180 Ap ril 23, 1982 A SURCHARGE THE WORST TAX INTRODUCTION Faced with a twelve-digit deficit and a budget impasse, the Reagan Administration has been considering a variety of measures designed to satisfy its critics is a punitive income tax surcharge for upper-i ncome Americans.

Proponents say that a tax surcharge is necessary to reduce the federal deficit and counter the liberal attempt to portray the Administration as favoring the rich. The proposal, however, is seriously flawed. The income tax surcharge is too small to reduce the deficit appreciably, yet large enough to. further depress economic activity, increase unemployment, and delay recovery most destructive and distortionary of all tax increases for it raises the marginal tax rates on the most productive g roups percent surcharge on incomes over 40,000, for example, would lift the top marginal tax rate from 50 percent to 52 percent and the 40 percent marginal rate currently applied to households earning over $40,000 would be raised to 41.6 percent percent o f the 10 percent tax rate reductions in 1982 would be rescinded for those affected by the surcharge. And for what benefit? No one thinks the $4-6 billion a year raised by a 4 percent surtax would lower interest rates or speed economic recovery. To the cont r ary, the tax rate reductions, especially for upper-income Americans, lay the foundation for recovery and should not be diluted at the last hour by a tax surcharge Among the worst being considered A tax surcharge on upper income Americans is potentially th e A 4 Fully 40 Ironically, while pressure builds for destructive tax in creases, federal deficit estimates are being scaled down consi derably. The five-month revenue figures for EY 1982 indicate that OMB may be overestimating the budget deficit by between $25 to $35 billion. Warren T. Brookes, a Boston-based economics 2 analyst for The Heritage Foundation, argues that, barring a real depression, the deficit could be in the $65 billion range instead of 100 billion as many now claim revenue growth of 4.6 per cent over 1981, but the actual revenue figures from October 1981 to February 1982 present a far different picture. Actual federal revenues are growing by 12.9 percent.

High level Treasury officials indicate that they are puzzled by the better-than-expected revenue figures guessing games and, as such, the deficit projections are never very reliable. But the current deficit projections have taken on a heightened importance since the apparent OMB deficit overstate ment has the effect, planned or otherwise, of stampeding Congress and even the President into accepting a tax hike contrary to his supply-side strategy 65 billion range, as Brookes estimates, pressure to raise taxes would accordingly be relieved tions, new taxes on income are not the solution, especi a lly in a recession saving as much, if not more, than government borrowing to finance the deficit. Raising taxes on the most productive members of our society in the name of stimulating economic recovery makes no economic sense a bonanza from the recent ta x rate reductions. For the most part, however, the tax cuts only keep rates from going higher.

The marginal rates even for upper income brackets will be essentially the same in 1983 as they were in 19

78. Without the Reagan tax cuts, marginal tax rates on middle and lower incomes would have been 30 to 40 percent higher. The tax rate reductions passed last year will at least offset the effects of inflation induced tax bracket creep expected over the next three years, but the high rates existing in 1978 wil l continue OMB has been predicting In actuality, economic predictions are always mainly educated If the deficits could be limited to the Even if the federal deficit is closer to OMB's higher predic Tax hikes depress private sector initiative and Many think that upper-income Americans 'are currently reaping The tax surcharge currently being proposed is a 4 percent increase in taxes for income brackets over $40,0

00. Taxes would first be computed in the regular fashion for income classes above the income cuto ff and then a given percentage, say 4 percent would be added on to the bill. For an upper-income family, the proposed 4 percent tax surcharge would wipe out 40 percent of the 10 percent tax rate reduction they were scheduled to receive in 19

