The Policy, The Myth, and The Legacy of the Bush Tax Cuts

"THE BUSH TAX CUTS"

 The policy:
Depending upon who you ask, the Bush tax cuts evoke great pride or revulsion.  The controversial tax policy of the Bush administration was passed by Congress in 2001 and took effect for the 2003 tax year.  The policy is loosely based on the Reagan supply side economic theory where lower taxes stimulates the economy which increase the tax base for the government.  Supply side economics revolves around the private sector as the major economic engine for the economy as a whole where the government holds a small but important role in enforcement of law and maintenance of infrastructure.  The theory pinpoints an economic sweet spot where the taxes are low enough to encourage economic and taxable activities but not too low where further taxation would not prevent further activity.  Economist Art Laffer created the "Laffer Curve" that depicts the visual representation of this policy.

 The theory behind the Laffer curve states that if taxes are at 0 percent, the government will collect no taxes because it will tax 0 percent of income.  If the tax rate is 100 percent, then all income will go to the government so there is no incentive to earn an income that will go directly to the government.  Somewhere in the middle is a tax rate that maximizes the tax revenue.  Most economists understand that this optimal rate is lower than 40 percent but greater than 30 percent.  The Bush Tax Cuts adjusted the income rates downward closer to 35 percent for top earners. 



 The tax cuts affected income, capital gains, and estate taxation for all US citizens but it exempted the Alternative Minimum Tax (was later amended later).   These tax cuts lowered the marginal rates for everyone making over 27,000 dollars a year and decreased the taxes on all capital gains and estate income.  The most controversial portion of the tax cuts was the cut of the top tax rate from 38.6 percent to 35 percent.

 The Myth:
Critics of the Bush Tax Cuts argued that they were unnecessary, unproductive, and destructive to the US economy.  The reasons for this reaction vary from a political ideology or a misunderstanding of the goals and effects of the policy itself.  Political opposition coalesced around the idea that economic growth originates with government spending from the modern Keynesian economic model.  Keynesian economics is a middle ground economic philosophy between a form of managed capitalism and socialism where most investment is directed by the government.  The basis for this model states that government spending drives economic activity and the private sector is just an economic multiplier off of the public investment.

There is evidence that government spending does drive some economic growth in the fields of research, development, and infrastructure.  The basic equation to calculate the GDP (C + I + G + NX = GDP) includes government spending (G) as a factor.  Critics fail to look at the relative impacts of the lowering of G and the increase of C and I (consumption and investment).  Most critics assume the G is much bigger than any increase in C or I so G must be the most important.  Also, critics fail to see what an increase in G does to the other factors as well.  Tax revenue is money that would have been spent either in consumption, investment, or savings.  The more revenue that is paid in taxes the less there is for alternatives.  There is a point where so much money is taxed that there are punitive effects on the economy and retards economic growth.

In light of these arguments, critics of the Bush Tax Cuts have held on to a number of myths about their overall effect:

1. The Bush Tax cuts lowered government revenue and took money away from crucial health, education, and social welfare programs.

Many critics intuitively believe that when tax rates are lowered, less tax revenue is collected.  Immediately, this is true but lower taxes create an incentive for economic activities and expansion.  Although many people will be paying a lower tax rate, more overall people will be paying taxes thus increasing the overall revenue to the government.  This analysis will only determine if revenue increased per US resident, not where the revenue was spent because the later is a political decision not a matter of circumstance. 

To analyze the budget numbers a few concepts must be acknowledged.  First, when you compare fiscal data over a period of time (2000-2012) it is important to use constant dollars.  Inflation can skew the raw data and obscure the true trends in the numbers.  In this case the all the data is converted in to 2005 constant dollars in order to remove any inflation effects.  Second, tax revenue is complex and has many factors that may skew the actual results.  For example, the US has a consistently growing population, which means the tax revenue has a natural tendency to increase over time even if revenue decreasing per person.  The overall revenue may increase, while the taxes collected per person in the US may decrease.  This may signal budgetary problems for population sensitive agencies like Health and Human Services or Education.  Most of the comparisons in this analysis are normalized by the US population or by the total number of tax returns filed the owe taxes where possible.  It is mostly important to restrict the scope of analysis to focus on the question at hand, Did the bush tax cuts reduce the ability to fund these crucial programs?

