Bipartisan Compromise Produces a Lousy Tax Law
The new tax law -- the product of bipartisan compromise -- makes our tax code worse. For example, it waits nine years to phase out the estate tax, then restores it one year later.
by Jerome F. Winzig
In the aftermath of last year's close election, Democrats insisted on the need for a bipartisan approach in Congress. That approach has now led to the $1.35 trillion tax cut that was passed over the Memorial Day weekend with Democratic support and signed into law by President Bush last week. In spite of shrill assertions that the bill is dangerously weighted in favor of the wealthy, it is really a muddled mess of incoherent compromises that are lacking in economic principles and make for idiotic tax policy.
The most absurd provision of the new law is that it disappears entirely in 2011. On January 1 of that year, all of its provisions expire. The tax rates will go back up to current levels. The child care credit will drop from $1,000 back down to $500. IRA deductions will revert to their current levels. The estate tax will be completely reinstated in 2011.
Here's where the law becomes ridiculous. The elimination of the estate tax is stretched out over the next decade, staying at 45 percent until 2010. If you die during 2010, your heirs are lucky. Your estate will pay no death taxes. However, starting in 2010, your heirs will have to pay capital gains taxes on all of your assets. That will be a bookkeeping nightmare; if you own any stock, your heirs will have to determine its purchase price and date, even if you bought it 60 or 70 years ago. But if you die on or after January 1, 2011, your estate will be taxed at the old 45 percent rate. In addition, the new tax on inherited capital gains will not go away. Thus, starting in 2011, there will be a massive increase in total death taxes.
The tax cut bill includes other tax increases. Starting at the end of 2004, a sudden tax increase goes into effect for upper middle-class families in the form of the Alternative Minimum Tax. Over the lifetime of the new tax law, the number of taxpayers subject to this peculiar tax will skyrocket 2,400 percent, from 1.5 million to over 36 million.
The tax bill also includes two major new welfare benefits that really do not belong in a tax bill. The first increases the child credit to $1,000 by 2010 and makes it refundable. In other words, if your tax bill is zero, the government will pay you $1,000 for each of your children. In addition, if your income is below $50,000 and your tax bill is zero, the government will pay you back for your IRA contribution. (This measure expires in 2006.)
Whether these measures are good public policy is debatable. An increasing percentage of the U.S. population no longer pays any federal income taxes. The latest available figures, for 1997, indicate that 35 percent of all Americans who are 18 years old or older pay no income taxes at all. That's 70 million potential voters who may care very little about tax reform but may be very interested in income transfer. Perhaps that explains why this tax bill includes these two spending provisions.
This new tax law ignores a fundamental economic principle; the marginal tax rate -- the taxes we pay on each dollar of new income -- is very important to economic growth. High marginal tax rates suffocate economic growth because they discourage people from working harder, smarter, or better. Why earn more money if the government is going to take it?
The new $1,000 refundable child credit means that the marginal tax rate for poor Americans will now be as high as 48 percent. That is, when their incomes start to go past the earned-income tax credit cutoff, the federal government will take 50 percent of their increased income. And in 2006, when the new refundable IRA tax credit disappears, some Americans with incomes under $50,000 will see marginal tax rates as high as 1,200 percent. That is, in 2006 some Americans will see their take-home income decrease by $12 for every $1 increase in gross income.
The bottom line on this tax bill is that a misguided emphasis on compromise destroyed a tax reform measure that was in the long-term interest of all Americans and turned it instead into a muddled mess.