Suppose that your income, thanks to inflation, goes up 10 percent this year. It's an easy supposition, since 10 percent is likely to be close to the average increase.
Next, suppose that President Reagan and Congress cut income tax rates 10 percent this -- as Reagan has pledged to do. Do you come out exactly even?
Not likely. The net effect on your personal tax will depend on your income. If it is well below average, the combination of 10 percent wage inflation and a 10 percent tax rate cut will leave you actually paying a higher tax rate -- that is, a larger share of income -- than before.
If the income is only slightly below average, you come out at exactly the same rate as before, the tax cut just balancing the effects of inflation.
If your income is above average, you get a real tax cut -- a very modest one for the middle classes, a more than modest one for the more prosperous.
There are a couple of points that tax-payers and voters need to keep in mind as they listen to the tax policy debate that is now beginning. The first -- obvious enough, but not much mentioned so far -- is that all the talk about rate reductions refers to reductions before inflation, not after. Whether the promised 10 percent cut would actually have leave typical taxpayers with a larger or smaller share of their income going to the federal tax collector depends, above all, on the inflation rate. The second point is that rate cuts may sound simple and yet result in complex algebraic changes in the progressivity of the income tax system.
The Reagan tax proposed, and the Kemp-Roth bill on which it is based, are designed, among other things, to make the system a little less progressive. The logic here is that people with larger incomes will save and invest greater proportions of their money than people with small incomes and that the American economy needs more saving and investment. It's an attempt to use tax cuts to encourage people to work more and take more risks in ways that will make the economy grow.
To make up your mind about the coming changes in taxes, you need to do more than decide whether you agree with that logic in principle. yYou need also to see exactly how much money is involved in individual cases. The following examples are taken from figures supplied by Joseph R. Pechman of the Bookings Institution and the computer over which he and his assistants preside.
Take a family of four whose income in 1980 was 10,000. Its income tax for the year would be $374, which is 3.7 percent of its income. If inflation pushes its income up 10 percent in 1981, and at the same time Congress cuts tax rates 10 percent, its tax in 1981 will be $481, which means 4.4 percent of its income. That's a real increase despite the tax cut. The explanation is that a cut in rates does not affect the standard deduction and exemptions that were put in to protect the poor but are being eroded by inflation.
For a family of four with an income of $16,000 -- a little less than the average -- a 10 percent rate cut would exactly offset the tax effects of 10 percent inflation.
Now let's take a family of four with a 1980 income of $30,000. Assuming that its deductions were one-fifth of income, its tax was $4,169, or 13.9 percent of income. If inflation pushes that income up by 10 percent in 1981 and tax rates are cut the same amount, this family's 1981 tax will be $4,400, which is a real tax cut of 0.6 percent. That works out to $186 a year.
What about the wealthy? Assume a couple with no children and $200,000 a year, half of it interest and dividends. Their tax would be $80,000 or 40 percent. If inflation pushed income to $220,000 and Congress cut rates 10 percent, their tax would drop a full three points to 37 percent of income, which would mean $6,600 to them.
As a practical matter, nothing as simple as a straight 10 percent cut in rates is likely to be enacted. Present indications suggest that what Congress will actually give Reagan is a bill that looks very much like the one reported by the Senate Finance Committee last summer. The reductions probably won't be quite so large for the top brackets. Congress will certainly expand exemptions and deductions to prevent real tax increases for people at the bottom.
But President Reagan, with his promises of spectacular tax cuts, is risking a backlash of disappointment and disillusion among his middle-class supporters. For the great majority of them, in a year of continued inflation, even that 10 percent cut in tax rates would mean a reduction in their real taxes that is measured only in tenths of a percentage point.