OPTIONS TO CUT TAXES

June 2000
NOTES

Unless otherwise indicated, all years referred to in this report are fiscal years.

Numbers in the text and tables may not add up to totals because of rounding.
This memorandum, which first appeared as Chapter 2 in the Congressional Budget Office's

(CBO's) March 2000 Budget Options volume, examines a range of major proposals that have

been prominent in the public debate over cutting federal taxes. After an overview of the

current federal tax system and discussion of three criteria for assessing tax changes, the

memorandum considers specific proposals to reduce revenues under each of four basic

approaches: broad-based tax cuts that affect most taxpayers, tax cuts aimed at reducing

particular disincentives in the current tax system, tax cuts designed to simplify the tax system

or improve compliance, and tax cuts that provide new incentives for particular types of

behavior.

Roberton Williams, G. Thomas Woodward, and Richard Kasten of CBO's Tax Analysis

Division wrote the memorandum. Barry B. Anderson, Arlene Holen, and Steve Lieberman,

all of CBO, provided helpful comments.

Sherry Snyder edited the memorandum, and Christine Bogusz proofread it. Kathryn

Quattrone prepared it for publication, and Laurie Brown prepared the electronic versions for

CBO's World Wide Web site (www.cbo.gov).

Contents

THE FEDERAL TAX SYSTEM 1

The Individual Income Tax 1

Social Insurance Taxes 3

Other Federal Taxes 4

CRITERIA FOR ASSESSING TAX CHANGES 6

Efficiency 6

Fairness 6

Complexity and Costs 7

WAYS TO REDUCE REVENUES 7

Making Broad-Based Tax Cuts 8

Reducing Particular Disincentives of the Tax System 9

Simplifying the Tax System 12

Expanding or Adding to Current Incentives 13
vi CONTENTS June 2000

TABLES

1. CBO Projections of Revenues 2

2. Effective Tax Rates and Shares of Tax Liability, 

by Income Quintile and Source of Revenue, 1995 3

FIGURES

1. Total Revenues as a Share of GDP 1

2. Revenues, by Source, as a Share of GDP 4
1940 1950 1960 1970 1980 1990 2000 2010

5

10

15

20

25

Percentage of GDP

Actual Proj.

Options to Cut Taxes

F

ederal tax revenues will claim a postwar record

20.3 percent of gross domestic product (GDP)

in fiscal year 2000 (see Figure 1). The Congressional Budget Office (CBO) projects that revenues

measured as a share of GDP will decline over the next

few years to 19.8 percent, a level that is still higher

than in any year before 1998 other than the last two

years of World War II. In light of that situation, the

Congress may want to use some of the projected surplus to cut taxes. If so, it will face two issues: how

much to reduce revenues and how to accomplish that

reduction. Choosing among alternative approaches

requires understanding the current structure of the federal tax system as well as the criteria that may prove

useful in evaluating any tax change.

Figure 1.

Total Revenues as a Share of GDP

(By fiscal year)

SOURCE: Congressional Budget Office.

The Federal Tax System

The federal tax system will raise nearly $2 trillion in

fiscal year 2000 (see Table 1). Over 90 percent of

that revenue will come from income and social insurance taxes. Individual income taxes are the largest

source, accounting for nearly half of the total. Social

insurance taxes, levied primarily to support Social

Security and Medicare, make up another third. The

remainder splits roughly evenly between the corporate

income tax and a variety of smaller revenue sources

including excise taxes, the estate and gift tax, customs

duties, and miscellaneous levies.

The Individual Income Tax

Americans are most familiar with the individual income tax and its recurring April 15 deadline. Although it has many complexities, the basic structure of

the tax is straightforward: add up income from various sources; subtract exclusions, standard or itemized

deductions, and personal exemptions to determine taxable income; apply graduated tax rates to assess basic

tax liability; and subtract various credits to calculate

final liability. The tax falls most heavily on people at

the top of the income distribution: those in the highest

quintile—the fifth of families with the highest income—pay over three-fourths of the total revenue

from the individual income tax (see Table 2). By contrast, families in the bottom three-fifths of the income

distribution pay just 7 percent of the tax, and because

of the earned income tax credit (EITC), the lowest

quintile as a group actually receives a net payment. 
2 OPTIONS TO CUT TAXES June 2000

That distribution reflects two developments in the

1990s. First, tax acts in 1990 and 1993 added three

new tax brackets to the 15 percent and 28 percent

brackets set in the Tax Reform Act of 1986 (TRA86). The new brackets—with rates of 31 percent, 36

percent, and 39.6 percent—sharply increased the taxes

paid by high-income families. At the same time, the

income of families facing the higher rates rose much

more rapidly over the decade than did overall income,

making a markedly larger share of total income subject to the higher rates. Finally, the earned income tax

credit was greatly expanded in the early 1990s. Those

changes combined to boost the share of individual income tax liability in the top quintile from 72 percent in

1991 to 77 percent just four years later. The changes

were also an important cause of revenues from the tax

growing from 7.7 percent of GDP in 1992 to 9.9 percent in 2000 (see Figure 2).

The rate structure of the individual income tax

makes it the most progressive of the major sources of

revenue; that is, the tax measured as a share of income—the effective tax rate—rises most sharply as

income increases. In 1995, families in the lowest income quintile faced a negative effective tax rate, -5.6

percent, compared with 6.1 percent for the middle

quintile and 16.2 percent for the highest quintile.

Table 1.

