Testimony before the Committee on Finance, United States Senate
This testimony addresses revenues collected by the federal government, how taxes affect economic activity, and the tax burden and who bears it. Other elements of the current tax system–such as its complexity and the resulting costs of compliance–are also important but are not addressed here.
Federal Revenues: Trends and Projections
Over the past 40 years, federal revenues have ranged from nearly 21 percent of gross domestic product (GDP) in fiscal year 2000 to less than 15 percent in fiscal years 2009 and 2010, averaging 18 percent of GDP over that span. Most of the revenues–about 82 percent in 2010–come from the individual income tax and the payroll taxes used to finance Social Security, Medicare, and the federal unemployment insurance program. Other sources of revenues include corporate income taxes, excise taxes, estate and gift taxes–all together about 13 percent of revenues in 2010–and nontax revenues such as earnings of the Federal Reserve System, customs duties, fines, and various fees. Variation in individual income tax receipts, stemming from both policy changes and economic developments, has generated the largest fluctuations in revenues as a percentage of GDP.
Under current law, revenues will rise significantly from their recent low relative to GDP as the economy recovers from the recession and the tax reductions enacted in 2001, 2003, and 2009 expire. The Congressional Budget Office (CBO) projects that under current law, federal revenues will reach 21 percent of GDP in fiscal year 2020, just above their peak share of 10 years ago.
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CBO also projects that under current law, federal spending will decline for a few years relative to GDP and then increase again, reaching nearly 24 percent in 2020–slightly lower than the peak level of almost 25 percent in fiscal year 2009 but well above the average of roughly 21 percent over the past four decades. Compared with that historical experience, the components of federal spending that are projected, under current law, to be unusually large relative to GDP by 2020 are the expenditures for Social Security and the federal health programs (including spending for Medicare, Medicaid, and the subsidies to be provided in the new insurance exchanges); other nondefense spending is projected to roughly equal its historical share of GDP, and defense spending is projected to be a smaller share of GDP.
As a result, even with the projected substantial increase in revenues, under current law deficits between 2015 and 2020 will range between 2.6 percent and 3.0 percent of GDP. If lawmakers extended most or all of the 2001 and 2003 tax cuts and made no other changes to taxes and spending, revenues would be lower and deficits would be significantly larger.
How Taxes Affect Economic Activity: Marginal Tax Rates and Tax Expenditures
Taxes have an effect on the economy in addition to the revenues collected because they cause people to alter their economic behavior, which generally results in a less efficient allocation of resources. Taxpayers can respond in three general ways to taxes: They can change the timing of their activities, for example by accelerating bonus payments or the sale of assets into this year if they think tax rates on earnings or capital gains will increase next year; they can adjust the form of their activities, for example by substituting tax-preferred fringe benefits for cash wages if the tax rate on wages increases; or they can change more fundamental aspects of their behavior, for example by working or saving less if tax rates on earnings or capital income increase.
The crucial point is that taxes raise the price of taxed activities and thereby lower the relative price of other things. In particular, the income tax reduces the returns from working (the after-tax wage), which lowers the price of other activities relative to working; it also reduces the returns from saving (the after-tax rate of return), which lowers the price of current spending relative to saving for spending in the future.
One measure of the effect of taxes on the returns from working and saving is the marginal tax rate–the tax paid per dollar of extra earnings or dollar of extra income from savings. The highest marginal income tax rate (the tax rate that applies to the top income tax bracket) was 91 percent in the late 1950s and early 1960s and as high as 70 percent as recently as 1980, although a lower maximum rate applied to earnings in that year. Since 1988, the highest marginal income tax rate has ranged from 28 percent to 39.6 percent. For a representative family of four with median income, the marginal tax rate on earnings (combining the rates for both income and payroll taxes) during the period from 1955 to 1975 was around 20 percent. That rate climbed over the next 10 years as a result of rising payroll tax rates and inflation-driven increases in nominal incomes, which pushed median-income families into higher tax brackets. Following a reduction in income tax rates in 1986, the marginal tax rate for a representative median-income family has remained at about 30 percent.
Changes in marginal tax rates have two different types of effects on people. The lower that tax rates are, the more people can keep of the returns from additional work or saving, thus boosting people’s incentives to work and save. But lower rates also have a countervailing effect: By raising after-tax income, they make it easier for people to attain their consumption goals with a given amount of work or savings, thus possibly causing people to work and save less. On balance, the evidence suggests that reducing tax rates boosts work and saving relative to what would occur otherwise, if budget deficits are held the same. But without any other changes in taxes or spending, reducing tax rates from current levels will generally lower revenues and increase budget deficits. Increased deficits, even with lower tax rates, can reduce economic activity over the longer term.
