Ways and Means Committee Tax Plan Makes Heavy Use of Devices To Keep Costs of Upper-income Tax Cuts Artificially Low In Early Years
Net Cost in Second 10 Years Estimated at $600 Billion to $700 Billion
by Robert Greenstein, Iris J. Lav, and Isaac Shapiro
Summary and Overview
The tax cut plan the House Ways and Means Committee approved June 12 contains an array of tax cuts that are designed in a manner to keep their costs artificially low in the initial five-year and ten-year periods. The costs of these tax cuts eventually grow rapidly, however, and become much more expensive. The Joint Tax Committee revenue tables on the Ways and Means Committee package show that:
The costs of key elements of the Archer tax cut would continue to mushroom long after 2007. This is particularly true of the capital gains indexing and Individual Retirement Account tax cuts.
Based on the Joint Tax Committee's estimate of the year-by-year costs of the tax cut in the first 10 years and the design of these proposals, we estimate the Archer tax proposals are likely to lose between $600 billion and $700 billion in the second 10-year period, from 2008 through 2017. (See text box below for a discussion of these estimates and the methodology underlying them.) This is the period when the baby boom generation begins to retire and deficits are forecast to rise to alarming levels that will damage the economy unless unprecedented austerity measures are instituted.
Most of the provisions of the Archer plan that are heavily backloaded have a common characteristic they provide most of their tax cut benefits to high-income individuals. The backloading of those provisions enables Rep. Archer to fit his extensive array of tax cuts within the cost constraints the budget agreement establishes for the initial five-year and ten-year periods. The backloading devices also serve to mask the fact that when fully in effect, the Archer tax plan is heavily tilted toward those on the upper rungs of the economic ladder.
The capital gains, estate tax, and IRA provisions all make heavy use of gimmicks including delayed effective dates, slow phase-ins, and timing shifts in revenue collections to minimize the revenue losses these tax cuts cause during the first five years as well as for several years thereafter. Their costs then begin to rise sharply, with the pace at which these costs increase accelerating in 2006 and 2007.
Cost in Second Ten Years Likely to Be $600 Billion to $700 Billion
The cost of the tax package rises sharply between the eighth and the tenth year. The backloading devices responsible for this rise will continue to push up the cost of the tax cuts in years after 2007. As a result, the tax cut is likely to lose between $600 billion and $700 billion in the 10-year period from 2008 through 2017. Several methods of estimating the cost of the tax cuts during the second 10-year period produce similar results.
One conservative method of estimation is to assume that the cost of the tax cuts will grow by the same dollar amount in each year from 2008 through 2017 as the average amount that the Joint Tax Committee revenue tables show the cost will grow from 2004 through 2007. Using that assumption, the annual cost of the tax cut would rise from $40.4 billion in 2007 to $78 billion in 2017. Estimated in this manner, the total cost of the tax cut in the 10-year period from 2008 through 2017 would be $610 billion.(1)
Using the average annual increment in cost between 2004 and 2007 as the basis for projection, however, does not fully capture the rate at which the tax cut is growing in cost at the end of the first 10 years. For a number of reasons, capital gains indexing, the backloaded IRAs, and some of the estate tax provisions are likely to continue for a number of years to rise in cost at rates similar to the rates at which these provisions are growing at the end of the ten-year period. In the case of capital gains indexing, the cost would continue to grow at a rapid rate until the average number of years for which assets being sold that qualify for inflation-adjustment stabilizes, which would be sometime in the middle of the second decade after enactment. Similarly, backloaded IRAs generally are estimated not to reach a stable cost until withdrawals balance new deposits, probably sometime in the latter part of the second decade after enactment. In addition, the rate of growth of the estate tax provisions would remain high for a few years into the second decade; the increase in the amount of an estate excluded from taxation would be fully phased in by 2007, but delays in the settlement of estates and thus the payment of taxes would postpone the full revenue loss from being felt for an additional three or four years.
Thus an alternative, still-conservative estimate would assume that the average rate at which the tax cut would grow between 2004 and 2007 would continue through 2010; for the remaining seven years through 2017, the growth in cost is assumed to fall back to the rate of GDP growth.(2) Under these assumptions, the cost in the 10-year period from 2008 through 2017 would be $622 billion.