CBO Projections of Revenues (By fiscal year)

Source of Revenue

Actual

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

In Billions of Dollars

Individual Income 879 945 986 1,026 1,068 1,112 1,162 1,217 1,275 1,339 1,407 1,480

Corporate Income 185 189 189 187 190 194 200 208 216 225 233 242

Social Insurance 612 653 684 714 742 770 808 842 878 913 954 998

Excise 70 68 71 73 75 77 79 81 84 86 89 91

Estate and Gift 28 30 32 33 35 36 37 38 40 42 45 48

Customs Duties 18 19 20 22 23 25 26 27 28 29 30 31

Miscellaneous 35 40 36 41 44 49 50 52 51 53 55 57

Total 1,827 1,945 2,016 2,096 2,177 2,263 2,361 2,465 2,572 2,686 2,813 2,946

On-budget 1,383 1,465 1,515 1,571 1,630 1,693 1,764 1,843 1,923 2,010 2,106 2,208

Off-budgeta 444 480 502 525 547 570 597 623 649 676 707 738

As a Percentage of GDP

Individual Income 9.6 9.9 9.8 9.8 9.7 9.7 9.7 9.8 9.8 9.9 9.9 10.0

Corporate Income 2.0 2.0 1.9 1.8 1.7 1.7 1.7 1.7 1.7 1.7 1.6 1.6

Social Insurance 6.7 6.8 6.8 6.8 6.8 6.7 6.8 6.8 6.8 6.7 6.7 6.7

Excise 0.8 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.6 0.6 0.6 0.6

Estate and Gift 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3

Customs Duties 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2

Miscellaneous 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4

Total 20.0 20.3 20.1 20.0 19.9 19.8 19.8 19.8 19.8 19.8 19.8 19.8

On-budget 15.2 15.3 15.1 15.0 14.9 14.8 14.8 14.8 14.8 14.8 14.8 14.9

Off-budgeta 4.9 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0

SOURCE: Congressional Budget Office.

a. Social Security.
June 2000 OPTIONS TO CUT TAXES 3

Social Insurance Taxes

Social insurance taxes claim just under 7 percent of

GDP each year, primarily in support of Social Security and Medicare. The taxes, which are often referred

to as payroll taxes, principally comprise several separate levies. The tax that finances Social Security

equals 6.2 percent of wage, salary, and self-employment income up to a taxable maximum ($76,200 in

2000) paid by both employer and employee. Thus, the

total Social Security tax is 12.4 percent of earnings up

to the maximum. The Medicare tax has no cap and

equals 1.45 percent of earnings, again paid by both

employer and employee to yield a total tax of 2.9 percent. Economists generally agree that the entire payroll tax is actually paid by workers because their

wages are lower by the employer’s share of the tax.

Smaller taxes finance unemployment benefits and retirement benefits for railroad and government workers.

Table 2.

Effective Tax Rates and Shares of Tax Liability, by Income Quintile and Source of Revenue, 1995

Pretax Family Income Quintile

Source of Revenue Lowest Second Middle Fourth Highest All Families

Effective Tax Rate (As a percentage of pretax income)

Individual Income -5.6 1.8 6.1 8.7 16.2 11.3

Corporate Income 0.5 1.0 1.3 1.5 4.9 3.2

Social Insurance 7.8 9.9 10.7 11.2 7.9 9.2

Excise 3.3 2.0 1.5 1.2 0.7 1.1

Total 6.0 14.6 19.7 22.5 29.6 24.7

Share of Tax Liability (In percent)

Individual Income -2 1 8 16 77 100

Corporate Income 1 3 6 10 81 100

Social Insurance 3 10 16 26 46 100

Excise 10 15 19 22 32 100

Total 1 5 11 19 64 100

Pretax Family Income

Average (Dollars) 8,100 20,100 33,300 49,600 120,000 45,700

Share (Percent) 3 9 14 21 53 100

SOURCE: Congressional Budget Office.

NOTES: Families are groups of individuals living together. Individuals not living with relatives are included as one-person families.

Individual income taxes are distributed directly to families paying those taxes. Corporate income taxes are distributed to families according

to their share of capital income. Social insurance (payroll) taxes are distributed to families paying those taxes directly, or indirectly through

their employers. Federal excise taxes are distributed to families according to their consumption of the taxed good or service.

Pretax family income is the sum of wages, salaries, self-employment income, rents, taxable and nontaxable interest, dividends, realized

capital gains, and all cash transfer payments. Income also includes the corporate income tax and the employer's share of Social Security

and federal unemployment insurance payroll taxes. For purposes of ranking by adjusted family income, income for each family is divided by

the poverty threshold for a family of that size. Quintiles contain equal numbers of people. Families with zero or negative income are

excluded from the lowest income category but are included in the total.
4 OPTIONS TO CUT TAXES June 2000

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

0

2

4

6

8

10

12

Percentage of GDP

Actual Projected

Individual Income Taxes

Social Insurance Taxes

Corporate Income Taxes

Excise Taxes

From 1960 to 1988, payroll taxes climbed

sharply as a share of GDP, rising from 3 percent to

nearly 7 percent. The share of payroll taxes is roughly

7 percent today and will remain at about that level under current law. For most families, the payroll tax

now exceeds their income tax. Nearly three-fourths of

families who pay either tax face a combined employer/

employee payroll tax that is greater than their income

tax liability.

The cap on earnings subject to the Social Security tax and the fact that income other than earnings is

not taxed combine to impose somewhat higher payroll

taxes, measured as a percentage of income, on middleincome families than on those at the top or bottom of

the income distribution. In 1995, families in the lowest income quintile incurred payroll taxes equal, on

average, to 7.8 percent of their income, compared with

10.7 percent for families in the middle quintile and 7.9

percent for those in the top quintile.

Other Federal Taxes

One-sixth of federal tax revenues come from various

sources, none of which yield as much as one-tenth of

the total.

The Corporate Income Tax. After falling from 3.6

percent of GDP in 1962 to just over 1 percent in the

early 1980s, the corporate income tax has rebounded

somewhat to claim roughly 2 percent of GDP this

year. The recent rise resulted primarily from TRA-86

and from generally higher corporate profits in the

1990s. CBO projects that that percentage will decline

slightly over the next decade. The tax currently provides just under one-tenth of total federal revenues,

but that share is expected to fall over time. Although

the tax has four rates, the first two (15 percent and 25

percent) apply only to corporate income below

$75,000; the higher two (34 percent and 35 percent)

differ only slightly. At least 80 percent of corporate

income is taxed at the highest rate.

Regardless of how they are levied, taxes are paid

by individuals, not by corporations. Various theories

have been advanced to explain how the burden of the

corporate income tax might be borne by workers, owners of corporate capital, or owners of capital generally. Most economists now agree that all or nearly all

of the tax falls on the owners of capital, both corporate and noncorporate. Since the nation’s capital

stock is owned primarily by people at the upper end of

the income distribution, the tax falls most heavily on

Figure 2.

