Congress appears headed toward a tax bill containing less than $100 billion in tax cuts over five years. The passage by the House in early June of a budget resolution that would return $101 billion in tax revenue to Americans, which followed the Senate's vote to return only $30 billion, sets the stage for one of the most disappointing tax "cut" bills in recent history.

This is discouraging because rarely has there been a better opportunity, or clearer need, to return tax revenues to America's families. Consider:

• Tax revenues are far above the projections made in last year's budget. The Congressional Budget Office (CBO) estimates that the government will take in $340 billion more revenue between fiscal year 1999 and fiscal year 2003 than it forecast as recently as January 1997.²

• Federal revenues are expected to consume nearly 21 percent of economic output in 1998, a peacetime record.³

• Since Bill Clinton became President in 1993, the tax burden as a proportion of output has risen by nearly two percentage points, equivalent to $157 billion in extra taxes this year. Just reducing taxes to their level at the time President Clinton took office would mean the average family of four would receive more than $1,930 in annual tax relief this year.⁴

• The House-passed tax cut resolution of $101 billion over five years pales in comparison to a tax cut of $1.3 trillion--in terms of today's dollars and gross domestic product (GDP)--proposed by House Democrats in 1981 as an alternative to the Reagan tax cut.

TOTAL SAVINGS FROM THE TAX PORTION OF THE HERITAGE PLAN = $314.48 billion over five years. Even after this tax cut (which excludes Social Security reform), the federal budget not only remains in balance, but runs a surplus of $30.4 billion over five years.

Full implementation of the Heritage tax plan would produce the following economic benefits:

• The total indebtedness of the government would decline. The "present value" of government obligations is projected to decline by over $15.5 trillion between 1999 and 2075 under the Heritage plan.⁶ The long-term unfunded Social Security liability is reduced by approximately $21 billion. Changes in the major components of on-budget spending and revenues account for the remaining decline in government indebtedness.

• Personal savings would increase nearly $1 trillion. Diverting five percentage points of the payroll tax to private investment accounts nearly doubles the personal savings rate between FY 1998 and the end of FY 2003 to 8.9 percent. In fact, the total amount of personal savings rises by $1.1 trillion over this five-year period.

• There would be an average of 451,000 more jobs per year. Repealing the marriage penalty, federal death taxes, and the rollover prohibitions of cafeteria plans, as well as reducing the capital gains tax and creating education IRAs, reduces the taxes on labor income an average 5.8 percent per year from FY 1999 to FY 2003. Lowering the tax costs a worker faces leads some people to find employment and others to increase their hours. The WEFA model forecasts an increase of 552,000 jobs in FY 2001.

 

• The cost of capital would fall by an average of 5 percent per year. The Heritage tax plan encourages more investment in equipment and factories by reducing the taxes on capital. These lower capital costs stem from repealing the death taxes, which directly tax capital assets, and cutting the capital gains tax rate by 50 percent. The lower capital costs lead to a 24.1 percent increase in investment over five years, which contributes to an increase in worker productivity.

• The economic well-being of succeeding generations would grow dramatically. The Heritage tax plan focuses on building wealth in all households. Low- and moderate-income households benefit substantially from the hundreds of billions in new savings that Social Security privatization creates. Not only will these new savings provide for comfortable retirement in the future, but they also will be used as nest eggs for the children of current savers. For the first time, Social Security payroll taxes will provide the means for passing wealth to the next generation, who in turn will start their working lives with more money for education, health care, and housing than their parents had. Accompanying this significant public policy change with repeal of the federal death taxes assures that the new wealth of American families will be protected from the rapacious tax appetite of the federal government.

THE HERITAGE TAX CUT PLAN

Congress can craft a tax cut plan that delivers significant tax relief to millions of Americans without undermining the integrity of each individual measure. To be sure, this is not the perfect tax cut plan; but given the range of tax proposals that may be possible in this Congress, if tax writers keep in mind a few simple principles, they can craft tax cuts that would benefit families and the U.S. economy:

• Taxpayers must see an immediate benefit from this year's budget agreement. The tax cuts should not be phased in over the next five years in order to reduce their "cost" to the Treasury. Taxpayers should not have to wait until after the turn of the century to see the benefits of this relief.