82. When the final stage of the tax cut becomes effective in 1983, the surcharge will offset fully 20 percent of the rate reduction then in place. And finally in 1984, for those Americans subject to the surcharge, over 16 percent of the tax relief offered by Reagan in the initial tax reduction package will be erased by the tax surcharge A typical family affected by the surcharge will find in 1983 that the lion's share of their promised tax cut will be taken 3 away by the surcharge or by inflation the story A two-earner household making $50,000 a year in 1980 paid a marginal income tax rate of 43 percent tax rate is scheduled to drop to 40 percent in 1983 as a result of the Reagan tax bill. A 4 percent surcharge, however, will raise the family's tax liability in 1983 to 4 1.6 percent. As a result the tax surcharge will wipe out over 50 percent of the already small marginal tax reduction Simple arithmetic tells Their marginal One does not need to shed tears for families earning $40,000 or more a year to understand the devas t ating effects of higher marginal tax rates on the important saving and investing activity carried on by Americans in this tax braket. Two-thirds of all U.S. personal saving comes from the 5 percent of all income earners making more than $50,000 a year. At a time when the U.S needs more saving and investment, an additional tax increase on productive Americans will simply depress an already capital-starved private sector Table I Income Share & Saving Rate By Income Category 1978 Income Income Saving Category Share Rate 1978 I I Under $6,000 6,000-10,000 $10,000-16,000 $16,000-25,000 25,000-50,000 Over 50,000 8.4 11.4 17.8 26.5 26.8 9.1 65.0 10.0 2.8 11.0 19.5 35.0 Source: A. Gary Shilling Company, Inc THE LESSON OF THE 1968 TAX SURCHARGE In 1968, the last tim e an income tax surcharge was levied There is no reason to think a similar tax today would the tax revenue collected was largely offset by reductions in savings have a different economic impact.

Unfortunately, economic history is often forgotten or ignored . In 1968, Congress legislated a 10 percent tax surcharge much like the one currently recommended, on income taxes paid by individuals retroactively to April 1, 1968, and by corporations retroactively to January 1, 19

68. The Revenue and Expenditure Control Act of 1968 also reduced government spending in that year and established a ceiling on government spending for the fiscal 4 year 19

69. The,tax surcharge was explicitly recognized as tempo rary and was slated to expire in June 1969, although it later was extended for six months and then extended another six months at a reduced rate of 5 percent.

Arthur Okun, then a member of Lyndon Johnson's Council of Economic Advisors, justified the tax surcharge as a means to reduce inflation and the high level of aggregate demand passed the surcharge in June 1968 to reduce the budget deficit then climbing to o ver 10 billion surcharge are instructive for policymakers today considering a similar policy, not this time to reduce consumption expenditures and inflation but rather to lower interest ratess by reducing the budget deficit Congress The results of that ta x As Table I1 indicates, tax revenues increased $11 billion between the second quarter and third quarter of 1968 in response to the tax increase. And by FY 1969, the federal budget enjoyed a $5.2 billion surplus, up sharply from the $12.3 billion budget de ficit the previous year tax surcharges can reduce deficits, and, if large enough and applied to a sufficiently large number of income tax brackets may even raise enough revenues to eliminate sizable budget aeficits.

But over this same period, personal savi ng sharply declined by $9 billion, offsetting almost 80 percent of the revenues raised by the tax surcharge. The personal saving rate declined by 7.6 percent of personal income in the second quarter of 1968 to a low of 5.3 percent in the second quarter of 19