Revenues, by Source, as a Share of GDP (By fiscal year)

SOURCE: Congressional Budget Office.
June 2000 OPTIONS TO CUT TAXES 5

the wealthy and is therefore progressive. In 1995,

families in the top income quintile effectively paid corporate income taxes equal to about 4.9 percent of their

income, compared with 1.3 percent for families in the

middle quintile and 0.5 percent for those in the lowest

quintile.

Excise Taxes. Excise taxes, which are levied on such

goods and services as gasoline, alcohol, tobacco, and

telephone use, represent a small and declining share of

total federal revenues. Most of those taxes are levied

on the quantity rather than the value of goods, and

rates have generally not kept pace with inflation. In

the early 1960s, excise taxes were just over 2 percent

of GDP; this year, they will be only about one-third as

large, or 0.7 percent. 

Because consumption claims a smaller share of

income as income rises, effective excise tax rates are

higher for families at the lower end of the income distribution than for those at the top. Families in the lowest income quintile faced an average effective rate of

3.3 percent in 1995, compared with 0.7 percent for

families in the top quintile.

Estate and Gift Taxes. The estate and gift tax combines the taxation of assets given away during a person’s life and bequests made at death. The tax applies

only to large estates and gifts. Under current law, estates valued at less than $675,000 are exempt from

taxation, but those valued at more than $675,000 are

taxed at rates ranging from 37 percent to 55 percent.1

Annual gifts in excess of $10,000 per recipient are

subject to similar levies. The $675,000 exclusion,

which applies to the lifetime sum of taxable gifts and

bequests, is scheduled to increase incrementally to $1

million by 2006 and remain at that level. By contrast,

the $10,000 annual limit on gifts will increase to keep

pace with inflation since 1997, but only in $1,000 increments.

Revenues from the estate and gift tax have grown

rapidly in recent years, nearly tripling from $11 billion

in 1991 to a projected $32 billion in 2001. Even so,

the tax is relatively small. CBO projects that revenues

from that tax will claim only 0.3 percent of GDP over

the next decade. Furthermore, the tax affects few taxpayers: less than 2 percent of estates (just over

100,000 in 1998) incur any tax liability. Gift tax returns, which may be filed annually and may or may

not involve tax liability, are more numerous (about

260,000 in 1998), but they represent less than 0.5 percent of all taxpayers.2

Assessing the distributional impact of the estate

and gift tax is difficult. Measured with respect to the

well-being of decedents and gift-givers, the tax is

clearly highly progressive; only the largest estates and

gifts pay any tax. Some economists argue, however,

that it is more appropriate to assign the burden of the

tax to beneficiaries. Unfortunately, research yields

incomplete and conflicting findings about the distributional impact of the tax from that perspective.

Customs Duties and Miscellaneous Receipts. The

final pieces of federal collections are customs duties

and miscellaneous receipts. Customs duties grow over

time in tandem with imports and claim about 0.2 percent of GDP. Tariff reductions enacted in 1994 will

continue to phase in over the next few years and constrain any growth in revenues from that source.

The largest component of miscellaneous receipts

is the profits of the Federal Reserve System, which are

turned over to the Treasury and counted as revenues.

The other major source of receipts is the Universal

Service Fund, collected from the telecommunications

industry to finance Internet service for libraries and

schools and to subsidize basic telephone service for

high-cost areas and low-income households. Those

two and other, smaller components of receipts equal

about 0.4 percent of GDP, a level that is projected to

remain fairly constant over the next decade.

1. Rates actually range from 18 percent to 60 percent. However, rates

below 37 percent apply only to that part of an estate below the

$675,000 exemption and are therefore irrelevant. The 60 percent rate

applies to that part of an estate valued between $10 million and about

$17 million in order to phase out the benefits of the graduated estate

tax brackets.

2. The Taxpayer Relief Act of 1997 gave taxpayers an incentive to file

gift tax returns, even if gifts were below the $10,000 limit. Under the

act, the Internal Revenue Service (IRS) may not question the information on those returns after three years. If no return is filed, the IRS

may audit gifts when an estate tax return is filed upon the taxpayer’s

death.
6 OPTIONS TO CUT TAXES June 2000

Criteria for Assessing 

Tax Changes

Any examination of potential tax changes requires a

set of criteria by which to evaluate the effects on individuals and the economy as a whole. Economists focus their evaluation of taxes on three characteristics: 

o Efficiency—the impact of the tax on economic

activity and growth,

o The fairness of the tax with respect to who bears

its burden, and

o The costs of complying with and collecting the

tax.

Those three criteria are often in conflict, however, and

the Congress faces inevitable trade-offs in its decisions

on tax policy.

Efficiency

Taxes change behavior. Consumers buy less of taxed

goods and more of untaxed goods. People decide

whether and how much to work on the basis of their

after-tax wages and thus may choose to work less

when income taxes are higher. Firms pick production

methods on the basis of input costs after taxes—using

less machinery, for example—in the face of higher

taxes on capital. And individuals make decisions

about saving on the basis of after-tax returns. All of

those responses distort the economy from the way it

would be in the absence of taxes and may lead to

slower economic growth and thus a lower level of national well-being. Typical estimates of the economic

cost of a dollar of tax revenue range from 20 cents to

60 cents over and above the revenue raised.3

Those negative effects do not mean, however,

that taxes have only negative effects. Some taxes may

induce behavior consistent with other policy goals;

cigarette taxes lead to a reduction in smoking and its

associated costs, and emission taxes cause firms to

shift to production methods that pollute less. Furthermore, the government needs revenues to carry out its

various functions. Nevertheless, economists agree that

taxes should distort behavior as little as possible, consistent with other objectives. In general, that means

not levying taxes that affect some activities more than

others. Economists generally refer to minimizing distortions as maximizing efficiency. 

Fairness

Unfortunately, maximizing efficiency can mean imposing taxes that many people feel are unfair. The

most efficient tax from an economist’s viewpoint is a

head tax—a specific levy on every individual, regardless of his or her well-being. Because liability under

such a tax does not depend at all on behavior, the only

distortion comes from the revenue collection itself.