As noted, however, the high rate at which the tax cut is growing at the end of the first 10 years is likely to continue for more than three years beyond the initial ten. A third potential method of estimation would assume that the average rate at which the tax cut would grow between 2004 and 2007 would continue through 2012, the middle of the second decade after enactment. For the remaining five years through 2017, the growth in cost is assumed under this third method to fall back to the rate of GDP growth. This method, while still conservative because the cost of IRAs (as well as some other tax breaks) is likely to continue to grow at rates exceeding GDP in years beyond 2012, is probably the one that best reflects the likely growth in cost of the tax cut in the second decade. Under this set of assumptions, the cost of the tax cut would rise from $40.4 billion in 2007 to $87 billion in 2017, and the cost in the 10-year period from 2008 through 2017 would be $681 billion.
When the upper-income tax cut provisions of the Archer plan are considered together, the magnitude of the backloading of these provisions becomes evident.
These tax cuts would mushroom in cost just as the baby boom generation is beginning to retire. Both CBO and GAO long-term forecasts indicate that deficits will shoot up in the baby boom generation's retirement years, as Medicaid, Medicare and Social Security costs rise substantially while the ratio of workers to retirees falls. These long-term forecasts show that deficits are expected to reach levels in these years that would cause serious damage to the economy over time.
Furthermore, some of the principal upper-income tax cuts in the Archer plan in particular, the capital gains indexing and backloaded IRA provisions are designed in a fashion that makes them irreversible. Future Congresses could not undo the swelling revenue losses these provisions would have caused, no matter how large the budget deficit was becoming. This is because the capital gains indexing and backloaded IRA provisions utilize devices that induce taxpayers, primarily at high income levels, to pay billions of dollars in additional taxes in the next five years in exchange for very large tax breaks for decades thereafter. Essentially, large future tax cuts would be "sold," with the selling price being pre-payment of certain tax amounts in years through 2002. Once taxpayers have entered into such a bargain and paid substantial additional taxes upfront to purchase large tax breaks for years to come, the government cannot renege on the future tax reductions.
Moreover, the billions of dollars in additional taxes that would be paid in the next five years are taxes that otherwise would largely be collected in subsequent decades. Once these taxes are accelerated into the initial five-year period, they cannot be collected again in the future. The revenue "hole" created in future years is permanent. As a result, a substantial portion of the backloaded revenue losses the Archer plan creates would be locked in permanently.
New Features of Archer Plan Increase Plan's Regressivity
Several unexpected features of the Archer plan increase its regressivity. First, the plan denies the child credit to four million children in lower-middle income families that would have received the credit under early versions of the child credit. The plan denies the credit to these children by limiting the credit to families that have an income tax liability after the earned income tax credit is computed. Earlier versions of the credit would have provided it to families that had an income tax liability before the EITC is computed.
This change would deny the credit to several million families in the $15,000 to $30,000 range and would raise to 40 percent the proportion of children that would fail to qualify for the credit because their families' incomes are not high enough. While reducing the number of lower-middle-income children qualifying for the credit, the Archer plan does not scale back the number of children at higher income levels who qualify for it. While 40 percent of children would not qualify for the credit because their families' incomes are not high enough, fewer than three percent would fail to qualify because their families' incomes are too high.
Changes in Education Proposals
The Archer plan also alters the Clinton proposal for a deduction of up to $10,000 a year for postsecondary education costs in a way that makes it valuable for high-income families. The Clinton proposal would have limited the full value of this deduction to tax filers with incomes below $80,000 and phased it out between $80,000 and $100,000. The Archer plan places no income limits on this deduction. Like other deductions, this deduction would be worth more than twice as much to families in the top tax brackets the 31 percent, 36 percent, and 39.6 percent tax brackets as to those in the 15 percent bracket. The families that would gain the most from this proposal are those that need no government subsidies to send their children to college.
Finally, the plan changes the $1,500 tuition credit from a credit for 100 percent of the first $1,500 in tuition costs to a credit for 50 percent of the first $3,000 in tuition costs. Students with a $1,500 tuition cost thus would get a tax credit of $750 instead of $1,500. Students from near-poor and lower-middle-income families are more likely to attend community colleges with modest tuition than are students from upper-middle income families. As a result, the change in this credit is likely to have an adverse effect primarily on students of more modest means.
Why Do The Revenue Losses in the Archer Plan Explode in This Fashion?
A number of the key tax cuts in the Archer plan are designed in a manner that minimizes their cost in the initial five-year and ten-year periods through delayed effective dates, slow phase-ins, and acceleration into the budget period of revenue that otherwise would be collected in future years. The capital gains, IRA, and estate tax provisions in particular are fashioned in this manner. The following sections of this analysis explain how the backloading works in each of these areas.
