes and specifically lower capital gains taxes.  Entrepreneurs benefit from a lower cost of investment in order to invest in business ventures.  Entrepreneurs must have significant capital in order to invest in their ventures, as the capital gains tax increases, it lowers their threshold for investing and less capital is available.  A direct measurement of this is the unemployment rate and workforce participation rate.  As the economy expands the demand for jobs increases and the unemployment rate decreases.  Although, this is not the only factor in the unemployment rate, unemployment does affect middle and lower income groups harder than the higher income groups.

U6 and U3 are two important measures of unemployment in this country.  U3 is the traditional unemployment rate that measures who is working and who is not.  This measure does not take in to account the individuals who are working part time but want to work full time or individuals who have given up looking for work and are no longer counted as part of the workforce.  U6 is a comprehensive measure that accounts for everyone who is working and who is not as compared to the entire workforce eligible person.  U6 is always larger than U3 because it is more inclusive but together they provide a good snapshot of the conditions for the middle class.  U3 in 2003 was 6.0 but that number decreased to 4.6 by the end of 2007 and increased to 5.8 once the recession began.  U6 began 2003 at 10 percent and steadily declined to just under 8 percent in 2007.  Overall the total workforce participation (% of able workers employed as part of entire population) remained at 66 percent, a level that has existed since the early 1990's and prior to the current tax code. Based on these numbers, the middle class was experiencing an improving job market and thus benefiting from an expanding economy.

Another sign that the Bush Tax Cuts could help the rich and hurt the poor and middle class is the relative incomes of each class.  If the Bush Tax Cuts hurt lower income individuals and helped higher income individuals, you could expect to see more people filing tax returns in lower income brackets.  In reality, after the Bush Tax cuts were passed, a higher percentage of tax returns were in the middle and high income brackets in each successive year.  This means one of three things, either people were moving up the income scale and moving in to higher brackets, the US was importing an unusually high number of high earning foreigners, a significant number people who have not filed a tax return in years past began filing tax returns that were middle income or higher.  The most likely scenario is the first and the third options which means more people were finding work and those already working were increasing their incomes.  Both of these circumstances is a positive sign for the middle class regardless of the increasing revenue for the highest income earners.  The following graph shows this trend:



After 2003, the percent of total tax returns that were in the higher income brackets (200k and above) increased from 1.97 percent to 3.17 and 3.07 in 2008 through 2008.  The returns with middle incomes (22k to 200k) increased from 56.56 percent to 59.65 percent in 2008.  Finally, the low income tax returns declined from 40.98 percent to 37.28 percent in 2008.  Since there were more tax returns filed in every successive year, an increase in these sub groups means an increase in absolute terms.  The increase in the highest brackets is interesting because the increase in high earners had to come from somewhere as high earners do not file multiple tax returns.  The answer is that they came from lower tax brackets, non filers, or imports (immigrants).  This shows a positive trend in social and economic mobility.  Social or economic mobility is the ability of an individual to climb the social ladder and increase their social and economic standing by increasing their income and/or wealth based upon the free moving job market economy.  This measure of social mobility once again reiterates the positive effects that the post Bush Tax Cuts had on everyone including the middle class and rich alike.

Income equality is another talking point that critics like to use as a weapon to prove that the middle class was  hurt by the Bush Tax Cuts.  There are a number of definitions of "income inequality" but in summation it means that the "rich" are getting richer while the middle class is becoming poor and the poor are getting poorer.  Taxable Incomes per tax return have all decreased from 2003 to 2008 leading with the lowest income brackets which declined by 31 percent followed by the highest incomes at 9.83 percent and the middle class saw the smallest decrease of 7.91 percent.  These numbers seem to indicate that the poor and middle class are losing ground to the highest incomes. Outside of the fact that the highest incomes are falling faster than the middle incomes, other factors have to be considered.  The question at hand is if the Bush Tax Cuts are a cause of the class income inequality.   The US Census historical data for income shares by income level shows that the income inequality has drastically shifted since the late 1960's.  




Since 1967, the top five percent of income earners increased their income share from 17.2 percent to 22.3 in 2011.  Overall, the top fifth of all income earners have increased their income share from 43.6 to 51.1 percent in 2011.  The point of this data is that this income trend began long before the Bush Tax Cuts and has persisted through a number of different tax policies. The long term trend of income distribution appears to be independent of tax policy because the trend persisted during times when the taxes were much higher then they were when the Bush Tax cuts were implemented.  This trend occurs because the more people are making money in higher brackets.  If the number of people in the top brackets are increasing while the number of people in the lower brackets are decreasing the total share of income will shift to the upper income quartiles.  The following graphic shows this trend:



http://www.census.gov/hhes/www/income/data/incpovhlth/1995/index.html



The data shows that beginning in 2005, there were more people earning a middle income than lower income as a percentage of all income earners in the US.  This is another indicator of social mobility or the ability of people to improve their economic circumstances.  Prior to 2005, the majority of income earners (as % of all income earners) earned an income lower than $22,000.  After 2005 the majority was in the group of middle incomes making between $22,000 and $100,000.  The percentage of high earners also increased which means individuals from lower income groups were making higher incomes after 2005.  A reduction in taxes reduces the cost of economic activity and increases the options an individual has in the stewardship of their income and wealth.  More options is another way to say that you have more economic freedom and control over the decisions they make in their day to day lives.  The increase in the percentage of earners earning a middle income means that a significant number of people were moving from the lower brackets to the middle brackets and a number of people are moving from the high brackets to the middle brackets, both signs of a growing middle class. 




Overall the Bush Tax Cuts had a positive effect on the tax burden, employment, and economic mobility of the middle class.  The fact that the cuts also helped the rich is independent of the fact that the lower incomes also encountered a improving economic environment.  When critics scoff at the Bush tax cuts and mock that it was only a favor to the rich, it is doing a disservice because a little research will uncover the true effect of the cuts.  Just because a greater share of the income is concentrated in the top brackets does not mean that the rich are hoarding the income, it may mean (in this case), that a growing number of people are earning incomes in the higher brackets than in the lowest ones.  Since 2005, the majority of income earners switched from low income to middle income which indicates a positive trend in economic and social mobility.  The poverty rate during this time remained constant at 12.5 percent which means generally people weren't falling down the economic ladder at a pace any faster than in previous years.  In fact, the substantial increase in middle class tax returns is a positive sign showing that more an more people were earning middle and high incomes. This positive trend proves that the economic mobility increased after the Bush Tax Cuts occurred and economic mobility helps everyone and thus the rich were not the only beneficiaries of the Bush tax policy.

Resources:
http://www.census.gov/hhes/www/poverty/data/historical/people.html

http://research.stlouisfed.org/fred2/data/U6RATE.txt http://www.taxpolicycenter.org/taxfacts/listdocs.cfm?topic3id=39&topic2id=30

http://www.irs.gov/uac/Tax-Stats-2

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