However, few people would argue that the U.S. government should pay its bills by charging every citizen

$7,000 (the total of gross government expenditures

divided by the total number of citizens). Most would

view such a head tax as inherently unfair. Rather than

focusing only on maximizing efficiency, the country

faces trade-offs between doing what is best for the

economy and what is fair.

Economists have developed various ways of assessing fairness. Horizontal equity occurs when people in equivalent economic positions have the same tax

liability; that is, equals are treated equally. The major

difficulty in interpreting that metric comes in defining

“equals.” Much of the complexity of the individual

income tax derives from the various adjustments to

income, such as personal exemptions and itemized deductions, that are intended to yield a measure of taxable income defining “equals.” Any such measure,

however, is open to interpretation and debate.

Vertical equity occurs when tax liabilities rise

with ability to pay, often interpreted as having more

income. Progressivity measures that characteristic. A

tax is progressive when it claims a greater percentage

of income as income increases—higher-income families pay a larger share of their income in taxes than do

those with lower income. The reverse situation is la- 3. Charles L. Ballard and Don Fullerton, “Distortionary Taxes and the

Provision of Public Goods,” Journal of Economic Perspectives, vol.

6, no. 3 (Summer 1992), pp. 117-131.
June 2000 OPTIONS TO CUT TAXES 7

beled regressive; the tax is a larger share of income

for those at the bottom of the income distribution than

for those at the top. A tax that claims the same percentage of income from all taxpayers is termed proportional.

Vertical equity can be assessed in terms of either

effective tax rates (tax liability as a percentage of

pretax income) or the effect of the tax on the distribution of after-tax income. The two approaches are

quite different but yield comparable assessments of a

given tax. A progressive tax, for example, has effective tax rates that rise with income; it also generates a

more equal after-tax distribution of income. But that

consistency fails to hold when evaluating a change in

taxes. For example, a tax reduction that cuts all rates

of a progressive tax by the same percentage has no

effect on relative effective rates; relative shares of the

total tax bill are unchanged. However, the change

raises after-tax income much more for families at the

top of the income distribution than for those at the bottom, thus increasing inequality. The choice of metric

matters.

Complexity and Costs

The costs of collecting taxes are net losses to the economy. Taxes that cost less to collect raise more net

revenue relative to resources taken from the economy

than do more expensive alternatives. The collection

costs include both the costs the government incurs in

administering and enforcing the code and the costs the

public incurs in complying with it. Administrative

costs are frequently associated with the ease of evasion. Compliance costs are usually associated with

complexity.

Complexity in the tax system largely results from

features of the tax code that are designed to affect behavior by taxing some endeavors more or less than

others. Those features include activities that are exempt from tax, from various deductions for preferred

items, and from credits for undertaking certain actions.

As a consequence, many of the same aspects of the

system that reduce economic efficiency also increase

complexity.

In a number of instances, complexity also arises

from efforts to achieve vertical equity. For example,

the phaseouts of various tax credits and deductions

throughout the code are designed to give benefits only

to people with the greatest need, but they make taxes

more difficult to calculate. Similarly, the earned income tax credit provides wage subsidies to low-income families but requires them to fill out an additional form. And the alternative minimum tax (AMT)

is intended to limit the use of incentives by higher-income taxpayers but requires taxpayers to recalculate

their tax liability in an entirely different way and then

pay the larger of the regular and alternative taxes.

In some cases, complexity results from trying to

make the code efficient. That occurs most frequently

in the case of business taxation, in which considerable

complexity stems from the need to define income consistently so that it may be taxed with a minimum of

distortion.

Minimizing complexity, therefore, in some instances involves a trade-off with vertical equity and

efficiency. In other instances, probably most, it is

consistent with horizontal equity and greater efficiency. All else being equal, taxes that are simpler

and easy to enforce are preferred in order to minimize

the costs of collection.

Ways to Reduce Revenues

Given the near-record levels of federal revenues as a

share of GDP, the Congress may want to use some of

the projected surplus to cut taxes. In doing so, it

faces two issues: how much to reduce revenues and

which approach to use in making that reduction. Cuts

need not be restricted to a single approach; different

approaches can be combined into a package that accomplishes the desired reduction in revenues. The

Congress can choose from a range of approaches, including:

o Broad-based tax cuts that affect most taxpayers;

o Tax cuts aimed at reducing particular disincentives in the current tax system;
8 OPTIONS TO CUT TAXES June 2000

o Tax cuts designed to simplify the tax system or

improve compliance; and

o Tax cuts that provide new incentives for particular types of behavior.

Options based on each approach may have different

effects on the complexity of the tax code, incentives or

disincentives for particular behavior, and the distribution of after-tax income among families and individuals.

Estimates of the amount of revenue that would be

lost under each of the options discussed in this memorandum should be viewed as approximate. The estimates for options in this memorandum come from

CBO.

Making Broad-Based Tax Cuts

Two federal taxes—individual income taxes and the

payroll taxes funding Social Security and Medicare—

affect most families. Consequently, cutting either or

both of those taxes is the easiest way to provide substantial across-the-board tax relief.

Individual Income Taxes. Rapidly rising incomes

over the past decade have caused individual income

tax revenues to climb more sharply than GDP, reaching 9.6 percent of GDP in 1999, the highest level ever.

Although much of the increase in revenues has come

from the concentration of income gains in the top income brackets that face the highest tax rates, many

observers argue that the increase calls for some form

of across-the-board cut in individual income taxes.

Such a cut would lower top tax rates toward levels

experienced in the early 1990s and could have positive

effects on both incentives to work and the national

saving rate.

Most evidence suggests that income taxes modestly reduce incentives to work because they reduce

after-tax wages. The negative effects are particularly

strong for workers who are not their family’s principal

earner. Lowering income tax rates would decrease

those disincentives and result in an expansion of the

national labor supply. Evidence with respect to the

effect of income taxes on saving is weaker, but many

analysts have concluded that they also reduce the incentive to save. Hence, reducing tax rates would also

reduce the disincentives to save that may exist and

could lead to an increase in the national saving rate. 

