Citizens for Tax Justice
1311 L Street, NW
Washington, DC
202-626-3780

In This Issue!

What About Welfare for the Well-Heeled and Politically Powerful

Just How Expensive Would It Be to Cut the Capital Gains Tax Rate?

The Bottom Line on the Tax Cuts in the 1995 GOP Budget Plan

While "Contract" Axes Aid to Needy, "Corporate Welfare", and Handouts to Wealthy Cost Over Twice the Budget Deficit

CTJ, Sen. Bill Bradley Release Study Detailing "Welfare for the Well-heeled"

A CTJ study found 128 entitlement programs hidden in the income tax code that cost taxpayers $456 billion annually and whose principal beneficiaries are corporations and the well-off. Robert S. McIntyre, director of CTJ, and Sen. Bill Bradley (D-N.J.) released the analysis, "The Hidden Entitlements" at a Capitol Hill press conference.

"A Congress that is eager to challenge low-income welfare entitlements ought to be at least as tough--if not tougher--on welfare entitlements for the well-heeled and politically powerful if it truly wants to bring the budget deficit under control," said McIntyre.

"If we are serious about balancing the budget and cutting the deficit," said Bradley, "we must realize the fact that `spending is spending' whether it is in the tax code or in appropriations bills."

According to the study, tax entitlements currently cost the federal government two-and-a-half times as much as all means-tested direct entitlement programs such as welfare and Medicaid. And tax entitlements will soon cost more than what the federal government spends on defense, roads, environmental protection and all other "discretionary" programs combined.

These hidden tax entitlements, also known as tax expenditures, are reductions in taxes awarded to people and companies that engage in congressionally-favored activities. Such benefits are paid to any taxpayer meeting the eligibility requirements, with no limit on their total cost.

"It is costing us money," said Bradley. "If we are truly serious, not just about how this government works, but who it works for, we must reduce this special interest pork-barrel spending."

"We can't pretend that tax loopholes for the affluent and corporations don't hurt the rest of us," said McIntyre, "To balance the budget we must start rooting out some of the expensive corporate and high-income welfare programs in the tax code."

"These tax subsidies aren't just hugely expensive," McIntyre added, "many of them don't work. For example, industrial investment actually fell in the early eighties after giant new corporate loopholes were enacted, but then rose sharply after many of the loopholes were eliminated in 1986."

"The special interests love their tax breaks because they know full well they could never survive the scrutiny that applies to the regular budget," McIntyre said. "Many of these programs are targeted to industries with lots of political clout. Others are designed to give their biggest subsidies to people with the highest incomes. And by sending the wrong signals to businesses, investors and consumers, many of them cost jobs and impede economic growth."

The report details 128 "tax expenditures" -- 87 in the business, investment and savings category plus 41 in the personal category.

• In total, these programs are estimated to cost $456 billion in fiscal 1995 and $2.5 trillion over the next five years under current law.
• By 1999, the $565 billion annual cost of these tax-based programs will equal the cost of all "discretionary" federal spending. Under tax legislation just passed by the House, tax subsidies will soon exceed total discretionary spending.

Among the hidden entitlements that the study particularly targets as both unfair and bad economics are business and investment tax subsidies costing $568 billion over the next five years. These "corporate and high income welfare" programs include:

• Multinational tax breaks, costing at least $57 billion over five years.
• Capital gains tax loopholes, costing $165 billion over five years (not counting the proposed capital gains tax rate cut).
• Tax breaks for mergers and acquisitions.
• Business meals and entertainment write-offs ($29 billion over five years).
• Tax benefits for insurance companies and their products ($88 billion in five years).
• Oil, gas and energy tax breaks ($19 billion over five years).
• Tax breaks for timber, agriculture and minerals ($7 billion over five years).
• Tax breaks for banks and other financial institutions ($5 billion over five years).
• Tax subsidies for state and local bonds, especially the subsidies for non-public purpose bonds. The latter will cost $38 billion over the next five years.

Many tax entitlements are targeted to the wealthy. For example, 97 percent of the benefits from the current 28 percent maximum rate on capital gains income goes to those with incomes over$200,000. Likewise, more than three-quarters of the benefits from tax-free interest goes to those with incomes over $100,000.

In contrast, most families get little or nothing from the tax entitlement system, because they neither earn tax-favored kinds of income, nor itemize deductions.

The report praises the bipartisan 1986 Tax Reform Act, which cut the cost of tax entitlements almost in half -- "before reform, the tax code had literally become more loophole than tax," McIntyre said. But even after the 1986 reforms, tax entitlements are still far higher than they were prior to the Nixon administration, which began the loophole craze that culminated in the loophole-ridden 1981 tax act.