• The tax package must be a step toward good, long-term tax policy. It should not make the current system more complex and thus undermine the future potential for tax reform. To the extent tax cuts can be implemented, lawmakers should insist that the changes lower marginal tax rates, reduce double taxation, and simplify the tax code.

• The tax cuts must be broad-based and benefit the greatest number of Americans possible. Lawmakers should avoid means-testing or other devices that exclude some families to the benefit of others. Moreover, they should not create special or targeted tax breaks that benefit a select group of individuals or industries at the expense of others.

• The tax cuts must promote good, long-term economic effects. Tax cuts for education, for example, should promote long-term savings rather than subsidize college fees or encourage more family debt. Subsidizing college fees and debt will boost higher education costs; long-term savings will control higher education costs.

Features of the plan include the following:

1. Empowering Families to Save: Create Private Savings Accounts.⁷

The Social Security system faces two severe crises. First, it faces a funding crisis: The system simply cannot pay promised benefits to future retirees without major changes in the program. Beginning in 2032, if Congress and the Administration do not make changes, it will not be possible to pay full benefits.

In addition, the system will be burdened with the huge costs of the aging baby boomers. If we consider the workers and retirees currently in the Social Security system, the "present value" of the unfunded liability, measured by the amount (in today's dollars) of extra money beyond payroll taxes that would be needed today to pay benefits, would be as much as $9 trillion to $12 trillion.⁸ That liability does not appear on the government's books--it is not figured into the official national debt--but, like the national debt, it is money that future taxpayers will have to pay.

Second, Social Security is a terrible way for most Americans to save for their retirement. Although the system currently provides reasonably good benefits for the disabled and the dependents of deceased workers, most workers face their own Social Security crisis because the program typically is a very poor way to save for retirement. Indeed, the retirement income generated from Social Security contributions generally is far below the amount these same contributions would generate in the safest private investments or even in U.S. Treasury bills.

For example, Social Security's inflation-adjusted rate of return is only 1.2 percent for a typical average household of two 30-year-old earners with children, in which each parent makes just under $26,000.⁹ Such couples will pay a total of about $320,000 in Social Security taxes over their lifetime (including employer payments) and can expect to receive benefits of about $450,000 (in 1997 dollars, before applicable taxes, after retiring at age 67, the retirement age when they are eligible for full Social Security Old-Age benefits).

Had this average household placed that same amount of lifetime employee and employer tax contributions into conservative tax-deferred IRA-type investments--such as a mutual fund composed of 50 percent U.S. government Treasury bills and 50 percent equities--they could expect a real rate of return of over 5 percent per year prior to the payment of taxes after retirement. In this latter case, the total amount of income accumulated by retirement would equal approximately $975,000 (in 1997 dollars, before applicable taxes).

Social Security needs to be reformed to deal with these twin crises. The reform should do two things: help secure the ability of the system to deliver on its promises to beneficiaries, and enable today's workers to look forward to more income in retirement.

The Heritage Proposal. The Heritage tax plan would achieve both of these goals by allowing--not requiring--workers to place a portion of their payroll taxes now devoted to retirement income (but not disability or other insurance elements) into a private savings account instead.

Workers who exercised this choice would exchange income from their Private Savings Accounts for the Social Security retirement benefits associated with the portion of their taxes they placed in a private account. They would, however, receive the Social Security benefits financed by the rest of their payroll taxes.¹⁰ The insurance elements of Social Security, such as disability and benefits for the dependents of workers who die before retirement, would not be affected, and all Americans, whether or not they opened a private savings account with a portion of their payroll taxes, would be entitled to a minimum benefit from traditional Social Security.