Over the course of the Bush administration, the total number of tax filers as a percentage of the population actually increased as shown in the chart:

For one reason or another a higher percentage of people decided to file tax returns.  This does not necessarily mean that more revenue was collected but it does mean that a higher percentage of people were engaging in taxable activities.  There was a general increase over the course of the Bush term and it culminated in a spike in 2007 when the percent of the population filing a return reached 52 percent. This fact trend is important when calculating the tax collection statistics.  For example, when looking at the tax collection for the capital gains tax or the income tax it is easy to say that the increases in revenue is due to the natural population increase when the taxes per person are falling in the country as a whole.  To separate revenue increases by regular population increases from that of genuine revenue creation, you have to look at the revenue per tax payer and per US resident.  If the tax revenue per person and per tax return increases, the tax revenue created is independent of the population trends. Since the percent of the population paying taxes over Bush's term was increasing, the additional revenue per person also increased.  This also shows that trends in the tax collection data is significant since the tax payer rate was growing faster than the overall population.  Therefore increases in the revenue is due to the behavior of the tax payers and not because of ambient population increases.

To determine if the tax cuts limit these programs, it must be determined that the revenue was stagnant or decreasing in the following years.  If the revenue from income taxes (per member of the US population), capital gains, and corporate income decrease there will be less revenue for the Government to allocate to those programs then in previous years.

Individual Income Tax Revenue

In the eyes of a producer or consumer, an income tax is the cost of working and earning the next marginal dollar.  The higher the income tax, the more likely that an individual will decide their time is better spent on alternatives.  Basic economic principle states that if you increase the cost of something, less will be yielded.  Higher income taxes should result in less income generation and thus less income tax revenue.  Alternatively, lower income taxes should result in more income generation and thus more income tax revenue for the government.  Thus the myth about the Bush tax cuts will be nullified if more revenue per US resident occurred after 2003 than before.  The Bush Tax brackets were reduced by the following amounts:

• a new 10% bracket was created for single filers with taxable income up to $6,000, joint filers up to $12,000, and heads of households up to $10,000.
• the 15% bracket's lower threshold was indexed to the new 10% bracket
• the 28% bracket would be lowered to 25% by 2006.
• the 31% bracket would be lowered to 28% by 2006
• the 36% bracket would be lowered to 33% by 2006
• the 39.6% bracket would be lowered to 35% by 2006

Under these changes, if the rates are decreased, the total revenue generated should increase and that is in fact what occurred after the tax cuts were implemented. The following chart and graphic show this in detail:

The data shows that following the passage of the Bush Tax cuts in 2003 and 9/11 financial recession, income tax revenue (per US resident) increased in the years after the passage of the law up until the housing crash and subsequent recession starting in 2008.  In 2003, the income tax revenue collected per tax return was $6,413.00 and it steadily increased to a maximum of $7,242.00 in 2007.  The income tax revenue per person increased from $2,928.00 in 2003 and steadily increased to $3,668.00 in 2007.  Income tax changes was the largest part of the Bush Tax Cuts and the most controversial.  This means that more tax revenue was generated from each tax return resulting in more tax revenue AFTER the tax cuts.  The fact that this increase in tax revenue was realized proves that the Bush tax cuts did not reduce income tax revenue and deprive crucial services of these resources.

Another useful measure of the change in revenue overtime is to measure it as a percentage of the GDP.  The GDP is the measure of the nations income and it includes all consumption, investment, government expenditures, and net exports during the year.  Presumably, as the national income increases or decreases, the income tax collected will follow the same pattern.  During the time following the Bush Tax Cuts (2003 -2008), the GDP increased 65 percent in real terms from a little over 10 trillion to almost 16 trillion dollars.  Over this same time frame the income tax collected as a percentage of the GDP remained at about 7 to 8 percent.  This means  that the revenue collected increased because the overall GDP increased and the revenue collected percentage remained constant. The following graph displays this data:

Critics may argue that the fact that the income tax collected as a percent of the GDP did not increase much was a sign of a decline in revenue.  That is not the case because the raw data shows that per person and per tax return, the income tax revenue increased in absolute terms.  The fact that the percentage remained constant as the GDP grew by 65 percent in 5 years means much more revenue was generated.

