February 1, 2001

Something had to be wrong with the claim that taxes are higher relative to income than at any time in the past forty years. Nevertheless, federal tax payments have been growing by double digits per year in the past half decade even as the economy has been growing only half as rapidly.

Government spending has been growing slightly less than the growth of the economy (which should surprise many economists, who believe that demand for government goods rises faster than the economy.) Indeed, the surplus is caused by the rapid growth of tax payments relative to spending.

But many taxes are indexed for inflation. Forty years ago, when President Kennedy worried about "fiscal drag", rising inflation pushed taxpayers into higher brackets. As a result, government collections rose faster than the economy. The "drag" was what happened to consumer spending when these tax increases reduced the paychecks of taxpayers, slowing the economy.

In the 1980s, most taxes were indexed for inflation. As a result, inflation generated "drag" is nowhere near as significant as it was in Kennedy's era.

To be sure, some adjustments for inflation are not complete. Estate taxes tend to become a significantly higher burden to heirs because the unified tax credit that provides a threshold before taxes are levied is not adjusted for inflation. This is one of the reasons why a phase in of larger unified credits is now occurring. Nevertheless, when the higher tax credit phase in is completed, inflation will again erode the amount of real purchasing power that heirs can hold without paying taxes.

A more serious omission is the brackets used to determine the alternative minimum tax. As inflation increases, the number of people shoved into the alternative minimum tax also increases. By the end of this decade, an estimated 20 percent of all households may be paying the alternative tax rather than the more generous normal tax schedule.

Even after considering these oversights on inflation adjustment (ones that could be fixed by a comprehensive tax reform, if the administration is willing to back away from its campaign proposal and do something that really is needed), tax yields should not be increasing as rapidly as they are.

Although economists are not totally sure why so many taxes are being paid, the more rapid growth of corporate taxable income relative to personal taxable income accounts for some of the gains. Higher capital gains taxes from rapidly appreciating taxable transactions for assets accounts for much of the remaining surge in tax collections.

The reasons for higher corporate earnings and higher capital gains tax collections are not hard to find. Higher collections are the result of much higher economic gains from capital (and better returns for capital's owners). As long as capital remains efficient, these higher tax collections will continue.

Indeed, the Congressional Budget Office and the Federal Reserve believe that capital will continue to provide substantial economic gains in the future. Economic history suggests that this belief eventually will be wrong. Even the most fundamental technological innovations eventually exhaust their best uses. Then, productivity gains slow. As a result, tax collections also will grow more slowly when that occurs.

To be sure, no one knows when that slowing in the growth of capital efficiency will occur. The Federal Reserve believes that tax yields will remain abnormally high for a long time to come. Therefore, the surpluses will continue and the government debt eventually will be paid off. It was this prospect that led Federal Reserve Chairman Alan Greenspan to assert that some cuts in tax revenues would be economically prudent.

(The existence of long term government surpluses is not sufficient to defend tax cuts. Private investing and savings must also be considered. If household savings remain low, then government savings may need to remain high to finance a continued boom in capital spending. Why Greenspan did not say anything about this question in his testimony remains troubling to me.)

My own feeling is that the surge in capital efficiency is beginning to subside. The "low hanging fruit" already has been harvested. If this is true, then tax yields will begin falling in the next few years. Certainly, there remains room for some tax reductions, especially if they will fix the inflation indexing flaws that remain in the tax codes.

I still believe that tax reform is more important than tax cuts. A massive ten year tax cut almost certainly will eliminate political prospects for meaningful tax reform in this new decade.

However, I am also concerned that tax yield may be falling just as tax rates are declining. If so, that much vaunted surplus may be much less than Chairman Greenspan currently thinks.

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