Specifically, every worker would be permitted to divert five percentage points of his or her Social Security payroll tax into a private retirement savings account that met certain federal requirements. General federal revenues would be used to make up the resultant shortfall in trust fund receipts. The reduction in Social Security benefits would be based on the number of years during which the individual elected to place a part of his or her payroll tax in a private account.

While this proposal involves a significant "cost" to the Treasury from the perspective of the annual unified budget accounts, it leads to a reduction in the long-term unfunded liability of the Social Security trust fund. Taken together, the total liabilities of the federal government that will have to be paid by future taxpayers (specifically, the national debt plus the unfunded liabilities of Social Security) would be sharply cut.

Meanwhile, workers could look forward to a higher income during retirement, thanks to the better returns likely to flow from private accounts.¹¹

2. Eliminating the Second Earner Bias: Repeal the Marriage Penalty.¹²

In the government's attempt to tax equal-earning couples at the same rate, to incorporate progressive marginal rates, and to enforce marriage neutrality, the federal tax system unintentionally penalizes millions of American families. As the Congressional Budget Office has stated, "The incompatibility of those three goals...results in continuing tension within the tax code."¹³

This tension in the tax code harms the pocketbooks of Americans and the institution of marriage, and has significant implications for the economic and cultural health of our nation. Throughout the tax code, joint filers are repeatedly disadvantaged: Married couples are forced to pay more than they would pay on aggregate as single filers, benefits are consistently lower for married couples in comparison to single individuals, and secondary earners receive lower levels of Social Security benefits than they would have realized had they remained single.

The marriage penalty is arguably the most significant of the secondary earner biases. In short, "the basic source of the marriage tax is the fact that key elements of the tax law depend on an individual's family situation, including the rate schedule, the standard deduction, and the earned income tax credit. Hence, the act of getting married per se affects individuals' tax liabilities, even if their work and saving decisions stay the same."¹⁴

 

 

 

 

 

 

 

 

 

 

 

In most cases, federal income tax laws require that married couples file joint tax returns based on the combined income of husband and wife. When a husband and wife both work, the secondary earner (that person with the lower income) in effect is taxed at the top rate of the primary earner, taxed at the margin. As a consequence, a married couple may pay more taxes than they would if each spouse were taxed as a single.

Unfortunately for the American taxpayer, the federal government has grown dependent on the marriage penalty. The millions of dollars in excess revenues that the government reaps at the expense of married couples has led many to argue preposterously that any significant change in the tax system is impossible because of the potential cost. These revenues do not belong in Washington in the first place, and they must be returned to the taxpayer.

According to the Congressional Budget Office, an estimated 42 percent of married couples incurred marriage penalties in 1996; "more than 21 million married couples paid an average of nearly $1400 in additional taxes in 1996 because they must file jointly."¹⁵ Most severely affected by these marriage penalties were couples with a more equal division of income between husband and wife and those who receive Earned Income Tax Credit (EITC) benefits. Essentially, Americans with the lowest incomes and those families dependent upon two wage earners are the biggest casualties of our current tax policy.

Consider what happens to two $30,000 wage earners who decide to wed. As a single individual, a $30,000 wage earner would pay $3,457.50. The principle of marriage neutrality means that when a $30,000 wage earner marries another $30,000 wage earner, the new tax liability should be $6,915. Under joint filing, however, this married couple, who now earn a combined total of $60,000, are now taxed $7,795 per year; there is, in other words, an $880 penalty for marriage.

According to the ideal of marriage neutrality, tax burdens should not be altered when two people decide to marry. However, the goal of progressive taxation is violated under such circumstances. Progressivity states that a person (or, under today's joint filing, a combination thereof) who has twice the income of another pays more than twice the taxes. The tax system has sided with the ideal of progressive taxation and punished hard-working Americans.