Capital Gains Revenue

The Bush Cuts also included changes to the long term capital gains rates.  Capital gains are the income earned on a variety of investments.  Capital investment is the life blood of the US economy and it is in the best interest of society as a whole to create incentives to invest as much as possible.  Investment is initiated by private individuals, organizations, and businesses and it is investment that allows the rapid expansion of most economic activity.  In this light, the Bush administration lowered the taxes on long term capital gains (to about 15 percent), depicted in the chart below:

The following table shows the subsequent capital gains tax collections before, during, and after the Bush Tax Cuts were implemented.  The following is a chart of the capital gains tax revenue:

Again, the data shows positive increases in the overall capital gains tax collection after the capital gains rates were lowered. The total capital gains revenue collected increased from 54 billion in 2003 to 129 billion in 2007.  Normalizing for population increases, the per person capital gains revenue increased from $168.00 in 2003 to $487.00 in 2007.  The revenue per tax return also increased from $368.00 in 2003 to over $941.00 in 2007. This represents a revenue increase increase of 190 and 156 percent respectively. 

The last measure is the capital gains collected as a percentage of the real GDP.  The following graph shows the data from the late 1990's to 2009:

 The data shows that from 2003 to 2007, the capital gains as a percent of GDP increased because the capital gains increases outpaced the increases in the real GDP.  The income created through investments was growing at a faster rate then the increases in all other revenue.  In absolute terms, and when combined with the previous data, it is clear that the Bush tax policy did not prevent the increase of capital gains revenue.  In fact, there is strong evidence that the cuts in the capital gains tax rate was the most effective of all the cuts under this policy based on the year to year increases from 2004 to 2007 (46%, 44%, 19% and 20%). 

The caveat to this result is that the capital gains is highly dependent upon the health of the stock market.  The stock market largely drives investment returns and thus drives the level of capital gains tax revenue.  This is shown by the precipitous drop in revenue leading up to the housing crash of 2008.  But, the question is not what drives the gains, just if the tax cuts prevented extra revenue collection by the government.  Although it is debatable to measure if the tax cuts increased the capital gains increases, like the individual income tax numbers, the numbers show that the tax cuts did not hinder, or reduce the capital gains tax revenue collection and there is strong evidence to the contrary.

Estate and Gift Taxes

The estate and gift tax rates were also reduced as part of the comprehensive income tax reformation.  These are taxes on large gifts and transfers of property assets.  The changes consisted of a gradual increase of the per person exemption and a gradual decrease of the tax rate.  These changes allow for larger gifts to be given without taxation and lower tax rates paid on applicable gifts.  The following chart shows the changes over the decade:

The problem tracking this tax exists because the transactions subject to this tax is infrequent and subject to many methods  of tax avoidance.  This makes the estate/gift tax volatile and difficult to see the effects of any given policy. The following table shows the estate/gift tax collection by the Federal Government:

The data shows that the revenue from gift/estate taxes increased in absolute terms after the implementation of the Bush Tax Cuts.  Overall the revenue increased from 23 billion in 2003 to over 26 billion in 2008.  Once the data is normalized for population increases, it reveals that the revenue increased above an beyond the natural population increase.  The revenue per person increased from $81.01 in 2003 to $86.91 in 2008.   The revenue per tax return also increased from $178.71 in 2003 to $183.67 in 2008.  In aggregate, the data shows that the revenue from these taxes increased and dispels the myth that the Tax Cuts lowered revenue from this source.

The gift/estate tax revenue as a percent of the real GDP remained constant at about .20 percent from 2003 to 2008.  As the GDP was increasing over this time, so was the revenue from this tax because .20 percent of an increasing number, is in itself also increasing in absolute terms.

Tax Expenditures: Expanded Exemptions under the Bush Tax Cuts

A lesser know aspect of the Bush tax policy is the expansion of a number of tax expenditures. A tax expenditure is an increase in a tax credit or deduction.  The Bush tax policy increased the eligibility for the child tax, retirement deduction, earned income, student education, and foreign tax credits.  These tax credits apply to middle to low income tax filers which means that those filers had more of their income shielded from taxes while high earners did not benefit from most of the exemptions.  Critics of the Bush policy argue that the tax credits took more away from the tax collections than the previous policies and thus suppressed tax revenue.  Measurement of the credits and deductions can be difficult due to the highly complex nature of the US Tax code.  Many outside factors affect the amount of tax credits and deductions are exercised due to the ever changing eligibility subject to political whims   The eligibility for each tax credit and deduction can change on a yearly bases based on political decisions.

