As millions of Americans file their 1984 personal income tax returns by April 15, they will be seeing in the numbers the final step of the big 1981 tax cut.
At the urging of President Reagan, tax rates were cut by 23 percent spread over four years. However, by 1984, inflation-induced "bracket creep" had effectively reduced the size of the cut to between 10 and 15 percent for most taxpayers.
Except for taxpayers at each end of the income scale, rates are little different than they were during most of the 1960s and 1970s once incomes are adjusted for inflation. Of course, on this same basis, the rates would be considerably higher had the Reagan cuts not been made.
According to administration estimates, the personal cuts reduced income taxes by about $100 billion last year. The economic impact of the cuts continues to generate heated debate among economists, though all but a small minority think they were a major factor in sparking a strong economic recovery from 1983 onward.
The debate centers on whether the spark was provided by the sheer increase in consumer buying power -- a traditional Keynesian view -- or by increasing incentives for taxpayers to work harder and save and invest more -- the so-called supply-side view. A second part of the often contentious debate revolves around whether the continuing large federal budget deficits, which have been exacerbated by the drop in income tax receipts, represent a serious danger to future economic growth.
The supply-side economists successfully urged in 1981 that any cut should concentrate on reducing the level of marginal tax rates so as to increase economic incentives. A taxpayer's marginal rate is the share paid in taxes of his income falling in his highest tax bracket. Prior to the '81 cut, rates ranged from 14 to 70 percent, except on earned income, on which the top rate was nominally 50 percent.
With the final step of the cuts last year, the marginal rates now range from 11 to 50 percent for all types of income that must be included in a taxpayer's adjusted gross income (AGI). (Some income, such as 60 percent of long-term capital gains and $200 worth of qualifying dividends, is excluded altogether. Income figures are reduced further by adjustments -- for example, for moving expenses or contributions to an IRA -- to arrive at AGI.)
Beginning this year, the tax system is "indexed" to offset the impact of inflation. The income levels within each bracket, the personal exemption, the zero-bracket amount (formerly the standard deduction) and the earned income credit will be adjusted each year to reflect inflation the previous year. Thus, bracket creep is eliminated and any change in marginal tax rates in the future will come only as a result of deliberate actions by Congress and a president. In other words, for any income with a constant level of purchasing power -- such as the four shown in the charts -- the burden of real taxation should remain the same.
That does not mean that the actual dollar amount of taxes paid each year will not go up. But if a taxpayer's income rises only in line with inflation, so will his tax liability.
As the charts show, some taxpayers have received larger cuts in marginal rates than others. For instance, the family of four with an AGI of $29,640 this year -- the equivalent of $25,000 in 1981 -- faces a top marginal rate of 22 percent. This is almost as high as at any time since 1960. Similarly, the family with a $47,423 AGI ($40,000 in 1981) has a top rate of 28 percent, a rate as high or higher than any for that income level between 1960 and 1977.
In general, single individuals have had their marginal rates, which were higher in the first place, reduced by larger amounts. That is a consequence of reducing rates by the same percentages. A 23 percent reduction in a 34 percent rate rounds to 8 percentage points. The same cut in, say, a 22 percent rate is a 5-percentage-point reduction.
The same thing has happened for upper-income individuals whether single or married. The drop from a 70 percent to a 50 percent top rate on investment income was a 28.6 percent decline.
A few unlucky taxpayers, such as a family of four with an AGI of $41,495 this year ($35,000 in 1981) will have the same 28 percent marginal rate that it had between 1977 and 1980. The current rate is higher than any that applied to that income level between 1960 and 1977 and is lower only than the rates in 1981 and 1982.
The debate among economists about the impact of the tax cuts on incentives to work, save and invest undoubtedly will continue for years, if for no other reason that empirical data about the response of taxpayers will become available only as time passes. The latest specific information now available is preliminary data for 1983, released earlier this month by the Internal Revenue Service.
The IRS figures show that in 1983, the second full year of the tax cuts, total AGI rose to $1.951 trillion from $1.852 trillion in 1982. As a result of the cuts, however, total personal income taxes paid fell slightly from $277.6 billion to $276.1 billion.
Continuing a trend of many years, attributable largely to the effects of inflation, the share of total AGI reported by taxpayers with incomes of less than $25,000 dropped by 2 percentage points, to a level of 37.4 percent. That income group's share of total taxes paid also fell by 2 percentage points, to 21.6 percent. About 71 percent of all taxpayers were in this below-$25,000 group.
The 24 percent of taxpayers with incomes between $25,000 and $50,000 also saw their share of total AGI decline, but by only 0.5 percentage point , to 40 1/2 percent. This group's share of taxes paid fell from 40.7 percent in 1982 to 38.8 percent in 1983, a 1.9-percentage-point decline. Meanwhile, the incomes reported by the 5 1/2 percent of taxpayers with AGIs above $50,000 rose to 23.3 percent of the total. That share naturally was up by the same 2 1/2 percentage points that the shares of the lower-income groups fell. The share of total taxes paid by the $50,000-and-up group rose by 3.9 percentage points.