The second earner bias, and the marriage penalty specifically, can have significantly negative economic implications for the country as a whole. Not only do these faults of the tax system stand as an obstacle to marriage, but they can discourage husbands or wives from entering the work force. "By adding together husband and wife under the rate schedule, tax laws both encourage families to identify a primary and secondary worker, and then place an extra burden on the secondary worker because her wages come on top of the primary earner's. The secondary earner is on the margin."¹⁶

As the family realizes lower income levels, the nation realizes lower economic output. From a strictly economic standpoint, for potential workers to avoid the labor force as a result of peculiarities within the tax code is a clear sign of failure to maximize eligible resources. As a result, the nation as a whole fails to reach its potential, demonstrated by decreased earnings, output, and international competitiveness.

The Heritage Proposal. Families with married parents should not be penalized by federal tax policy. The Heritage proposal permits married taxpayers to choose the tax filing status that gives them the lowest tax on the income they earn individually.

This option is available widely in the states: 10 states allow married couples to file separately when paying state income tax; an additional 21 states have rate schedules that reduce or eliminate the marriage penalty.¹⁷

In nearly half of all married households, such taxpayers will find that filing as single taxpayers will result in lower taxes. Common income (such as interest on a savings account or dividends) would be apportioned between the two taxpayers according to the percentage of total income that each earned from their jobs.

The standard deduction or the itemized deductions would be treated in a similar fashion. These married taxpayers would recombine their income when determining whether or not they are eligible for tax credits.

The Marriage Penalty: Struggling Middle-Income Couples Are Hit Hard. Take, for example, a family in which the husband, Paul, earns $60,000 annually. Paul's first $16,000 of income goes untaxed under the modern-style married tax rate schedule; earnings from $16,001-$42,350 are taxed at a 15 percent rate; and earnings from $42,351-$102,300 are taxed at a 28 percent rate. With two young children, Paul's wife Sara seriously considers joining the labor force. Unfortunately for Sara and her family, because of the secondary earner bias, her first dollar of income will be taxed immediately at a 28 percent rate. Even if Sara accepts a job that pays only $30,000-half of what her husband makes-she will end up paying $8,400 in taxes, just below her husband's burden of $11,290. With increased child care costs and work expenses, what appeared to have increased the family's income to $90,000 now looks like a wash. With reference to women in Sara's situation, the Congressional Budget Office has said, "The higher initial tax rate she faces when married reduces the value of her work and thus may induce her to work fewer hours each week, fewer weeks each year, or even not to work at all."1 Inherently, Sara's decision to work less or avoid the workforce entirely affects both her family and the national economy. The CBO went on to say that "generally higher tax rates for lower-earning spouses prompt them to work between 4 percent and 7 percent less than they would if they could file individually. Overall, requiring couples to file joint tax returns induces them to work less. As a result, their total earnings are between 0.7 percent and 1.2 percent less than they would otherwise be."2 1. CBO, For Better or For Worse, p. 10. 2. Ibid., p. 12.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In other words, those taxpayers who would benefit from a 50 percent cut in the capital gains tax rates are likely to be in the middle class.

Just as lawmakers should shun the "tax cuts for the rich" argument, they should reject the counsel of those tax economists who suggest that lowering the effective tax rate on capital will not result in a significant change in capital gains declarations. History suggests otherwise.

Experience with changes in capital gains tax rates over the past 25 years indicates strongly that rate decreases (or exclusions) produce more declarations of capital gains, and thus more capital gains taxes. Owners of appreciated assets who face high tax rates generally hold on to their assets in anticipation of lower future rates. When rates come down, the amount of capital gains taxes goes up. In fact, it appears that last year's reduction in the capital gains tax rate has produced a huge windfall of federal tax revenue.

Economists estimate that trillions of dollars in unrealized capital gains (perhaps as much as $7.5 trillion) exist in the portfolios of American taxpayers.¹⁹ Some economists have estimated that significant capital gains rate changes could produce substantial economic benefits and create revenue windfalls for federal and state governments.