Due to some changes in the way the IRS reports their data, not all the tax credit information is available for the time span needed for this analysis.  The data is available for the child tax credit, the retirement savings contribution, the earned income credits, and the alternative minimum tax credit for most of the years needed.  If the critics are right, the credits would remove tax revenue from the tax collection that otherwise would have gone to the government.  This statement is true, but the statement that the tax cuts took away from crucial programs looks at the entire revenue stream.  If the revenue stream decreases (normalized by population) then they are right.  If it increases, then they are incorrect.

Some credits were claimed less frequently after the Bush Tax Cuts.  Even though the child tax credit is an incentive to file a tax return and claim it, fewer tax returns claimed the credit after the 2003 enactment then before.  About 26,600,000 returns were filed with a child credit in 2001 and that number declined to 26,200,000 in 2004 and further declined to  25,700,000 in 2006 and the down ward trend continued in to the recession.  These numbers are interesting considering the fact that more total tax returns were filed each progressive year.  It appears that either there were less kids in the country (not possible given the birthrate, immigration, and population data), less people were a where of the credit, or fewer people were eligible for it than in the previous years.  Regardless of the reason for the decline, the question still remains, did the tax policy reduce the total government revenue?

The bottom line effect of tax credits is the tax liability that they leave behind.  Tax liability is the amount of money that a tax filer owes to the government.  If tax filers claim tax credits and deductions, their taxable income decreases and the total revenue collected from them will decrease over time.  For the period of 2000 through 2010, the tax liability for the average tax return (with a tax liability, and total) is shown in the following graph:

Overall the total tax liability for all tax returns increased from around 844 billion in 2003 to a total of 1.1 trillion in 2008.  This means that in aggregate more taxes were owed to the government in the period after the tax cuts.  This was in spite of the fact that more tax shielding was available through the use of credits than before, the government collected more revenue.  The liability per tax return increased from $6,428 in 2003 to $7,119 in 2008.  The tax liability per tax returns that had a liability increased from $8,584 in 2003 to over $10,299 in 2008.

The total tax liability increased as a percentage of the real GDP as well.  The graph below shows that over the time frame 2003 -2008, the total tax liability increased from 7.25 to 8.44 prior to the financial crash in 2008.

In absolute terms the liability of tax filers, and in total, increased over this time period which again dispels the notion that the tax cuts and credits decreased the revenue collected by the government.  Although looking closer at the data, the caveat to this is that fewer overall tax returns had tax liability.

The percent of total returns that owed taxes before 2003 was 78 percent and trending down until it reached a minimum of 69 percent in 2007.  Although the percent of tax returns that owed taxes decreased over the Bush term, the decreasing trend in tax liability began in the late 1990's and it stabilized in the years following 2003 at 74 percent before continuing the trend.

In summation, fewer tax payers were paying more total taxes to the government.  This is the net result of the expansion of tax credits.  The high income earners continued to pay taxes as before and the low and middle income tax payers had more of their income shielded from taxation.  Income is the major diver of the tax liability, as income grows so does the liability of the taxpayers.  Both of these indicate an expanding economy and one that is fostering growth and revenue to the government.  Normalizing for the total number of tax returns (which continued to increase during this time) it shows that overall, fewer tax payers were paying more taxes during this period.  Since the tax rates were lower, and fewer tax payers were paying taxes, the increases had to be a result of greater incomes by a smaller group of tax payers in the upper income brackets.

In conclusion to the tax credit data, The total number of returns filed in the years following the Bush Tax Cuts increased, but the returns with a tax liability decreased.  Some of the extended credits, like the child tax credit, saw decreased usage after 2003.  The overall revenue increased with fewer tax returns owing taxes, resulting in a higher revenue per tax return.  This results in the logical conclusion that the passage of the Bush tax credit expansion did not decrease overall revenue but it created a stronger correlation to high income than before. 