The study also cautions against flat-rate consumption taxes. "Voters should not be fooled by the special interests' version of tax reform -- or deform," McIntyre said, referring to the so-called "flat taxes"endorsed by many corporate-backed lobbies. "Abandoning graduated tax rates in favor of a single flat rate has nothing to do with tax simplification or closing loopholes. It's simply a way to increase taxes on most families to pay for huge tax reductions for the wealthy."

"In fact," McIntyre added, "the leading flat-rate tax plans -- as proposed by House Majority Leader Richard Armey (R-Tex.) and Ways and Means Chairman Bill Archer (R-Tex.) -- actually would expand rather than close the most egregious upper-income loopholes. Armey, for example, would provide a 100 percent exclusion for interest, dividends and capital gains, and both plans would consolidate the current corporate tax subsidies into one all-encompassing loophole: complete repeal of the corporate income tax."

In releasing the report, CTJ said that it was not calling for abolition of every tax deduction and credit, noting that some of them serve legitimate tax-equity purposes.

Bradley agreed. "I do not believe that all tax expenditures should be eliminated. Some, such as the home mortgage interest deduction, state and local taxes, charitable contributions, and the Earned Income Tax Credit are legitimate spending in our tax code. They serve a valid purpose and benefit large numbers of people," said Bradley. "It is the loophole for narrow special interests that must be eliminated. Until we control those expenditures for the few, we cannot ask for shared sacrifice from the many."

CTJ did, however, call for a review of tax entitlements as rigorous as Congress is applying to direct spending programs. "Taking $2.5 trillion off of the table at the outset of the debate would distort the decisions that will be required to achieve our shared economic and fiscal goals," McIntyre concluded, referring to the cost of tax entitlements between now and the end of the century.

"I applaud Bob McIntyre and CTJ for their thoughtful analysis of these `hidden entitlements' and for their continued work and focus on tax injustices," Bradley concluded.

Cost of Capital Gains Tax Cut for the Wealthy Pegged at Almost Double Official Estimate

According to a CTJ analysis, government estimators grossly underestimated the cost of the capital gains tax cuts passed as part of the recently approved House/Senate Conference Agreement. The key to estimating revenue effects of capital gains tax changes is determining what, if any, change in taxpayer behavior will result from the tax law change. CTJ’s analysis finds that government estimators have significantly overstated the likely taxpayer response and failed to properly account for the retroactice date of the provision.

Capital gains are the profits from the sale of stock, land and other capital assets. It is widely believed that a lower rate on capital gains results in more sales. This occurs, in theory, because the incentive to sell is greater if the seller can keep more of the proceeds.

The volume of the response is, however, disputed. Some believe there is little or no response. On the other hand, some advocates of capital gains tax cuts claim that sales go up so much that cutting the rate actually raises revenue. This would happen, for example, if cutting the tax rate in half caused capital gains realizations to more than double. Federal government estimators currently do not take this extreme position, but do assume a response substantially greater than the latest evidence supports.

The most recent battleground for this dispute is the capital gains tax cut passed this year in Congress. The official estimate of the cost of these cuts is $35 billion over the next seven years. CTJ, however, estimates the cost at $112 billion. CTJ’s estimate reflects recent economic research indicating that previous assumptions about taxpayer response to lower capital gains taxes overstate the potential increase in sales of capital assets. Furthermore, since the cut is effective for gains already realized during 1995 - a windfall tax break for investors who have already sold assets - there cannot be any additional taxpayer response for this period. This “deadweight” revenue loss is estimated by CTJ to be in excess of $16 billion.

Because capital gain income goes predominantly to the well-off--with those making more than $200,000 getting 65 percent of capital gains--the huge additional windfall predicted by CTJ will mostly benefit the wealthy. The additional cost shows that a bad idea--giving tax cuts to the rich while facing a budget deficit and cutting important programs--is even worse policy than previously believed.

CTJ's analysis found that under the revised Congressional capital gains tax cut plan:

• Federal revenue losses in fiscal 1995-2005 would total $112.5 billion.

• By fiscal 2001, the annual revenue loss would be $20.4 billion.

• Three-fifths of all capital gains tax breaks under the revised law would go to those making more than $200,000 a year--the top one percent of all tax filers.

• The average annual tax benefit to people making more than $200,000 would be $7,575 (in 1996 dollars).

• The average annual tax benefit for the 20 percent of families in the middle of the income distribution would be $7.

  The Conference Agreement replaces some of the existing capital gains tax breaks with more generous provisions. It would exempt approximately one-half of realized capital gains from tax by (a) excluding from taxable income half of the realized gain; and (b) indexing the basis of capital assets for inflation when computing capital gains. Since this latter break is delayed until after 2002, it represents a budget “time bomb” - the cost of which is not included in these figures. In addition, the plan would set the corporate capital gains tax rate at a maximum of 25% (compared to the regular top corporate rate of 35%). These changes would be in addition to a number of existing capital gains tax breaks that already make capital gains the lowest-taxed form of capital income.