In a 1994 article for the American Economic Review, Leonard Burman and William Randolph, two leading tax economists on the staff of the Congressional Budget Office, estimated the response of taxpayers to rate reductions as being on the order of 1 to 6 in the short term. This means that for every 1 percent drop in the rate (or the equivalent in exclusions), capital gains realizations would rise by 6 percent.²⁰

A 50 percent reduction in the capital gains tax rate, therefore, has the potential of raising declarations by 300 percent. It is from this increase in declarations that the federal government receives capital gains revenues above what it would have received without the 50 percent tax cut.

The Heritage proposal. Congress should cut the tax rates on long-term capital gains from 20 percent to 10 percent, and from 10 percent to 5 percent for lower income tax margins, and repeal the complex "holding" rules enacted last year.

Congress reduced the top capital gains tax rate from 28 percent to 20 percent in the Taxpayer's Relief Act of 1997, which resulted in significant increases in federal revenues as investors sold appreciated assets that the higher tax rate had "locked up." However, at the same time that Congress boosted tax collections and lowered the cost of capital by cutting the top capital gains tax rate, it also passed accounting and tax rules that increased taxpayers costs of complying with capital gain tax law.

The new "holding period" rules are so complex that even the IRS had great difficulty determining how to design the tax form (Schedule D) that taxpayers use when declaring their capital gains; not until late February of 1998 did the IRS issue this important schedule for the 1997 tax year.

By cutting the tax rate by 50 percent, Congress will add new revenues as more taxpayers "unlock" more of their appreciated assets. And by repealing the complex holding period rules, Congress will reduce the cost taxpayers currently face when complying with tax law. Both reforms lead to a fairer, simpler, and flatter tax code.

4. Providing Health Choices for Americans: Allow Workers to Roll Over Flexible Spending Accounts.²¹

Members of Congress have the opportunity to put Americans more in charge of their own health care decisions and to make health insurance and medical services more accessible, more accountable, and more affordable for working families. That opportunity lies in making a slight revision in Section 125 of the Internal Revenue Code, which governs flexible spending accounts (FSAs) and "cafeteria" plans.

These tax-free accounts allow workers to save for unexpected costs of medical services or benefits not covered by their employer-provided health insurance packages. Today, both employers and employees can contribute to FSAs, and the money in these accounts can be used to pay for out-of-pocket medical expenses or for the co-payments and deductibles of their employer-provided packages.

Under the "use-it-or-lose-it rule," however, employees who do not use all of the pre-tax money they set aside each year for medical needs must lose any excess money in the accounts at the end of that year. From the standpoint of cost control, this policy is counterproductive since it creates an incentive for working families to expend all the funds in their FSAs, even if the medical services they purchase are only marginally desirable or beneficial, rather than lose the money entirely.

The Heritage Proposal. Congress could easily correct this flaw by modifying Section 125 to allow workers to roll over up to $500 of unused FSA funds, year after year, tax-free. The immediate results of such a change would be an increase in the direct purchasing of medical services from doctors and other providers, a change in the dynamics of the current insurance market, and an increase in personal savings for future health care spending or retirement.²²

As more funds are saved through such rollover FSAs or cafeteria plans and are available for retirees' health care coverage, the future demands on Medicare would decline. The change in revenue to the federal Treasury in the meantime, based on Heritage Foundation calculations, would amount only to an average revenue decrease of $482 million per year, or $2.1 billion over five years.

Revising Section 125 of the Internal Revenue Code would result in immediate benefits for a significant portion of the American work force. According to the Bureau of Labor Statistics, as of 1994, 21.7 million private-sector employees chose to take advantage of employee-provided FSAs--14.8 million employed in medium to large establishments and 6.9 million in small establishments. In addition, 50 percent of state and local government employees had FSAs.²³

Today, FSAs and cafeteria plans are gaining popularity in the marketplace. They have been proven to meet the needs of a diversified pool of workers. If FSA funds can be rolled over tax-free, they will become a great boon, stimulating employee savings and enhancing employee security.