69. Hence Lesson Two for policymakers considering a tax surcharge: A tax surcharge may help balance the federal budget, but only at the cost of a substantial reduction in saving. In short, a tax surcharge may reduce the federal demand for credit to fin ance the deficit, but only at the expense of the pool of savings. From the lessons of 1968, it seems certain that an income tax hike will not reduce interest rates or relieve pressure on the capital markets The first lesson of the 1968 surcharge Table I1 B illions of dollars at annual rates The Effects of the 1968 Tax Surcharge'on Consumption and Saving 19681 I I 19681 I I I Change Personal Income 68 1 699 18 11 104 93 Less: Taxes, etc Equals: Personal Less: Consumption disposable income Equals: Personal sa v ing 588 543 45 595 7 16 559 36 -9 Source: Survey of Current Business, 1973 Supplement 5 The Saving Rate in Response to the 1968 Tax Surcharge 1967 1968 1969 1970 I I1 I11 IV I I1 I11 IV 7.3 7.2 7.6 6.0 6.2 5.3 5.3 6.6 6.8 7.9 Source: W. L. Springer Did th e 1968 Surcharge Really Work American Economic Review, September 1975 At the same.time that taxes were being raised by President Johnson, the Federal Reserve was pursuing an expansionary monetary policy. Many are,demanding that Reagan follow a similar cour s e today. According to Senator Roger Jepsen (R-Iowa), the loose money-higher tax policy of 1968-1969 failed to reduce interest rates,. keep inflation low, or encourage economic expansion. To wit, soon after the tax surcharge was imposed 1 Interest rates ro s e. By December 1968, interest rates were generally higher than they were in June higher in 1969 5.3 percent in the first half of 1968 and 5.5 percent in June. It averaged 5.9 percent in December 1968, 6.5 percent in June 1969 and 7.7 percent in December 1 9 69 rates also increased by a similar amount They moved still The three-month Treasury bill rate average Other interest 2. llInflation accelerated. The CPI rose 3.0 percent in 1967 I I 4.7 percent in 1968, and 6.1 percent in 1969 3. l'Economic growth slowe d . Real growth of the gros's national product declined from-5.1 percent in the four quarters ending in June 1968 (and an annual rate of.6.4 percent in the first half of 1968) to an annual rate of 3.5 percent in the second half of 1968 and 2.4 percent per y ear in the first half of 1969 1969 I A recession began in the second half of There is no apparent reason why a combination of a tax surcharge and monetary expansion would produce a different economic outcome today.

TAX CUTS: WELFARE FOR RICH?

Some justify an,income tax surcharge by saying that the Reagan tax cuts disproportionately benefit the rich economic report conclusively shows that proportional tax cuts like the ones enacted last year, far from being "welfare for the rich," actually shift the tax bu r den toward the wealthy. Accord ing to a recent article in Economic Review by economists James Gwartney and Richard Stroup, proportional tax rate reductions for all income brackets provide the greatest incentives to persons in upper-income brackets to expa n d their taxable income by shifting A new 6 their resources from tax-sheltered investments and consumption into productive activities generating tax revenue reducing marginal tax rates both in 1964 and in the 19201s, the economists point out, has been to s h ift the tax burden toward higher income groups means of "soaking the rich" is to lower their taxes, in ess.ence, coaxing rich Americans to engage in taxable economic activity rather than non-taxable consumption. After the 1964 tax reduc tions, for example , the number of tax returns reporting an adjust ed gross income of $50,000 or more grew rapidly, reaching 272,000 by 1966; previously these high-income returns ranged only between individuals bore proportionately more of the total tax burden of the country after they received a tax cut than before The effect of Gwartney and Stroup present potent evidence that the best 125,000 to 162,0

00. As Table I11 indicates, these upper-income Table I11 The Share of Tax Revenue Collected from Various Percentile Grouping s Ranked According to Adjusted Gross Income Prior to and Subsequent to the 1964 Reduction in Tax Rates Percentile of All Returns Tax Revenue Collected Percent of Ranked from Lowest to from Group Personal Income Taxes Highest Income in billions of 1963 dol l ars Collected from Group Percent 1963 1965 Change 1963 1965 Bottom 50 percent 5.01 4.55 -9.2 10.4 9.5 50 to 75 percentile 10.02 9.61 -4.1 20.8 20.0 Total $48.20 $48.06 -0.3 100.0 100.0 I 75 to 95 percentile 16.00 15.41 -3.7 33.2 32.1 I Top 5 percent 17.17 18.49 +7.7 35.6 38.5 i I qhese estimates were derived via interpolation. I Source Internal Revenue Service Statistics of Income Individual Income Tax Returns (1963 and 1965 Before the tax cut, the top 5 percent of income earners bore 35.6 percent of the t o tal tax burden, but in 1965 those in the highest tax brackets paid the larger proportion of 38.5 percent of income taxes. Conversely, the bottom 50 percent of income earners contributed proportionately less of total income taxes after the tax cut: a drop from 10.4 percent in 1963 to 9.5 percent in 19

