CIAO DATE: 8/01

A Tax Phantom Is Stalking You

Kevin A. Hassett

On The Issues

October 2000

American Enterprise Institute for Public Policy Research

Although inflation can no longer push Americans into higher income tax brackets, real economic growth still can—and does.

If you were an unscrupulous tax-and-spend politician, you would be frustrated by the unpopularity of tax hikes. It puts you in a bind: Most of the money that comes in each year is already targeted for old programs. So how are you going to find money to pay for your own pet projects?

Wouldn't it be great if you could conjure up a Tax Phantom? The Tax Phantom could take money away from people in the dark of night. He would be so stealthy that nobody would see him come or go. Many citizens wouldn't even miss the money, and the extra revenue could be divided up among all your friends in Congress. With luck, there would be so much to go around that everyone could be reelected.

Guess what? There is a Tax Phantom. Our tax system is set up so that every year in which the economy grows, taxes are raised automatically on millions of people. Real growth is just about a sure thing in America: Since 1959, there have been only five years of economic contraction. And so tax hikes are a sure thing as well.

I'm not describing the "bracket creep" you've heard about before, in which inflation—the watering-down of our money by politicians—unjustly pushes folks into higher tax brackets. That cheap trick has been ended by law.

So how does this other tax scam work? The class-warfare specialists in the Democratic Party have given us a highly "progressive" tax structure. This means that as you earn additional income, the tax rate you pay (not just the amount, but the actual rate) goes up as well. Now when the economy grows, the incomes of ordinary Americans grow too. But our tax brackets are only indexed to factor out inflation, not real growth. As a result, almost every year a large number of Americans are pushed into higher tax brackets and get hit with an automatic marginal tax rate hike.

 

Real Bracket Creep

The following table reveals that this "real bracket creep" is a very big deal. From 1993 to 1997, the most recent years for which we have enough data to make the necessary calculations, the percentage of people in the 28 percent tax bracket increased by 7.3 percent. The increases are even sharper in the higher tax brackets, with the number of taxpayers in the top 39.6 percent percent bracket posting a whopping 55.5 percent increase over just those four years.

Mid-1990s Bracket Creep . . .
Tax bracket	Proportion of returns falling in each bracket
	1993	1997
15 percent	64.3%	60.6%
28 percent	30.1	32.3
31 percent	3.2	3.8
36 percent	1.5	2.1
39.6 percent	0.9	1.4

Economists know that higher tax rates lead to all sorts of economic inefficiencies. Yet our tax code introduces steep rate increases each year, automatically. The next table shows just how much these rate hikes will shove tax returns into higher brackets by the year 2010, assuming that 1993—1997 income growth patterns continue. For comparison, I include the 1993 distribution of returns.

The numbers are shocking. In 1993, barely over a third of all taxpayers faced a marginal tax rate higher than 15 percent. By 2010, if nothing changes, well more than half will. Approximately 20 million tax returns will experience a rate hike!

. . . Accumulates into Big Tax Increases
Tax bracket	Proportion of returns falling in each bracket		Percent Change
	1993	2010 (projected)
15 percent	64.3%	46.6%	-28%
28 percent	30.1	34.4	+14
31 percent	3.2	11.0	+244
36 percent	1.5	5.9	+293
39.6 percent	0.9	2.1	+133

When you're shoved into a higher tax bracket, your bill goes up. With 20 million Americans jumping brackets, that means a big chunk of the budget surpluses our politicians are racing to spend is attributable to unlegislated rate increases. How much?

There are two piles of revenue created by real bracket creep. The first comes from people who actually edge into higher brackets. If you are right at the top of the 15 percent bracket, for example, and have your income grow at the same real rate as GDP, then a chunk of your income ends up in the 28 percent bracket. If the 15 percent bracket had been expanded along with your income, you would pay fifteen cents tax for each new dollar, but since the bracket was not expanded, you instead pay twenty-eight cents on every dollar. The difference, thirteen cents, is the new revenue from the tax hike. This pile of money amounts to about $200 billion over the next ten years.

The second pile is much, much bigger. Suppose you are Bill Gates, camped out in the top tax bracket for all time. If we move the limit on the 15 percent bracket higher to keep up with economic growth, it will affect even your tax bill. Why? Because the brackets apply to everybody. Bill Gates's first $41,000 is taxed at a 15 percent rate. If we fight real bracket creep by increasing the top of the 15 percent bracket to, say, $42,000 this year, then even Bill Gates would get a small tax cut on the $1,000 that previously was taxed at the higher rate. This pile of money amounts to about $1.1 trillion over the next ten years.

Putting the two effects together, one can say Americans will pay about $1.3 trillion extra over the next ten years because their income tax system is not indexed for real growth. To put that number in perspective, it's about the same size as the revenue reduction from Governor Bush's proposed tax reduction. His across-the-board 30 percent cut is just enough to offset tax hikes that are already in motion!

With luck, the Bush tax cut will become law. And when it does, Congress should be sure to index tax brackets for real economic growth in the future. That way, tax hikes will happen only if politicians muster the political support for them, and the Tax Phantom will be out of business.

 

Kevin A. Hassett is a resident scholar at the American Enterprise Institute. This article appeared in the October/November issue of AEI's magazine, The American Enterprise.