5. Helping Families Afford a Total Quality Education: Expand Education Savings Accounts.²⁴

Last year, as part of the Taxpayer's Relief Act of 1997, Congress and the President established education IRAs as a new way for American families to save for their children's college education. As a result of the new law, families with an annual income of less than $110,000 are able to set aside up to $500 in after-tax earnings each year for future college expenses. This money can then be withdrawn to pay for qualified higher education expenses without any further taxes being paid.

With the exception of the income cap on eligible families, education IRAs are sound tax policy (the accounts eliminate the double taxation on savings) and sound education policy (they also encourage savings for college rather than debt).

The rising cost of higher education is one of the major concerns facing American families today. Over the past 18 years, the cost of a college education has increased some 221 percent, while the general rate of inflation and the average household income have increased only about 80 percent.

Furthermore, the cost of college is uncertain, making it difficult for families to anticipate just how much they must put aside or how much debt they or their children will have to incur to pay for a college education. Both the uncertainty and the generally high cost of a college education should be matters of concern to Congress and the President.

The Heritage Proposal. Congress should expand the scope of education savings accounts to cover not only higher education expenses, but also primary and secondary education costs.

Senator Paul Coverdell (R-GA), Senator Robert Torricelli (D-NJ), and House Speaker Newt Gingrich (R-GA) proposed such a sensible approach earlier in the 105th Congress. The measure (H.R. 2646), as passed by both the House of Representatives and the Senate, would expand education IRAs to cover primary and secondary education expenses and would increase the annual contribution limit to $2,000 per student.

Ideally, both the annual contribution limit and income cap should be eliminated. In the end, all families should have the ability to save all that is necessary to secure a quality education for their children from kindergarten through graduate school.

Moreover, the coverage of tax-free education savings should be expanded to include new and innovative education investment plans. Numerous states and several private interests, for example, have established prepaid tuition plans. These programs allow families to lock in future college tuition at or below today's tuition rates.

Such prepaid tuition plans are attractive to families because they guarantee a predetermined amount of future education. Thus, prepaid tuition plans not only help families save for college, but also eliminate the uncertainty of ever-increasing college tuition costs. All of these plans, both public and private, as well as other innovative education investment options, deserve the full support of Congress and the President.

6. Helping Family Businesses and Farms: Repeal the Death Tax.²⁵

Death taxes place burdens on those groups in society that current tax policy intends most to help: minority and female business people; farmers; the self-employed; and (indirectly but no less significantly) blue-collar workers, especially those just starting their working careers.

The estate tax hurts small businesses. Investing in a business is one of the many forms of saving--for some families, the only form. For most small firms, every available dollar goes into the family business--the dry cleaning business, the restaurant, the trucking company--because the business creates an asset for the children and income for the owners. Women re-entering the work force after raising children often find self-employment the only employment open to them. Minorities also rely heavily on self-employment.

All of the financial security provided by these businesses is put at risk if the owner dies with a taxable estate. In an important 1995 study of how minority businesses perceive the estate tax,²⁶ Joseph Astrachan and Craig Aronoff found that:

• Some 90 percent of the surveyed minority businesses knew that they might be subject to the federal estate tax;

• About 67 percent of these businesses had taken steps (including gifts of stock, ownership restructuring, life insurance purchases, and buy/sell agreements) to shelter their assets from taxation;

• Over 50 percent of these same businesses indicated that they would not have taken these steps had there been no estate tax; and

• Some 58 percent of all businesses in the survey anticipated failure or great difficulty surviving after determining their estate taxes.

Death taxes are, in a real sense, more "affordable" as income rises. In other words, what appears to be a progressive tax contains a regressive dimension.

Students of the estate tax are continually struck by the frequency with which taxpayers are insufficiently prepared to pay the tax, and nearly as frequently by the correspondence between those unprepared and those who have not had the benefit of high-priced legal and accounting advice. Indeed, legal avoidance of high death-tax liabilities is closely related to the fees taxpayers can pay throughout their lives for expensive tax-planning advice. Taxpayers who cannot pay these tax-planning fees end up paying high estate taxes.