When the IRS first released figures for 1982 a year ago, supply-siders asserted that the data showing a rise in the share of total taxes paid by those with upper incomes were clear evidence that the tax cuts were having the predicted impact on economic behavior. With lower marginal tax rates in effect, individuals were generating more income and therefore more tax revenue, they said.
An analysis of the changes in tax shares between 1981 and 1982 by economists Richard K. Vedder and Philippe Watel of Ohio University, published last fall by Congress' Joint Economic Committee, declared, "Why did the 'rich' pay more in 1982 than in 1981, despite a big tax cut and the onset of a major recession? The answer is that the tax cut lowered marginal rates far more on higher-income Americans than on lower-income Americans, so the rich responded to tax incentives much more than the nonrich.
"The maximum marginal rate for those in the highest bracket fell from 70 to 50 percent, a 28.6 percent decline, yet those in lower brackets received only a cut of about one-fourth that amount in 1982. Consequently, the rich changed their behavior considerably, working more and taking income out of shelters or the illegal underground economy, while other Americans confronted with less dramatic rate reductions changed their behavior much less," Vedder and Watel wrote.
There has been little disagreement on the point that a cut in capital gains taxes, such as occurred in late 1978 and again in late 1981 -- in the latter case to a maximum of 20 percent -- would increase reported incomes as asset-holding individuals take advantage of a lower tax on selling an asset. The disagreement has been over whether a lower capital gains rate would generate more revenue once a transition period was past.
Taxpayers with AGIs above $1 million in 1981 included $3.7 billion worth of capital gains in their AGIs, up about 23 percent from 1980. The figure rose sharply to $6.8 billion in 1982, with the rise in reported capital gains representing about two-fifths of the increase in AGI for that group. No separate capital gains figures have been reported by IRS for 1983, but interpolating from data on income from other sources suggests gains of about $9 billion. Some of the additional gains in 1983 undoubtedly were attributable to the fact that the value of corporate stocks rose by about one-third that year.
But an increase in revenue is clear. If these year-by-year gains were taxed at the maximum marginal rate, then the revenue was $2.1 billion in 1980, about $2.3 billion in 1981, $3.4 billion in 1982 and about $4.5 billion in 1983.
However, if capital gains rates are not cut again, the impetus to sell existing assets -- in effect, hold an average asset for a shorter period of time -- will diminish as the average holding period for assets approaches the new level commensurate with the current level of tax. When that occurs, revenue could begin to fall again. Whether it will be higher or lower than before will depend on whether the level of transactions has risen in percentage terms more than the tax rate has fallen. In any given year, revenue will continue to be affected by changes in asset values, of course.
But what about income other than capital gains?
The $1-million-and-up group's total AGI rose from $11.1 billion in 1981 to $18.8 billion in 1982 and to $25.3 billion in 1983. Thus, this group's AGI was up 68.7 percent in 1982 and 34.9 percent the next year. About two-fifths of the 1983 rise was apparently because of the increase in capital gains. However, unlike 1982, income from wages was up almost as much as were capital gains. In addition, there was a very sharp rise of $1.7 billion in income from so-called small business corporations.
These corporations, which can have only a limited number of shareholders, are treated for most tax purposes as if they were partnerships. That means that their income is not taxed at the corporate level but is "flowed through" to the shareholders according to their respective ownership share.
This pattern of a very large increase in capital gains immediately after a rate cut and a strong rise in other types of income after a year's lag is consistent with the analysis of Vedder and Watel. But it remains very difficult to sort out all the factors influencing income flows and tax revenue, and data from future years will be needed to reach firm conclusions about the incentive effects of the 1981 tax cuts on upper-income individuals and the revenue consequences.
Nevertheless, even Vedder and Watel suggest that the incentive effects are probably small on the great mass of taxpayers whose marginal rates have been reduced much less than those at the top. After all, if a taxpayer has a marginal rate of 24 percent, and it drops, say, 20 percent, his new rate is about 19 percent. If he gets another $1 in income, he gets to keep 81 cents instead of 76 cents. In other words, his after-tax income goes up 6.6 percent (5 divided by 76), not 20 percent.
But if a taxpayer in a 70 percent bracket gets a 20 percent marginal rate cut, his after-tax income goes up 14 cents on the dollar, almost a 50 percent increase (14 divided by 30).
If the supply-side story turns out to be true for the handful of taxpayers in the upper brackets, a serious question still remains whether the nation could afford to give those incentives -- considering what has happened to federal budget deficits since 1981. There was no way politically to reduce rates at the top without cutting rates across the board. Indeed, at the time, a number of supply-side advocates argued that the incentive effects would be a powerful force for all income groups.
Except at the top, as the charts show, the 1981 cuts did not reduce marginal rates much below their levels on the same real incomes during the 1960s and 1970s, if at all. The cuts were hardly excessive in that sense. On the other hand, they came at a time of rising demands on federal revenue from medical care costs, elderly income support and defense spending. Even with significant cuts in other spending programs, deficits rose sharply.
Perhaps, as the supply-siders claim, the nation was in the position of being able to cut marginal rates at the top and get more revenue -- although that may not be true indefinitely. It clearly was not true for more than perhaps the top 1 percent or taxpayers, according to the record so far.