The Archer capital gains tax cut includes both a cut in the capital gains tax rate from 28 percent to 20 percent for most investors and capital gains indexing. In the first few years after enactment of a capital gains rate cut, only modest revenue losses occur. The Joint Tax Committee assumes that if the capital gains tax rate is reduced substantially, as it would be under the Archer plan, investors will initially respond by selling a large volume of assets to take advantage of the lower tax rates. These additional asset sales produce additional tax revenue in the short run, although most of this revenue simply represents an acceleration of revenue from subsequent years when the assets otherwise would have been sold. Within the five-year budget window, these accelerated revenue collections partially offset the revenue losses that result from reducing the capital gains tax rate. This keeps the size of the revenue loss from the capital gains tax cut much lower in the first five years than it otherwise would be.
Beginning in 2001, the Archer plan adds a second, large capital gains tax reduction. From that point on, the purchase price of assets held for at least three years would be indexed for inflation when capital gains tax is figured at the time the assets are sold. This would give investors a double tax break in calculating the capital gains tax, part of an investor's profit would be shielded from taxation through indexing, while the remaining profit would be taxed at a significantly lower rate than under current law. As the box on the next page explains, many very wealthy investors would actually pay about 10 percent of their profits in capital gains taxes, rather than 28 percent as at present; they thus would secure a capital gains tax cut of more than 60 percent.
Capital Gains Indexing Results in Tax Rate Lower than Lowest Rate on Wages
The Archer plan's combination of a provision lowering the top capital gains tax rate to 20 percent and an inflation-indexing provision would result in a very deep cut in the capital gains tax. Consider a stock initially purchased for $100,000 and sold after five years for $134,000. Under current law, most investors would pay tax at a rate of 28 percent on the $34,000 capital gain; the tax would equal $9,520. Under the Archer proposal, however, the price for which the investor purchased the stock would be adjusted for inflation and then the remaining gain would be subject to taxation at a 20 percent rate.
Assuming inflation of three percent per year, the $100,000 purchase price first would be adjusted upward to approximately $116,000 to account for five years of inflation; the investor's capital gain thus would be considered to be $18,000 (the $134,000 sale price minus the indexed purchase price of $116,000) rather than $34,000. This $18,000 gain would be taxed at a 20 percent rate, causing the investor to owe tax of $3,600. This would represent a 62 percent tax reduction from the $9,520 in capital gains tax the investor would pay under current law.
Looked at another way, under current law, the investor would pay tax equal to 28 percent of the $34,000 profit. Under the Archer plan's combination of a rate cut and capital gains indexing, this investor would pay $3,600 in tax on this gain, an amount equal to only 10.6 percent of the $34,000 profit. This wealthy investor would pay a lower effective rate of tax on this profit than moderate-income families pay on their wages and on interest they receive on modest savings accounts.
The inclusion of capital gains indexing substantially increases the backloading of the tax cuts. Indexing would apply to the sale of assets held for at least three years after the starting date in 2001. As a result, indexing would begin to apply to taxes paid on assets sold in 2004; the capital gains indexing provision would result in no revenue losses before that time. The losses then would mount with each passing year after 2004. Assets purchased in 2001 and sold in 2004 would qualify for three years of indexing; assets purchased in 2001 and sold in 2011 would qualify for 10 years of indexing. The cost of indexing would rise for a number of years, during which time it would be shielding a steadily growing share of capital gains profits from taxation.
Delaying the start of indexing until 2001 also would generate a one-time increase in revenues in 2001 and 2002. Revenues would increase in these years because the indexing provisions in the Archer plan include an additional device. The additional device would accelerate the collection of a substantial amount of revenue that otherwise would be collected in future years into fiscal years 2001 and 2002 instead. The device works as follows.
Investors who own assets on January 1, 2001 would be allowed to qualify these assets for indexing from 2001 forward (that is, when they sold these assets in future years, they would be able to reduce the profit otherwise subject to taxation by the amount of inflation since January 1, 2001). Investors would qualify assets they already hold for indexing by paying capital gains taxes at the new, lower capital gains tax rate on the increase in the value of their assets from the time the assets were purchased until January 1, 2001. The bulk of these taxes would be paid in fiscal year 2002, when much of the capital gains tax for tax year 2001 is allocated. Most of these taxes would not constitute additional revenue collections for the Treasury; this device essentially accelerates the collection of revenues that otherwise would be paid in future years when the assets actually are sold.
Figure 2 shows the 10-year revenue loss caused by the capital gains provisions of the Archer plan. As the Figure shows, the capital gains tax cuts would produce a one-year revenue spike in 2002 but then began to lose substantial revenue, with the losses mounting as the years pass.