Not only do death taxes reduce potential employment and undermine the promise that hard, honest work will be rewarded, but they also reward consumption and undermine saving. What can be said generally about income taxes can be emphatically affirmed about death taxes: Accumulation of even modest wealth will lead to heavy taxes, while consumption of income results in relatively light taxation.

In other words, it makes tax-planning sense to buy vacations in Aspen or a painting by Rubens rather than invest in new productive equipment and new factories.

Federal death taxes are probably the most expensive taxes to pay and to collect. Death taxes raise just a bit more than 1 percent of total federal revenues, but they are amazingly expensive for the taxpayer and the tax collector.

Christopher Erblich places total compliance costs (including economic disincentives) at 65 cents for every dollar collected. Other studies that subtract disincentives and examine only direct outlays by taxpayers to comply with estate tax law put compliance costs at about 31 cents.²⁷ This additional cost of compliance means that the $20 billion collected in federal death taxes last year actually cost taxpayers $26 billion.

The Heritage Proposal. Congress should repeal the death tax. The economic effects of the disincentive to savings and investment are quite striking, especially in light of the relatively small amounts of federal revenue raised by federal death taxes.

An analysis by The Heritage Foundation, using the WEFA Group's U.S. Macroeconomic Model, found that repealing the estate tax would have a large and beneficial effect on the economy.²⁸ Specifically, the Heritage analysis found that if the tax were repealed this year, over the next nine years:

• The nation's economy would average as much as $11 billion per year in extra output;

• An average of 145,000 additional new jobs could be created;

• Personal income could rise by an average of $8 billion per year above current projections; and

• The deficit actually would decline, since revenues generated by extra growth would more than compensate for the meager revenues currently raised by the inefficient estate tax.

Richard Fullenbaum and Mariana McNeill recently confirmed these results in an important study for the Research Institute for Small and Emerging Business.²⁹ In a simulation of estate tax repeal using the WEFA U.S. Macroeconomic Model, they found that private investment would rise by an average of $11 billion over the seven years following repeal. Consumption expenditures would rise by an average of $17 billion (after inflation), and an average of 153,000 new jobs would be created in this more buoyant economy.³⁰

7. Helping Families Care for Their Children: Create a Parental Care Preschooler Tax Credit.³¹

During the baby-boom era, when most of today's parents were born, the federal government had a deliberately low-tax policy which was friendly to families and children. But that family-friendly policy has long since disappeared.

In 1950, the typical family of four paid about 5 percent of its income in taxes to the federal government. Today, that same family would pay roughly 23 percent of its income in direct federal taxes. Adding state, local, and indirect taxes raises the tax bite typically to about 37 percent. This means that in the average two-earner married-couple family, the mother works not to raise her family's standard of living, but primarily to pay for the enormous tax increases imposed by decades of government spending.

Studies show that many parents would prefer to work less and spend more time with their children. But with today's record peacetime levels of taxation, many mothers feel compelled to enter the work force.

Working mothers with young children, particularly preschool children, commonly pay for some child-care services. Combined with the impact of the marriage penalty, this means that a mother can work full-time and yet add only a few dollars to the family's net monthly income. If, on the other hand, the mother stays at home to care for her children, leaving the husband as the only earner, the family does not receive the dependent care tax relief available to mothers who work outside the home.

President Clinton proposes to "solve" this problem with new subsidies for day care. The Clinton proposal targets over $20 billion of the projected budget surplus on one kind of service: the care of children outside of the family environment and away from parents. In addition to providing tax relief to middle-class parents who use day care, Clinton is proposing billions in new government day-care spending through such programs as the Child Care and Child Development Block Grant and Head Start. Two-thirds of the funds under the Clinton plan is allocated to new government spending, not tax reduction.