More important, because it taxes some incomeproducing activities and not others, the income tax

code distorts choices about production, consumption,

and portfolio allocation. Those distortions result in

economic inefficiency—too much activity in areas

subject to lower or no taxes and too little activity in

areas subject to higher taxes. Lowering tax rates reduces those differentials and consequently improves

efficiency. Since some of those distortions were deliberately enacted to encourage particular activities such

as home ownership and charitable giving, however,

lowering tax rates can lead to less of what has been

legislatively deemed to be desirable behavior.

Across-the-board rate cuts may be implemented

in various ways that have differing consequences for

the distribution of income. The two most commonly

suggested methods are cutting all rates by a given percentage or by a given number of percentage points.

Either form of rate cut could accomplish any level of

desired revenue reduction, determined by how much

rates are lowered. CBO expects nearly $1 trillion in

individual income tax revenue in 2001, so a 10 percent

tax cut would reduce tax liabilities in that year by

about $100 billion. Cutting all individual rates by 2.2

percentage points would yield about the same revenue

loss. Regardless of how rates were reduced, however,

taxpayers would not realize the full benefits unless the

alternative minimum tax was also adjusted to preclude

the lower tax rates from making more returns subject

to the AMT.

A proportional cut—say, 10 percent in all tax

rates, including capital gains and the AMT—would

not affect the progressivity of income tax rates. However, because the individual income tax is the most

progressive part of the federal tax system, reducing

income taxes while leaving other taxes unchanged

makes overall federal taxes less progressive. Furthermore, because the effective tax rate facing highincome taxpayers would be reduced more in terms of

percentage points, such a cut would make the distribution of after-tax income more unequal and would thus

reduce progressivity under that measure.
June 2000 OPTIONS TO CUT TAXES 9

A rate cut that reduced all tax brackets by the

same number of percentage points would actually increase the progressivity of tax rates by making proportionately larger cuts in the lower rates. However,

since low- and middle-income families face relatively

low effective tax rates, their total taxes would be cut

by a smaller percentage than would the taxes of other

families.

Payroll Taxes. Most families pay more in payroll

taxes—deductions from paychecks to fund Social Security and Medicare—than in income taxes. Cutting

taxes that finance Social Security (the Old-Age, Survivors, and Disability Insurance program, or OASDI)

and Medicare’s Hospital Insurance program could

thus have a greater impact on most families than

would cutting income taxes by the same total amount.

Cuts in payroll taxes would have the same kind of effects on work incentives as cuts in the individual income tax. However, the incentives of workers with

earnings above the taxable maximum would not be

affected by a reduction in OASDI tax rates. Furthermore, because payroll taxes do not apply to investment income, cutting them would have less of an effect

on incentives to save than cutting income taxes would.

Finally, because payroll taxes are a larger share of

total taxes for low- and middle-income families than

for those with higher income, cutting payroll tax rates

would increase the overall progressivity of the tax system.

An immediate 10 percent reduction in the Social

Security and Medicare tax rates would reduce revenue

by about $60 billion in fiscal year 2001. The reduction could be scaled to produce a greater or smaller

level of tax reduction. For a fixed amount of revenue

reduction, cutting the Social Security tax rate would

focus more tax relief on low- and middle-income families than would a change in the Medicare tax rate because of the limit on earnings subject to the Social Security levy.

One concern about cutting payroll taxes is the

effect on the Social Security and Medicare trust funds.

Although the trust funds currently have positive balances, the retirement of the baby-boom generation will

deplete them rapidly. Trust fund balances, however,

can be misleading. Transfers to the trust funds, for

example, will not by themselves provide the resources

for future benefits. Ultimately, it is not the size of the

balances in the trust funds that will limit the ability to

meet long-term obligations but the amount of the benefits and the size of the economy.

Reducing Particular Disincentives 

of the Tax System

Rather than provide broad-based tax relief, the Congress might choose to focus tax cuts on particular

groups of taxpayers. Marriage penalties and estate

taxes are two aspects of the current tax system that

observers have frequently identified as in need of

change. The double taxation of corporate income has

also drawn the criticism of many tax experts.

Marriage Penalty. Many married couples who file a

joint return have higher tax liabilities than they would

if they were allowed to file as individuals or heads of

household (single taxpayers with dependents). At the

same time, many other married couples pay lower

taxes than they would if they filed as individuals.

Whether a couple incurs a marriage “penalty” or receives a marriage “bonus” depends on the spouses’

relative incomes: penalties generally occur when

spouses have similar incomes, and bonuses occur

when only one spouse works or when spouses have

substantially different earnings. Penalties tend to be

larger for couples who have dependents that would

qualify them to file as heads of household if they were

not married.

Just over 40 percent of married couples incurred

marriage penalties averaging $1,480 in 1999, and

about 50 percent received bonuses averaging $1,600.

Overall, however, bonuses totaled $43 billion, about

$10 billion more than total penalties. High-income

couples were more likely to incur penalties and less

likely to receive bonuses than those with lower income. About 70 percent of both penalties and bonuses

affected couples with income above $50,000.

Any tax system that treats married couples as

single taxpaying units subject to progressive tax rates

will have marriage penalties, bonuses, or both. One

way to reduce the penalties would be to allow couples

to choose to file either jointly or individually. That

option would erase all penalties other than those associated with the head-of-household filing status and
10 OPTIONS TO CUT TAXES June 2000

would not affect couples with bonuses. However,

couples with the same amounts of income would no

longer face the same tax liabilities.

Beyond allowing married taxpayers to choose

their filing status, penalties can be reduced by lowering the taxes of penalized couples, increasing the taxes

of other taxpayers, or both. Some options would increase tax revenues. For example, requiring all married couples to file individual tax returns would eliminate all marriage penalties but only at the cost of increasing the tax liabilities of couples now receiving

bonuses. Alternatively, tax brackets and standard deductions could be made less generous for individuals

and heads of household, thus raising their taxes. That

change would reduce penalties for some married couples and increase bonuses for others.

Other options would reduce both tax revenues

and marriage penalties. The options differ in how

much of the tax relief goes to couples incurring penalties and where in the income distribution the tax relief

occurs. For example, setting the standard deduction

for married couples equal to twice that for single filers

would reduce penalties by about 6 percent at an annual cost of roughly $5 billion. That approach would

favor low- and middle-income couples: penalized couples with annual income below $50,000, who incur

just over one-third of total penalties, would get twothirds of the tax savings. But half of the tax reduction

would go to couples not now incurring penalties. Alternatively, setting both the standard deduction and tax

bracket widths for joint filers to twice those for individual filers would offset roughly 40 percent of total

penalties at an annual cost of about $40 billion. But it

would focus that reduction on higher-income couples:

more than 90 percent of the cut in penalties would go

to those with income above $50,000.