An indication of how large the future losses from indexing would be can be gleaned from the Joint Committee on Taxation's estimate of the cost of the capital gains indexing provision in the original "Contract with America." The Joint Committee estimated the cost of this indexing provision separately from the cost of other capital gains tax cut changes.(3) It found that the cost of indexing would triple between the first five years it was in effect and the second five years. In addition, the Joint Tax Committee estimated that the revenue loss from indexing would reach $9.2 billion in the tenth year it was in effect, with this loss still growing at that point.
Designing the capital gains indexing provision in this manner with a delayed effective date until January 1, 2001 and a three-year holding period allowed Rep. Archer to shoehorn both capital gains indexing and a large capital gains rate cut into his package, since indexing would not begin to lose money until the seventh year. And by raising revenue in 2001 and especially in 2002, the indexing proposal helps create room to fit other tax cuts fit within the $85 billion cost constraint for the first five years.
The Archer plan includes an increase from $600,000 to $1 million in the amount of an estate exempt from the estate tax. This increase in the amount of an estate exempt from the tax would be phased in over 10 years, reaching $1 million for people who die and leave estates in 2007 and subsequent years.
This slow phase-in results in an even greater degree of backloading than may initially be apparent. The revenue effects of an increase in the estate tax exemption are not felt fully until several years after such an increase takes effect. Probate and settlement of an estate generally must precede tax filing, and most estate tax returns for people who die in a given year are filed one to three years later. This fact, in combination with the Archer plan's slow phase-in of its estate tax cut, means that only a small fraction of the ultimate cost of the Archer estate tax cut is seen in 2002. Nor is the full annual cost seen in 2007. The revenue losses from this provision would not reach their full dimensions until several years after the end of the initial 10-year period.
Individual Retirement Accounts
The Individual Retirement Account provisions in the Archer plan are designed in an especially backloaded manner. These provisions create a new type of "backloaded" IRA, the main purpose of which is to keep the initial revenue losses small so that a generous IRA tax break may be squeezed within the budget limits.
Under current law, married filers with adjusted gross income exceeding $50,000 are not eligible to make deductible contributions to IRAs if they also have access to an employer-sponsored, tax-favored retirement savings plan. (Eligibility for IRA deductions was eliminated for these taxpayers in the 1986 Tax Reform Act as one of the base-broadening measures included in the Act in return for a substantial lowering of the top tax rate, then 50 percent.) The principal function of the Archer IRA tax break proposal is to restore the eligibility of these upper-middle and upper-income taxpayers for IRA tax preferences.
Restoring eligibility for a $2,000 IRA tax deduction would, however, be very expensive over the next 10 years. As a result, the IRA expansion in Rep. Archer's tax package would enable the taxpayers to use a new type of "backloaded" IRA, under which most of the revenue loss this tax break causes would be deferred until after the end of the 10-year budget period.(4)
Under a conventional IRA, depositors receive a deduction of up to $2,000 in the year they make a deposit into their IRA account. When they retire and withdraw funds from the account, the withdrawals are taxed as ordinary income. By contrast, under a backloaded IRA, deposits in the accounts would not be deductible. But interest earned on funds in the account would be permanently free of tax. And when depositors withdraw funds from the account after they retire, the withdrawals would be entirely tax free.
Backloaded IRAs involve very little near-term revenue loss since no tax deduction is provided when deposits are made into IRA accounts. But revenue losses mount over time as interest earned on a steadily increasing share of national savings is shielded from taxation.
The Archer IRA proposal also includes another major backloading device a "rollover" provision that further reduces the near-term revenue loss from the new IRA tax breaks and further enlarges the long-term loss. Under the rollover provision, taxpayers that now have funds in conventional IRAs would be allowed to transfer them during 1998 (i.e., to "roll them over") to backloaded IRAs on which all future interest earnings would be tax-free and from which all withdrawals upon retirement would be tax-free. At the time of the transfer, the funds moved from conventional to backloaded IRAs would be taxed as ordinary income, with the income averaged over the ensuing four years (1999 through 2002). This rollover feature is essentially another gimmick designed to reduce the near-term cost of an Archer tax cut by "borrowing from the future"; it would accelerate into the current budget period some billions of dollars in tax payments that otherwise would be made in future years when current IRA account-holders retire.
IRA proposals that combine the creation of backloaded IRAs with a rollover provision, as the Archer plan does, have especially severe backloading effects. In the first five years, the Archer IRA proposal causes virtually no revenue loss. (The loss is $33 million.) The Archer plan achieves this feat because no deductions are taken when deposits are made into backloaded IRAs and because the rollover provision accelerates billions of dollars in tax revenue that would have been collected in subsequent decades into the five-year budget window instead. But the revenue losses begin to mount after 2002 and continue climbing for many years thereafter, as the interest on a steadily increasing share of national savings is sheltered from taxation and as the effects are increasingly felt of having accelerated into the 1999-2002 period billions of dollars in taxes on IRA deposits that otherwise would have been collected in later years.