Thus under Clinton's plan, middle-class parents who hire others to care for their children will receive some help for their day-care costs, but parents who make a great financial sacrifice so that one parent can remain at home to care for their young children will receive neither assistance nor tax relief. Indeed, families who care for their own children will be taxed to pay for day care used by typically more affluent families.

To deal with the burden of excessive taxes on families with children, Congress should provide tax relief to parents, not new spending directed to day-care centers. In providing that tax relief, Congress should allow parents to decide how best to care for their children; it should aim to expand rather than narrow their options.

Furthermore, Congress should treat all working families with preschool children equally. Under no circumstances should it discriminate against families who make a financial sacrifice so that one parent can remain at home (either full-time or part-time). Nor should paid professional day care be favored over the unpaid care given by the children's grandparents.

Congress took a small step last year toward rolling back the punitive taxation of families with children by enacting a tax credit for children under the age of 18. The credit will be worth $400 per child in 1998 and $500 in each subsequent year. Congress should build on this foundation by providing additional badly needed tax relief to working families with preschool children.

The Heritage Proposal. Current law provides a cumbersome and complex system of tax relief for second-earner mothers working outside the home who use child care services. Under the Heritage proposal, this Dependent Care Tax Credit would be replaced with a new $500 tax credit per preschool child. This would be in addition to the credit enacted last year, and the credit would not be refundable.

In other words, the total credit available would be limited to the amount that otherwise would be paid by the family in income tax--it could not be claimed against Social Security payroll taxes and would be calculated after the Earned Income Tax Credit had been computed.

The Heritage analysis using the WEFA model indicates that a balanced package of tax cuts to help families and encourage investment will result in a stronger, more vigorous general economy over the five-year period between FY 1999 and FY 2003 (see Appendix B). This analysis suggests that the Heritage tax cut plan would:

• Increase real GDP. The Heritage tax plan increases the real gross domestic product by $50.2 billion in FY 2003. Despite this increase in economic growth, inflation, as measured by the Consumer Price Index, remains a low 2.7 percent. The model also indicates that the increases in output are due in part to real growth in productivity. The rate of growth in productivity increases 0.3 percentage points in FY 1999 and 0.1 percentage points in FY 2001, which is a significant expansion for an economy currently operating at near-capacity levels.

• Increase average household income over $2,280. The Heritage tax plan produces $248.7 billion in additional, inflation-adjusted disposable income for households in FY 2003--equal to $2,288 in higher income for the average American household. Almost 92 percent of this increase flows directly into Private Savings Accounts.

• Increase household saving and investment. Personal saving increases by $229.2 billion and inflation-adjusted investment rises by $18.1 billion in FY 2003. This private-sector saving and investment will improve the productive capacity of the U.S. economy and the standard of living for future generations.

• Spur job creation. Repealing the marriage penalty and death taxes and reducing the capital gains tax rewards work and promotes economic growth. The Heritage tax plan produces an average of 451,000 more jobs per year over the five-year period. In fact, in FY 2001, the simulation shows that the private sector produces 552,000 more jobs. The average unemployment rate is lower under the Heritage plan than in the baseline economy.

• Produce economic "feedback." Using mostly "static" estimates that take only limited account of the tax cut's influence on the economy's performance, the Heritage tax plan would reduce revenues to the federal Treasury by $313.6 billion over five years (excluding Social Security reform). The more "dynamic" analysis using the WEFA model, however, suggests that because the tax cut plan promotes stronger economic growth, the expanding tax base feeds new tax revenues back into the federal Treasury. These new tax revenues replace or "feed back" 23.3 percent of the expected revenues lost to the Treasury under a static analysis.

 

 

 

 

In other words, when the tax cut plan's effect on economic performance is accounted for, the actual "cost" of the plan to the Treasury is only 76.7 percent of the purely static reduction in tax revenues over five years. This revenue feedback, when combined with the tax plan's impact on federal spending and the effect of slightly lower Old-Age and Survivors Disability Insurance (OASDI) benefit payments, increases the overall feedback effect on the federal deficit to 38.3 percent over five years.

Endnotes