WASHINGTON, September 17, 2017 – Now that President Trump has removed the pressure of passing a budget, raising the debt ceiling and dealing with illegal immigrants who came to the country as children, Congress can now concentrate on reforming the federal income tax code.
Trump said his planned tax cuts are “not to benefit the wealthy.” In fact, when asked about the possible tax rates on the wealthy he said,” if they have to go higher, they’ll go higher.” He continued, “the individual rate coming down will be substantial for the middle class.”
While his position is certainly popular with the middle class and with his new allies in the Democratic Party, it is not the best course of action. It also may be counter-productive to hold constant or raise taxes on the highest income earners.
To really help the middle class, tax cuts for the highest income earners are needed.
While middle-class workers pay a 6.2% Social Security tax (really 12.4% when counting the employer payment) and a 1.45% Medicare tax (really 2.9% when counting the employer payment), the average middle-class income earner who earns less than $50,000 per year, pays about a 4.3% tax rate according to the Pew Center.
Pew further says that 80% of American families pay more in Social Security and payroll taxes than they pay in federal income tax. And the top 20% of American families currently pay 84% of all federal income taxes collected.
While some taxes on the middle-class have increased in the last 10 years, mostly because of the Affordable Care Act, federal income tax rates declined by 10% in 2001 and have stayed there. But tax rates on the highest income earners increased by 10% in 2012. Tax rates on capital gains, mostly earned by the wealthy, increased up to 59% in 2012.
According to Pew, the middle-class annual income is between $38,000 and $113,000, which accounts for about 45% of the population. President Trump has used $200,000 as the upper limit for the middle class.
Cutting tax rates for the middle class will annually add at most a few thousand dollars of disposable income for each taxpayer. To really help the middle class, tax cuts for the wealthy are necessary.
What are the goals of federal income tax reform?
Trump says he wants Americans to keep more of the income that they earn, so lowering the tax rates on the middle class would achieve that goal. The other goal is to stimulate the economy so that annual GDP growth can increase to 3% or perhaps even 4%. That level of growth will really help the middle class.
Economic growth is extremely important. For the past 11 years, annual economic growth has been less than 3%. That is the longest period of economic stagnation in US history. A higher growth rate would mean businesses are expanding, which raises the demand for workers. That means more jobs would be available and wages would increase.
It also means that millions of Americans who have become discouraged by the lack of opportunity in the last eleven years and have dropped out of the labor market would re-enter to take advantage of new opportunities. It also would mean a reduction in many social problems and a reduction in government spending on income maintenance programs.
Since there are basically two inputs needed to stimulate growth, capital, and labor, the tax cuts should result in an increase in both inputs. The labor input would tend to increase because lower tax rates would increase tax home pay and draw discouraged workers back into the labor force. And there are plenty of discouraged workers still available. But what about capital?
Capital is created after income earners pay their taxes and spend on goods and services they consume. What’s left over becomes investment capital. Since middle-income earners spend almost all of their income on taxes and consumption, little is available to invest. Cutting their taxes would likely result in more consumption which is good when trying to increase demand, but does not create new capital.
Most new capital comes from higher income earners who have investment capital available after paying taxes and spending on consumption. By not reducing taxes on high-income earners there would be less capital available for expansion and less growth in the economy.
To really achieve the goals of a tax cut, rates should be reduced for all Americans including the highest income earners. This was the view taken during the Kennedy/Johnson tax cut, the Reagan tax cut and even the Clinton capital gains tax cut. All three of those tax cuts significantly increased economic growth. In 1984, after the Reagan tax cut, the economy grew at 7.5%
Although the opposition will claim that this is just another example of “cutting taxes for the rich,” the reality is that cutting taxes for the wealthy will really help the middle class.