Another option would restore the two-earner deduction that existed between 1982 and 1986. That

provision allowed two-earner couples to deduct from

taxable income 10 percent of the earnings of the

lower-earning spouse, up to a maximum of $3,000.

That approach would reduce current marriage penalties by more than one-fourth at an annual cost of

about $12 billion. Roughly 80 percent of the revenue

loss would go to reducing current penalties. Most of

the benefits would go to higher-income families: couples with income over $50,000—those most likely to

have two earners—would get more than four-fifths of

the tax reduction. Like other ways of reducing marriage penalties, that option would also widen the disparity of treatment between married and unmarried

couples.

A related issue involves marriage penalties associated with the earned income tax credit. Since many

low-income families pay no income tax, most of their

marriage penalty results from the loss of the EITC

because the percentages and income levels determining

the credit do not differ by marital status. As a result,

two single parents could lose as much as $5,310 of the

EITC if they married. Setting the credit parameters

for couples to twice those for individuals would eliminate that penalty, but it would also give the EITC to

couples who would not qualify at all if they had to file

as individuals. The penalty could be reduced somewhat at significantly lower cost by phasing the credit

out more slowly for couples than for individuals, but

that approach would leave many couples facing substantial penalties. Regardless of the approach taken,

any option to reduce marriage penalties that does not

address the EITC would leave in place much of the

penalty for low-income families.

The Estate and Gift Tax. The only federal tax on

wealth is the estate and gift tax, which imposes levies

on large estates and gifts. Proponents of the tax assert

that it provides limited redistribution of wealth and

gives people an incentive to donate to charities. It also

serves as a backstop to other taxes, taxing income that

would otherwise go untaxed. Critics complain that the

tax leads to the breakup of family farms and businesses, discourages saving, and induces costly efforts

to avoid paying the tax.

The tax may create problems for family-owned

farms and businesses, primarily because estates dominated by family enterprises may lack the liquid assets

needed to pay the tax. However, many small businesses are able to undertake tax planning, such as purchasing life insurance to cover any estate tax liability,

to mitigate the effects of the tax. Even so, the levy

could force the sale of part or all of the enterprise and

thus might jeopardize its viability. Provisions in the

tax reduce that effect by allowing estates to spread

payments over time. Despite anecdotal evidence about

the adverse effects of the estate tax on family businesses, however, no research has revealed whether the
June 2000 OPTIONS TO CUT TAXES 11

tax actually contributes to the breakup of such enterprises. In 1995, about 2,000 small businesses and

farms, roughly defined, incurred any estate tax liability; those enterprises paid less than 4 percent of all

estate tax revenues.

Some critics have argued that because the estate

tax reduces the size of bequests that can be passed on

to heirs, it reduces the incentive to save. The likelihood of such an effect depends on the reasons people

have for leaving bequests. On the one hand, if people

base decisions on the trade-off between their own consumption and their heirs’ consumption, the tax shifts

the balance toward their own consumption and they

would tend to save less. On the other hand, if people

want to leave particular levels of inheritance, the tax

forces them to save more to reach their goal. Empirical studies have reached no consensus on the net

effect.

Although the estate and gift tax accounts for less

than 2 percent of federal revenues, its effect on the

distribution of federal taxes among income groups is

substantial. Measured in terms of the giver, the estate

tax falls primarily on high-income families because it

effectively exempts all but the largest estates. As a

consequence, eliminating the tax would substantially

reduce the progressivity of the federal tax system. The

distributional consequences of the tax are less clear if

the burden of the tax is assumed to fall on beneficiaries.

The estate and gift tax may influence more than

personal saving. Because the tax does not apply to

charitable contributions, it may encourage donations

to charitable activities. Significantly lowering the tax

could reduce such gifts. The estate tax also interacts

with the taxation of capital gains. Under current law,

gains incur tax liability only when realized; accrued

gains held until death escape the income tax because

heirs receive assets with their basis set to the current

value (that is, "stepped up" from the decedent’s basis

to the value at his or her death). Because of that stepup in basis, accrued gains would avoid taxation entirely if the estate tax was removed. Many proposals

for modifying the estate tax would therefore either tax

any accrued gains at death or require that beneficiaries

assume the decedent’s basis.

A major criticism of the estate tax is that it leads

the owners of significant assets to pursue complicated

strategies in their attempt to mitigate or avoid the tax

liability. Such activity not only involves potentially

great expense but may also result in inefficient use of

assets and inequitable treatment of taxpayers, only

some of whom undertake actions to lower their taxes.

Furthermore, the tax’s complexity imposes large compliance costs; conservative estimates place the cost at

between 5 percent and 10 percent of revenue collected.

Eliminating the tax, or even substantially increasing its

exemption level, would mitigate both effects.

Although estate and gift tax receipts are projected to total about $32 billion in 2001, eliminating

the tax could have a larger or smaller effect on federal

revenues, depending on changes made to other parts of

the tax code. For example, if the step-up in basis for

capital assets was also removed, the lost revenue from

the estate tax could be offset by increased income

taxes on capital gains if taxpayers deferred fewer of

their gains until death. Similarly, because the estate

tax can significantly lower the after-tax cost of spending during one’s lifetime, removing the tax could lead

to lower levels of deductible expenditures like charitable contributions and consequent increases in income

tax revenues.

Other options would reduce the impact of the

tax. Under current law, the exempt value of an estate

will rise incrementally to $1 million in 2006 and remain at that level in future years. Indexing that exemption would keep inflation from raising the percentage of families subject to the tax, and increasing the

exempt amount further could lower that percentage.

Alternatively, lowering estate tax rates would reduce

incentives for taxpayers to avoid the tax through complicated actions. Any of those changes would affect

only the 2 percent of decedents who owe estate taxes,

and a rate change would give more of the benefit of

the cut to the wealthiest families within that group.

