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Article Excerpt
INTRODUCTION
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) which are the focus of this paper, incorporated the main elements of the Bush Administration's tax proposals. (1) The principal feature of this legislation was the reduction in individual income tax rates, including lowering of the top statutory rate from 39.6 percent to 35 percent and adding a new ten percent bracket. Reducing marginal tax rates was intended to improve the economic incentives to work and invest and reduce the other economic distortions associated with high tax rates, as well as lower overall tax burdens and improve the prospects for economic growth. (2)
This paper focuses on the effects of the lower marginal tax rates. It begins with a brief overview of the law changes and some historical background. The rest of the paper presents new evidence on the taxable income response using a panel of individual income tax returns that spans the period in which EGTRRA and JGTRRA were enacted.
ENACTMENT OF EGTTRA AND JGTRRA
The key elements of then--Governor Bush's tax program were laid out in a policy speech in December 1999 (Bush, 1999). The primary goal was to improve economic incentives by reducing marginal tax rates. Another key theme and rationale for the tax reductions was that taxes had increased to the highest percentage of GDP during peacetime (i.e., since World War II). The previous five-rate income tax structure (15, 28, 31, 36 and 39.6 percent) was to be replaced with four lower rates (10, 15, 25 and 33 percent). The child credit was to be doubled from $500 to $1,000 and, to reduce the marriage penalty, the ten percent "second earner" deduction for two-income married couples was to be restored. (3) The estate tax (popularized as the "death" tax) was to be repealed. The annual contribution limits on Education Savings Accounts were to be increased substantially and expanded to include education down to the kindergarten level. A charitable deduction was to be provided for non-itemizers. Equity concerns were addressed by ensuring that taxpayers with the lowest incomes would receive the largest percentage reductions in income taxes. (4) Overall, half of the revenue cost of the income tax cuts was to be used for provisions primarily benefiting lower--and middle--income households: a new ten percent bracket on the first $12,000 of taxable income for married couples ($6,000 for other taxpayers) and the increased child credit. The level at which a four--person family would start to pay income taxes was to be increased to $35,000 (from about $28,000 in 1999). The maximum income tax rate was to be limited to 33 percent to promote entrepreneurship and ensure that no taxpayers would pay more than one--third of their income in income taxes.
In response to a similar set of proposals made once President Bush was elected in 2000, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001, which was signed into law on June 7, 2001, and included most of the Administration proposals with some modifications. (5) The new individual income tax rates were 10,15, 25, 33 and 35 percent and were to be gradually phased in by 2006. (6) The 35 percent top rate represented a modest compromise from the 33 percent proposed top rate and took the top rate roughly half way back from the 39.6 percent rate enacted in 1993 to the 31 percent top rate effective for 1991 (see Figure 1). (7) To provide marriage penalty relief, Congress increased the size of the 15 percent bracket and increased the basic standard deduction for joint returns to twice the amount for single returns. This was in lieu of restoring the second earner deduction. To address concerns about inadequate private saving and increase incentives for retirement saving, Congress added provisions that expanded the contribution limits for IRAs and other defined contribution plans, noting that the IRA contribution limits had not changed since 1981. Education provisions included increasing the annual contribution limits for (later re-named Coverdell) education savings accounts to $2,000, increasing the income limits for eligibility to contribute, expanding coverage to elementary and secondary education expenses, and allowing tax--free distributions from Section 529 plans. (8) To keep the total tax reductions within the amounts allocated for tax cuts in the budget resolution, Congress phased in most provisions over several years and provided that most provisions would expire after 2010. While the enacted legislation differed somewhat from the President's original proposals, it met the primary Administration goals of reducing marginal tax rates, reducing the overall level of taxes, and providing larger percentage reductions in taxes to families and lower income households.
[FIGURE 1 OMITTED]
In response to the perceived slow pace of economic recovery from the 2001 recession and concerns over a possible double--dip recession, on January 7, 2003, President Bush proposed an economic growth package that would accelerate the phase-ins of many of the provisions previously enacted, such as the marginal tax rate reductions, expansion of the child credit, marriage penalty relief, and increased expensing for small businesses. (9) In addition, the 2003 growth package included a new dividend tax proposal to eliminate the double taxation of corporate income, which was intended to increase business investment during the economic recovery and improve incentives for economic growth in the longer term.
The dividend tax proposal addressed a long-standing problem with the income tax system. Even after the reduction in the top individual tax rate, the effective total top tax rate on corporate income from a new equity-financed corporate investment could be quite high--up to 57.8 percent--considering Federal corporate and individual income taxes. (10,11) Such high tax rates tend to discourage investment in the corporate sector and lead to various economic distortions such as a bias toward excessive debt relative to equity finance. High tax rates on dividends also raise corporate governance issues because corporate executives face reduced pressure to justify retaining corporate earnings rather than paying dividends, which in turn would allow stockholders to choose where to invest those funds. (12) The dividend tax proposal would have exempted dividends that had been taxed at the corporate level from the individual income tax and eliminated the capital gains tax to the extent that capital gains represented retained earnings previously taxed at the corporate level. Under this proposal, investments in both corporate and non-corporate businesses would be taxed at a maximum rate of 35 percent.
By late May 2003, Congress had passed the Jobs and Growth Tax Relief Reconciliation Act of 2003, which accelerated the marginal tax rate reductions, marriage penalty relief and child credits retroactively to the beginning of 2003. The temporary first-year bonus depreciation enacted in the Job Creation and Worker Assistance Act of 2002 was increased from 30 percent to 50 percent and extended through the end of 2004. Instead of the Administration proposal to eliminate the double tax on corporate income, Congress lowered tax rates on long-term capital gains and dividends to five (zero percent starting in 2008) and 15 percent. (13) While not eliminating the double tax on corporate income, the total effective tax rate on corporate income was substantially reduced from 57.8 percent to 44.8 percent (0.35 + 0.15*(1 - 0.35)). A number of studies have documented the effects of this provision in reversing the long downward trend in the payment of dividends. (14) The new dividend and capital gains tax rates were temporary, however, and initially were scheduled to expire at the end of 2008. They were later extended through 2010.
The effect of EGTRRA and JGTRRA on marginal tax rates is shown in Table 1. The table shows the distribution of by marginal tax rate class for tax year 2000 law using 2000 data, and both 2000 and 2005 law using both 2000 and 2005 data. By 2005 nearly all provisions were fully phased in. The table shows that the number of taxpayers subject to effective Federal marginal tax rates of 40 percent or more decreased from nearly 1.8 million taxpayers in 2000 to only 427,000 in 2005. Without the reduction in marginal tax rates in EGTRRA and JGTRRA, the number of taxpayers subject to these high rates would have increased to 2.3 million taxpayers by 2005. The effects of the new ten percent bracket and the increase in child credits are also evident in the table, as the numbers of taxpayers with marginal tax rates under ten percent increased dramatically as did the number of taxpayers with no income tax liability.
The effects of EGTRRA and JGTRRA on effective income tax rates and the shares of individual income taxes paid by income class are shown in Table 2. Effective tax rates decreased in all income groups between 2000 and 2005. The effective tax rates decreased by three percentage points for taxpayers in the middle--income quintile and by 3.7 percentage points for taxpayers in the top one percent. While the income shares of those in the highest income classes increased slightly (from 20.9 to 21.2 percent...
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