Provisions of the tax code can also affect economic activity by subsidizing certain types of expenditures. Until recently, most federal support for homeownership was provided through the tax code in the form of tax expenditures, which are revenues that are forgone because of special exclusions, exemptions or deductions from gross income, special credits, preferential tax rates, or deferrals of tax liabilities aimed at subsidizing certain activities. The largest and most widely used tax expenditure in the housing area is the deduction from taxable income for mortgage interest on owner-occupied homes, which results in an estimated $573 billion in forgone revenues from 2009 to 2013. That deduction encourages homeowners to buy homes and to take out larger mortgages than they might otherwise be able to afford, resulting in higher household debt, higher home prices in areas where the supply of housing is fixed, and less investment in other assets.
Another substantial tax expenditure is the exclusion of employers’ contributions for health insurance premiums from income and payroll taxes. That exclusion encourages employers to offer health insurance to their workers and to pay their workers a larger share of their compensation in that form; the resulting higher levels of insurance increase demand for health care services. Tax expenditures have helped to accomplish various goals, but because they reduce the base to which taxes apply, tax rates must be higher to collect the same amount of revenues that would be collected in the absence of those subsidies.
The Tax Burden and Who Bears It
Households generally bear the economic cost, or burden, of the taxes that they pay directly, such as individual income taxes (including taxes paid on dividends, interest, and capital gains) and employees’ share of payroll taxes. Households also bear the burden of the taxes paid by businesses. In particular, in CBO’s judgment (and that of most economists), employers’ share of payroll taxes is passed on to employees in the form of lower wages. In addition, households bear the burden of corporate income taxes, but the extent to which they bear that burden as owners of capital, workers, or consumers is not clear.
One measure of the tax burden is the average tax rate–that is, the taxes paid as a share of income. Federal taxes are progressive: Average federal tax rates generally rise with income. In 2007, households in the bottom fifth, or quintile, of the income distribution (with average income of $18,400, under a broad definition of income) paid about 4 percent of their income in federal taxes, while the middle quintile, with average income of $64,500, paid 14 percent, and the highest quintile, with average income of $264,700, paid 25 percent.
The largest source of federal revenues, the individual income tax, has average tax rates that rise rapidly with income. The next largest source of revenues, social insurance taxes, has average tax rates that vary little across most income groups–although the average rate falls for higher-income households, because earnings above a certain threshold are not subject to the Social Security payroll tax and because earnings are a smaller portion of total income for that group. The average social insurance tax rate is higher than the average individual income tax rate for all income groups except the highest quintile.
Between 1979 and 2007, the average tax rate for federal taxes combined declined for all income groups. The average individual income tax rate also declined over those years; the largest decrease occurred for the fifth of the population with the lowest income. (That decline in average tax rates is based on a comparison of rates for different income groups at different points in time but does not reflect the experience of particular households, which may move up or down the income scale over time.)
The share of taxes paid by the top fifth of the population grew sharply between 1979 and 2007. Almost all of that growth can be attributed to an increase in that group’s share of before-tax income. In 2007, households in the highest quintile earned 55 percent of before-tax income and paid almost 70 percent of federal taxes; for all other quintiles, the share of federal taxes was less than the share of income.
Further information about many of these issues is available in other CBO publications:
- Trends and projections of federal revenues are discussed in The Budget and Economic Outlook: An Update (August 2010); and Sources of the Growth and Decline in Individual Income Tax Revenues Since 1994 (May 2008).
- Analyses of the effects of tax policy options on economic activity are discussed in Statement of Douglas W. Elmendorf, Director, Congressional Budget Office, before the Senate Committee on the Budget, The Economic Outlook and Fiscal Policy Choices (September 28, 2010); An Analysis of the President’s Budgetary Proposals for Fiscal Year 2011 (March 2010); and Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates (December 2005).
- The effects of tax rates on economic activity are examined in The Effect of Tax Changes on Labor Supply in CBO’s Microsimulation Tax Model , Background Paper (April 2007); Computing Effective Tax Rates on Capital Income , Background Paper (December 2006); Effective Marginal Tax Rates on Labor Income (November 2005); and Taxing Capital Income: Effective Rates and Approaches to Reform (October 2005).
- Subsidies to expenditures through the tax code are discussed in An Overview of Federal Support for Housing , Issue Brief (November 3, 2009); Key Issues in Analyzing Major Health Insurance Proposals (December 2008), pp. 29-37; The Deductibility of State and Local Taxes (February 2008); and Statement of Peter R. Orszag, Director, Congressional Budget
Office, before the House Committee on the Budget, Performance Budgeting: Applications
to Health Insurance Programs and Tax Policy (September 20, 2007).
- Supplemental analyses and detailed data on average federal tax rates and income, by income category, for 1979 to 2007, are available at www.cbo.gov/topics/taxes/distribution-of-federal-taxes.
- Issues involving tax rates and how household income changes over time are discussed in Effective Tax Rates: Comparing Annual and Multiyear Measures (January 2005).