Double Taxation of Corporate Income. Many economists are concerned that the corporate tax creates

distortions that cause economic inefficiency. Firms

pay taxes on their profits, and investors pay additional

taxes when they receive dividends or realize capital

gains. The tax thus raises the cost of capital and discourages investment. More significantly, it creates

various distortions: between noncorporate and corpo-
12 OPTIONS TO CUT TAXES June 2000

rate business; between payment of dividends and internal reinvestment of earnings; and between financing

with debt (interest on which is deductible) and with

stock issuance (dividends from which are not deductible). All such distortions change how corporations

operate—in terms of production methods and investment decisions, for example—and thus create economic inefficiency.

The corporate tax will raise nearly $190 billion

in 2001, but eliminating it would reduce revenues by

less than that amount because both dividends and capital gains realizations would be greater in its absence.

Furthermore, removing distortions caused by differential taxation of business activities would improve economic efficiency, leading to a larger economy and consequent higher revenues. Eliminating the corporate

tax, however, might not be optimal in terms of efficient tax collection. The tax applies to the retained

earnings of firms; those earnings would either escape

taxation under the individual income tax or face lower

taxes because any tax on them is deferred until corporate shareholders receive them as future dividends or

realized capital gains.

Two approaches that would lose less revenue

than would eliminating the tax involve integrating the

corporate and individual income taxes to reduce or

eliminate the efficiency costs that come from double

taxation. The more complicated approach would replace the current tax with a comprehensive tax on

business income and eliminate taxes on capital income

at the individual level. The second, more straightforward approach would eliminate either the individual or

corporate taxation of business income within the current structure. That approach could be implemented

in stages by reducing the share of income subject to

both taxes incrementally over a number of years.

A final issue involves the distributional effects of

reducing corporate taxes. Most economists agree that

the burden of the current corporate tax falls almost

entirely on the owners of all capital, both corporate

and noncorporate. Because capital ownership is concentrated toward the upper end of the income distribution, the corporate tax is progressive. Any reduction

in the tax would give the bulk of gains to higherincome taxpayers and would almost certainly reduce

the progressivity of the federal tax system.

Simplifying the Tax System

Particular features of the tax system might also be

targeted because they complicate tax filing. Two features increasingly encountered by taxpayers are the

alternative minimum tax and the phaseout of personal

exemptions and deductions.

Alternative Minimum Tax. The Congress implemented the alternative minimum tax in 1969 to prevent

taxpayers from using tax preferences so intensively

that they pay little or no tax. The AMT requires that

taxpayers add some preference items to income and

then recompute their taxes under rules that disallow

most exemptions, deductions, and credits. That recomputation allows a single exemption—$45,000 for

joint filers and $33,750 for single filers—that is

phased out completely for high-income taxpayers.

The remaining income is then subject to two tax rates:

26 percent on the first $175,000 and 28 percent on

any excess. Those taxpayers then pay the higher of

the normal tax or the AMT.

The adjustments to the AMT include not just

preferences used by high-income taxpayers to avoid

taxes but also commonly used deductions, credits, and

personal exemptions. As a consequence, many

middle-income families would fall under the AMT but

for the Congress’s repeated exemption of personal

credits from the AMT. That exemption is not permanent, however; in 1999, the Congress exempted all

personal tax credits from the AMT only through 2001.

More important, unlike many other dollar values used

to calculate tax liabilities (such as tax brackets, personal exemptions, and the standard deduction), the

values for the AMT exemption and tax brackets are

not indexed for inflation. As a result, more taxpayers

become subject to the AMT each year. In any case,

even if the AMT does not result in greater tax liability,

an increasing number of taxpayers still have to compute it to determine their liability.

CBO estimates that the number of taxpayers subject to the AMT will grow from 1 million in 2000 to

15 million in 2010 if the tax code is not changed.

That growth will raise the revenue attributed to the

AMT from $5 billion to $35 billion over the decade.

Much of the increased impact of the AMT derives

from the fact that personal exemptions, the standard
June 2000 OPTIONS TO CUT TAXES 13

deduction, and tax brackets in the regular tax are indexed for inflation but the AMT exemptions and tax

brackets are not. Increasing those two parts of the

AMT over time to keep pace with inflation would

eliminate most of the growth in the AMT’s reach. If

such indexation began in 2000, the number of taxpayers subject to the AMT in 2010 would fall to about

1 million, and the revenue attributable to the AMT in

that year would drop by about three-fourths, to about

$9 billion. Eliminating the AMT would further cut

revenues by that amount.

Phaseout of Exemptions and Limitation on Deductions. Because of the progressive rate structure of the

individual income tax, reductions in taxable income,

such as personal exemptions and itemized deductions,

are more valuable to taxpayers in high tax brackets

than to those in low brackets. The tax code reduces

that disparity by phasing out personal exemptions and

limiting itemized deductions for taxpayers with income

above specified levels. In 1999, personal exemptions

were phased out for joint filers with adjusted gross

income (AGI) above $189,950 and for individual filers

with AGI above $126,600; itemized deductions were

reduced by 3 percent of AGI above $126,600. The

two limitations differ, however, in that personal exemptions are phased out completely for taxpayers with

the highest income but most taxpayers keep a substantial portion of their deductions.

The tax code thus effectively imposes higher tax

rates on income in the range over which the exemptions and deductions are reduced. The phaseouts also

add complexity to the tax code. Eliminating them

would simplify the computation of taxes for affected

taxpayers at an annual revenue cost of about $12 billion. In addition, it would slightly improve work incentives for taxpayers who face the higher effective

tax rates on any additional income. The gains, however, would accrue entirely to taxpayers with income

in or above the phaseout range—about 5 million taxpayers with the highest income. Taxpayers with income above the exemption’s phaseout range would

receive tax cuts with smaller changes in their marginal

incentives.

Expanding or Adding to 

Current Incentives

The Congress might choose to focus tax reductions on

people engaging in particular activities it wishes to

encourage. Any of the current incentives built into the

tax code could be expanded, and the cost would depend on how much the current credits or deductions

were raised. For example, the current child credit

could be raised, or the deduction for charitable contributions could be extended to families that do not itemize their deductions. A long list of new incentives

could be added. In recent years, the President has proposed expanding the EITC to assist low-income working families and creating new retirement savings accounts to encourage private saving. Either change

would probably involve refundable tax credits that

exceed basic tax liabilities in order to reach families

with little or no tax liability. The excess of those credits over basic tax liabilities represents not a change in

revenues but rather an increase in federal outlays.