  Based on old economic studies and other considerations, the Treasury Department and the Joint Committee on Taxation appear to assume that under the plan, capital gains realizations would increase by close to 50%—an astonishing $1.1 trillion over the next seven years (compared to the baseline prediction under current law). This is a very large realization response—both by historical standards and with respect to the volume of gains the economy can reasonably be expected to generate in the future.

  Recent, more sophisticated economic research indicates that taxpayer responsiveness to capital gains tax cuts is far less than had been previously assumed. In fact, one recent academic study finds that the permanent capital-gains-realization response to capital gains tax cuts is “not significantly different from zero.”

  CTJ adopted a middle ground, predicting about a 25% increase in cap gains realizations in response to the proposed tax changes.
  
  

  
  

  Figure 1 shows the recent history of total capital gain realizations for the period from 1970 until 1992, the last year for which data are available. One can observe that capital gains tax law changes can have important effects on realizations. But they do not tell the entire story. Recessions, economic booms, inflation and ancillary tax law changes can also affect the level of capital gains realizations. History also dramatically shows that realizations can also rise if tax rates are increased. This was the case in 1986 when taxpayers rushed to take advantage of a lower capital gains rate before it went up, effective in 1987, by cashing in gains earlier than they otherwise would have. Indeed, at more than $300 billion, the level of capital gains realizations in 1986 was by far the highest in history.

  Following that brief surge, there was a resulting fall off in realizations in the next few years (since there were fewer gains to cash in). By 1992, gains seem to have returned to about their historical trend line.

  Figure 2 shows a continuation of this response under three scenarios.

• The top line of Figure 2 indicates a revenue neutral scenario. This shows how much capital gains realizations would have to increase for a capital gains tax cut to cost nothing in lost revenues--a result sometimes predicted by capital gains tax cut proponents.

• The second line shows the assumption made by government estimators.

• The third line shows CTJ's predictions.

• The fourth line reflects the capital gains baseline as predicted by CBO. This shows capital gains if there is no change in law, or if there is no realizations response to law changes. (Note that with control of Congress

  passing to the Republicans in 1994, and the inclusion in the "Contract With America" of large capital gains tax cuts, realizations may be lower than indicated for 1994 as people hold onto their assets waiting for a tax cut.)
  
  

  Figure 2 shows that the government estimators are assuming an enormous immediate jump in capital gains realizations, almost up to the level of 1986. But in 1986 there was the driving force of a pending capital gains tax increase motivating a spectacular one-time, one-year, response. A capital gains tax cut does not provide nearly as compelling an inducement to realize gains quickly. After all, the reduced tax has no time-limit. Yet the government estimators predict an almost instantaneous response of 1986 magnitude, with unprecedented growth in later years from that already high starting point. Such a monumental response seems very unlikely. We believe that the behavioral response predicted by CTJ—which is still quite large—is much more in line with both the historical record and mainstream economic thinking on this subject than are other approaches.

  Congress needs to decide what is more important, a huge tax cut for those who don’t need it, or balancing the budget and maintaining important government programs. At $35 billion, the capital gains tax cut is a bad idea. At $112 billion it’s even worse.

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  The Bottom Line on the Tax Cuts in the 1995 GOP Budget Plan:

  Cutting taxes as part of a plan to balance the federal budget is extremely odd. Obviously, a big tax cut requires much more draconian reductions in federal programs than would otherwise be necessary to eliminate the deficit. The congressional GOP tax plan is especially odious: most of its tax cuts go to the best-off 10%, while two-thirds of all families get nothing--or actually pay higher taxes.

  Ideally, there should be no tax cut included in the final budget package. At minimum, any tax cuts that are enacted should be (a) much smaller in cost than the Republicans currently seek and (b) targeted to ordinary families, not the well-off.

  The President has rightfully denounced the Republican tax cuts as primarily benefiting the rich. As is well known, the main tax cut for the wealthy in the GOP plan is a huge capital gains tax reduction.

  In fact, almost three-quarters of the total GOP tax cut for the best-off one percent stems from the proposed reduction in the capital gains tax. If the President signs a tax bill that cuts capital gains taxes, he will have violated the basic principle of fairness that he has promised to uphold.

  To rectify the most egregious problems in the GOP tax plan, the President should at minimum insist that in any final budget bill there must be:

  • No capital gains tax cut.
  • No reduction in the corporate Alternative Minimum Tax.
  • No estate tax reduction.
  • No expanded IRAs (or "medical savings accounts")
  • No incentives for corporate pension raiding.
  • Lower income limits on the proposed child credits.
  • Much smaller reductions in the EITC.
  
  Taxes actually increase for Lowest 20%
  Source: Institute on Taxation and Economic Policy Microsimulation Tax Model.