It appears that even though the overall revenue did increase, there were some troubling signs in the composition of the tax paying public.  It is not healthy to have a decreasing number of citizens paying taxes that support a growing number of citizens paying no taxes.  Although this trend began prior to the bush administration's tax changes, the expansion of tax credits widened the gap between the two groups.

Total net effects on revenue collection of the Bush Tax Cuts

The total net effect of the Bush tax cuts on the revenue streams can not be completely isolated due to so many other factors that affect tax collections.  Natural variations in the economy can greatly affect the number of people who will owe taxes.  Economic downturns greatly reduce income and capital gains regardless of the tax rates.  Additionally, political decisions also skew the numbers based upon the incentives caused by the tax code.  Twice during the Bush Administration, George Bush issued a directive for a tax rebate where all tax payers under an income level received an extra credit for filing their taxes.  This obviously provided a strong incentive for more people to file their taxes regardless if they owe any to the government.

The question isn't how much the tax cuts helped increase the revenue, it is whether the revenue decreased and thus took away available resources for those crucial programs that are now in fiscal trouble.  If more revenue was collected, this criticism is unfounded because if more money per person is collected by the government, there are more resources to be allocated to these programs.  If because of the tax cuts, less revenue is collected per person, then the criticism has some basis and may have resulted in less available resources.

Below is a graphic showing the total aggregate revenue generated by the taxes affected by the Bush cuts (individual income tax, the capital gains tax, and the gift/estate taxes)

In aggregate, the total revenue from these three taxes, affected by the tax cut, increased after the cuts were implemented.  The peak was nearly as high as the previous peak realized during the previous economic boom.  Because this number does not account for the natural increase in tax revenue attributed to population increases, more data is needed for a complete verdict.

Below is a chart that shows the per person and per tax return aggregate tax revenue from the three key taxes:

The chart shows that when the data is normalized for population, the revenue still increased per person and by each tax return that was filed.  The increase in tax revenue per tax return is very significant considering it is almost 2000 dollars per return and over 130,000 returns were filed.  From these two graphs it is undeniable that tax revenue increased on an absolute scale in the key taxes, after the tax cuts were implemented.

As a final litmus test, another measure of government tax revenue is to compare it with the GDP.  The ratio of revenue to GDP will determine if the government is collected as much, more, or less tax revenue then in previous years.  If the GDP increases and the tax revenue as a percent of the GDP stays the same or increases, the tax revenue is increasing.  If the tax revenue as a percentage of the GDP becomes smaller over time as the GDP increases, the tax revenue decrease is smaller than in previous years.  The following graph shows this relationship:

For all the faults of the tax system and the policy itself, the statement that the Bush Tax cuts reduced the tax revenue is absolutely false.  This analysis has shown that all revenue from the affected taxes absolutely increased after the tax cuts were implemented. The total revenue per person, per tax return, and as a percentage of the real GDP all increased and brought more revenue to the US Treasury. With more revenue flowing in to the Federal Government, it was in a better fiscal position as a result from a revenue stand point.  Any reductions that critical programs faced was due to political decisions and expenditure expansion, and not for a lack of revenue.
 

The analysis of the rest of the Bush Tax Cut criticisms will continue in the following posts...

Citations

Bush Tax Cuts
http://kenhoma.wordpress.com/2010/04/07/encore-those-bush-tax-cuts/
Cuts lead to debt problem:
http://www.huffingtonpost.com/2011/05/20/bush-tax-cuts-debt_n_864812.html

http://www.cato.org/publications/commentary/tax-policy-under-president-bush

Cuts hurt the job market
http://www.huffingtonpost.com/2012/09/24/bush-era-tax-cuts-economic-growth_n_1910344.html

Data
http://www.whitehouse.gov/omb/budget/Historicals
http://www.irs.gov/uac/SOI-Tax-Stats-Historical-Data-Tables
http://www.irs.gov/uac/SOI-Tax-Stats---Historic-Table-2

fact check
http://www.washingtonpost.com/blogs/fact-checker/post/obamas-claim-that-the-bush-tax-cuts-led-to-the-economic-crisis/2012/09/30/06e8f578-0a6e-11e2-afff-d6c7f20a83bf_blog.html