High-Income Tax Cuts Become Locked in for Future Years
Both the capital gains indexing and the backloaded IRA provisions are designed in a manner that makes it virtually impossible to repeal or modify them once they have been enacted and taken effect. The revenue losses for future years set in motion by these provisions consequently could never be stanched.
These provisions induce taxpayers to pay substantial taxes up-front to "buy in" to these large future tax benefits. Once taxpayers have entered into this deal and paid these upfront taxes, the government is bound to uphold its end of the bargain.
For capital gains indexing, the "buy in" is the gimmick that would allow assets currently held by investors to qualify for indexing. As noted, to qualify, taxpayers would pay taxes on the gain in the value of their assets between the date an asset was purchased and the date on which indexing would become effective, January 1, 2001. If taxpayers choose not to "buy in" to indexing, no taxes would be due until their assets actually were sold at some point in the future. Each taxpayer who chooses to use the buy-in would be making a financial judgement that the ability to index future capital gains on the sale of assets is worth more to him or her than continued deferral of taxes on the assets until they are sold. Once taxpayers have made that judgement, accepted the terms of the government's offer, and paid tax on the gain in the value of assets as of January 1, 2001, the government cannot renege on its part of the bargain. Indexing must remain in place.
Similar circumstances exist with respect to funds now held in conventional IRA accounts that would be rolled over into the new backloaded IRA accounts. Taxpayers choosing to roll over their funds would be doing so because the ability to earn tax-free interest in future years is worth more to them, given their personal financial circumstances, than the continued deferral of taxes on deposits in current IRA accounts. Once taxpayers trade their continued deferral by paying taxes now in exchange for future tax-free interest, the government must honor its side of the bargain. The interest cannot be taxed.
Both of these provisions also accelerate into the next five years billions of dollars in revenue that otherwise would be collected in future years. Capital gains taxes that would have been collected in future years when assets are sold are collected in fiscal year 2002, as taxpayers qualify their assets for indexing. In the IRA area, taxes on IRA deposits and earnings that would have been collected in future years when current IRA account-holders retire are collected over the next four years, as taxpayers roll over existing IRAs into the new backloaded accounts. Once these revenues are collected, they never can be collected again.
In short, key provisions of the Archer tax package borrow from the future to finance current tax cuts. Once the borrowing occurs, it cannot be undone.
Implications for Long-term Fiscal Health
The increasing costs over time of the backloaded tax reductions discussed in this analysis would aggravate the fiscal problems the nation faces when the baby boom generation retires. As reports from CBO, GAO, and other fiscal watchdogs have repeatedly emphasized, the nation will face daunting fiscal challenges in those years. The costs of Medicare, Medicaid and Social Security will swell as the number of elderly individuals mounts, and deficits will rise to dangerous levels. In addition, the ratio of workers to retirees will fall to a low level.
The budget agreement contains reductions in domestic spending, primarily in discretionary programs and Medicare. But because these and the other budget cuts ultimately enacted this year will have to pay for tax cuts that mushroom in cost at around the same time the baby boomers begin retiring, the progress the budget agreement makes toward addressing our long-term fiscal problems is much more modest than would otherwise be the case. Spending reductions used to finance burgeoning tax cuts are not available to help finance mounting retirement costs and control long-term deficits.
The tax cuts in the Archer plan may seem affordable in the short run. But they seem affordable because they borrow revenue from future years and pass costs to future generations. With the vanguard of the baby boom generation having already reached age 50, the nation can not afford to budget with this type of sleight-of-hand.
1. The increases in cost of the Archer tax cust are $2.7 billion from 2004 to 2005, $5.2 billion from 2005 to 2006, and $5.0 billion from 2006 to 2007. The average increase of $4.3 billion understates the extent to which the tax package is growing at the end of the initial 10-year period.
2. GDP growth is assumed to be 4.6 percent each year. This is the growth rate for the years 2006 and 2007 in the Congressional Budget Office's March 1997 baseline.
3. Joint Committee on Taxation, Estimated Revenue Effects of the Tax Provisions Contained in the "Contract with America," February 6, 1995. The indexing provision in the Contract would have allowed indexing for assets held at least one year.
4. Taxpayers already eligible for IRA tax deductions also would be eligible for the new, backloaded IRAs.