Earned Income Tax Credit. In 2000, the earned income tax credit will provide low-income working families with up to $3,888 in income tax reduction or, for

taxpayers with low or no tax liability, payments in the

form of tax refunds. Of the $30 billion cost of the

credit in 1999, about 85 percent represented payments

to taxpayers in excess of their tax liability. That portion of the credit shows up on the spending side of the

federal budget rather than the revenue side. 

The EITC has a complicated structure. The

credit equals a fixed percentage of earnings up to a

maximum that depends on the number of children in

the family. The credit stays at that maximum as income rises further, up to a level beyond which the

credit is reduced by as much as 21 cents for each additional dollar of income. That reduction continues until

the credit falls to zero at a point termed the break-even

income. The phase-in and phaseout rates and the levels of income to which they apply depend on whether

the tax unit has no children, one child, or two or more

children, with maximum credits rising across the three

groups. The credit is refundable; that is, if the credit

exceeds a family’s tax liability, the family receives the

balance as a payment.
14 OPTIONS TO CUT TAXES June 2000

Roughly 13 percent of mandatory federal spending on low-income families is provided through the

EITC. Its structure, however, creates both incentives

and disincentives to work. Furthermore, because the

credit is the same for families with two children as for

those with more children, it provides less assistance

relative to need for larger families. Increasing the credits would concentrate the benefits of the tax cuts

among lower-income families. Depending on how the

credit was structured, it could improve the incentives

to work.

The EITC provides a work incentive for families

with earnings in the range over which the credit is rising. Taxpayers with earnings in that range and two

children, for example, can claim a tax credit equal to

40 percent of their wages. Such families receive an

effective wage that is 40 percent greater than that paid

by their employers, thus encouraging them to work

more than they would if the wage was unsubsidized.

That subsidy is reversed, however, for families with

income in the phaseout range. Those families face an

effective wage that is less than that paid by their employers; the difference between effective and actual

wages is the percentage rate of phaseout, roughly 21

percent for families with two children. Because their

net wage (reflecting the loss of the EITC) is lower

than their gross wage, families in the phaseout range

face a work disincentive and may choose to work

fewer hours (although the credit still provides an incentive for such families to continue to hold jobs).

Phasing out the credit more slowly would reduce

the work disincentive for families with income in the

phaseout range but would give the credit to families

earning more than the current break-even income and

would reduce their incentive to work. For example,

halving the phaseout rate for taxpayers with two children from 21.06 percent to 10.53 percent would raise

the break-even income from the current $30,580 to

$48,700—roughly the 60th percentile of all families

with children. That change would extend the credit to

about 4 million families that are not now eligible at an

annual cost of roughly $8 billion. The change would

have no effect on families with earnings below the

phaseout range.

Changes to the credit could take many forms.

The phase-in percentage could be increased to give

larger subsidies to working families with the lowest

income. That change would also raise the break-even

income unless the phaseout rate was also increased.

The phase-in range could be extended to increase the

income range over which wages are subsidized, thus

encouraging more families to work. That modification

would also lift the break-even income and make more

families subject to the work disincentives of the

phaseout. Or the amount of the credit could be raised

for families with more than two children, as the President has proposed. That approach would affect relatively few families and would focus added credits on

families with arguably the greatest need. For any of

the options, the bulk of the budgetary effect would be

to increase outlays for the refundable portion of the

credit rather than to reduce revenue collections.

Any expansion of the EITC could increase the

complexity of the tax code. Claiming the EITC requires completing an additional form, and any change

that raised the break-even income would impose that

requirement on more taxpayers. Another issue involves compliance: taxpayers not in traditional (married couple with children) families appear to be unclear about the living arrangements of children that

qualify them for the credit. As a result, many taxpayers erroneously claim the credit, either inadvertently or

intentionally. In many cases, the Internal Revenue

Service lacks the information needed to identify such

returns and may consequently allow the credit for ineligible taxpayers. Expanding the EITC would worsen

those problems.

New Retirement Savings Accounts. The tax code

encourages saving in many ways, most commonly by

deferring the taxation of income from savings or exempting such income from taxation entirely. Capital

gains are taxed only when realized, traditional individual retirement accounts (IRAs) are taxed when funds

are withdrawn, and the earnings of Roth IRAs are

never taxed. (Unlike the case of traditional IRAs,

however, contributions to Roth IRAs come from aftertax income.) Because those incentives to save are

greater for people in higher tax brackets, they disproportionately favor high-income taxpayers, who are

already the most likely to save. Taxpayers with AGI

above specified levels may not contribute to either

kind of IRA, however, and thus cannot benefit from

those incentives to save.
June 2000 OPTIONS TO CUT TAXES 15

Saving incentives that would give greater encouragement to lower-income taxpayers could involve refundable tax credits, which have equal value to all

families regardless of their tax liability. One proposal

to create new retirement savings accounts would make

annual deposits to private retirement savings accounts

for all low-income families and individuals and match

account holders’ contributions up to a fixed annual

limit.

The fixed annual contribution would in itself create no incentives. It might, in fact, reduce private saving to the extent that it would substitute for existing

saving, although that effect could not be large, given

the near-zero saving rate of low-income taxpayers.

Even if some substitution did occur, however, the program would still increase national saving relative to an

approach that would give equal sums to families but

not require that the money be saved.

Unlike the fixed contribution, the matching credits would encourage people to save more by increasing

the return to private saving, although the positive effect would be offset somewhat by the increased wealth

that the new savings accounts would represent. The

net effect of the program on national saving is uncertain. Economic analyses have reached differing conclusions about the impact of subsidizing saving.

The new savings accounts would concentrate

benefits on low- and middle-income families and individuals, particularly when compared with existing saving incentives. They might also introduce a large

number of families without bank accounts to financial

institutions and to the benefits of saving. The proposal would, however, add significant complexity to

the tax code.