Why taxes are going up
Revenues are on track to rise substantially in coming years, not just because of an economic rebound and expiring tax cuts. Our current tax structure ensures that revenues will grow faster than the economy.
It’s hard to imagine that spending restraint alone can solve America’s long-run fiscal woes. Facing an aging population and rising health care costs, the federal government will continue to expand even if policymakers take serious steps to trim spending. That’s why policy wonks are working so hard to evaluate ways to raise more revenue. Cutting back on loopholes and other tax expenditures, taxing carbon emissions, introducing a value-added tax – all of these deserve attention in case America decides that it wants to finance a substantially larger federal government.
However, that focus sometimes overshadows a key fact about our tax system: Revenues are already on track to rise substantially in coming years. And not just because of an economic rebound and expiring tax cuts. There are structural reasons why tax revenues will grow faster than the economy.
The Congressional Budget Office estimates that tax revenues will rise from 14.9% of GDP in 2010 to 20.7% in 2020 and 23.3% in 2035 if current law remains in place (the “extended baseline” scenario in pink):
To put those figures in context, note that federal revenues have averaged about 18.2% of GDP over the past forty years. Tax revenues today are thus remarkably low. Indeed, they are the lowest they’ve been since 1950. But that will quickly reverse under existing law. By 2020, revenues would near their all-time record (20.9% of GDP in 1944) and by 2035, revenues would be more than 25% higher than historical levels.
That rapid growth reflects six factors. First, the economy will recover, lifting revenues from currently depressed levels. Second, the 2001 and 2003 tax cuts will expire, as will tax cuts enacted in the 2009 stimulus. Third, the Alternative Minimum Tax, which is not indexed for inflation, will boost taxes for millions more taxpayers. Fourth, the new taxes that helped pay for the recent health legislation will go into effect. Fifth, retiring baby boomers will make more taxable withdrawals from tax-deferred retirement accounts. Finally, in a phenomenon known as bracket creep, growing incomes will push taxpayers into higher brackets and reduce their eligibility for various credits.
Together, those six factors will increase tax revenues by 8.4 percentage points of GDP over the next 25 years, according to CBO. About a third of that increase (2.7 percentage points) comes from expiring individual income tax provisions and the expansion of the AMT. Another third (2.6 percentage points) is due to real bracket creep and reduced credits. And about one-seventh (1.2 percentage points) results from the tax increases in the health legislation. The other factors account for the remainder.
We clearly have sizeable tax increases built into our revenue system. The trillion-dollar question, however, is whether policymakers will allow them to happen. That’s why CBO considers a second scenario in which Congress gives in to the temptation to cut taxes. Under that “alternative fiscal” scenario (blue), Congress would permanently extend most of the 2001 and 2003 tax cuts and would limit the growth of the AMT. That would slow the growth of tax revenues but they would still reach 19.3% of GDP by the end of the decade, well above the forty-year average. CBO assumes that policymakers would then enact a series of unspecified future tax cuts to hold revenues at that level rather than letting structural factors lift them higher.
CBO’s bottom line is thus simple: tax revenues will rise faster than the economy even if Congress does nothing new. Indeed, revenues may rise faster than the economy even if Congress enacts substantial tax cuts. Our long-run fiscal dilemma exists because the scheduled growth in future spending is even larger than the scheduled growth in future revenues.
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