65. Tax revenues collected from these upper income groups expanded rapidly. Before the 1964 tax cut, real revenue collected from returns with income above $50,000 rose at an annual rate of 6.1. percent. After the tax cut, Gwartney and Stroup discovered "tax revenues collected from these taxpayers grew at an annual rate of 14.1 percent. Even though the average 7 and more importantly the marginal) tax rate of taxpayers with incomes of $50,000 or more decline, th e constant dollar growth rate of revenues collected in this category rose substantially.Il In contrast to tax reductions, Gwartney and Stroup discovered that proportional tax hikes tend to reduce the reported gross income of upper-income taxpayers, lower t h e proportional contribu tion of upper-income Americans to total tax revenue,l and shift the tax burden to lower-income classes. In response to the 1932 tax hike, for example, the net income reported to the IRS fell by 4.7 percent in the first year of the t ax increase decline in reported income occurred with incomes above $300,000 In constant dollars, reported net income from this class fell 49.1 percent in a single year. In response to the tax hike, all income classes paid more income taxes to the governme nt. However the growth of tax revenues was,more modest for higher tax brackets.

Income categories less than $25,000 increased their tax contribu tion from 21 to 36.5 percent while the proportional income contri bution of individuals making over $300,000 ac tually declined from a 23.5 percent share of total revenues to 18.4 percent. Other high income brackets shifted a portion of the total tax burden to lower-income brackets The largest In short, Gwartney and Stroup conclude that criticism of tax rate reduct i ons for upper as well as other income classes is misplaced Far from shifting the tax burden toward the poor the Reagan program will shift the tax burden toward the rich A tax surcharge on upper-income Americans on the other hand, would have the opposite e f fect; that is, increase the tax burden on the lower-income classes, just as it did,in the 1932 tax hike CONCLUSION It would be ironic if a tax surcharge'is levied to soak the rich, only to find, as in the 1932 tax increase, that the rich withdraw their mo n ey from investment and shift it to tax-exempt bonds or consumption expenditures leaving those who cannot afford such options to toil in the marketplace under a proportion the tax surcharge is enacted, the incentive structure will be twisted to encourage t h e rich to take a trip to Monte Carlo or buy a bauble rather than invest in taxable activities that will earn them too small an after-tax return I ally heavier tax load than before the tax increase. And yet, if I I I Many assumed that Reagan was committed t o'reforming the tax system so that the incentives ceased being biased in favor of non-productive activities. Whether the deficits are 65 billion or $100 billion, it makes no sense to drive a class of productive taxpayers into hiding just as they are retur n ing to the marketplace after sitting it out for so many years But the deficit still remains, as we are constantly reminded many times by those who supported extravagant spending measures a in the past and,continue now to resist spending cuts be done with t he surging red ink? The Administration should reassert its commitment to cutting the budget, especially the rapidly-expanding entitlement programs, as the only means of reducing the current budget deficits. National public opinion polls still indicate bro ad support for further budget cuts.

A tax increase will simply give government officials more money for yet higher levels of spending reducing the federal budget is to deny the government further revenues What is to The most effective means of Ronald Reaga n was not elected to raise taxes; he was elected to reduce the burden of government on our daily lives.

An income tax surcharge on upper-income Americans would signal a disappoint ing retreat from that goal some ilenhancementll of revenues, the worst mean s of doing so would be the income tax surcharge And if political expediency demands Thomas M. Humbert Walker Fellow in Economics