My colleague Ben Landy has been cranking out an excellent series of blog posts delving into the least defensible “dirty dozen” tax expenditures on the books, as identified by TCF’s 2002 Working Group on Tax Expenditures report Bad Breaks All Around. For all the handwringing about the difficulty of comprehensive tax reform, Ben’s series illustrates that the tax code contains some low hanging fruit ripe to be axed—and these dozen had been selected for being so indefensible that bipartisan support might be mustered for elimination. But in thinking about dedicating the related revenue to either deficit reduction or revenue-neutral tax reform (i.e., reducing marginal rates while broadening the tax base), it’s worth noting how markedly the pertinent economic and budgetary context has shifted over the last decade.

Three stark differences stand out. First off, the United States is currently mired in a depression and liquidity trap following a severe eighteen-month recession and financial crisis, rather than the anemic recovery of the early aughts following a relatively mild eight-month recession. Second, the United States has since embarked on what can only be described as a costly, failed experiment with cutting top capital gains, dividends, and ordinary income tax rates—exacerbating both the structural budget deficit as well as pre- and post-tax income inequality. Lastly, the middle class has struggled through a lost decade of falling real wages and widening income inequality instead of emerging from the robust Clinton economy. This swayed economic context has important ramifications for the pace and composition of deficit reduction, as well as how the burden of deficit reduction is distributed—all compelling against revenue-neutral tax reform.

Deficit Reduction in the Context of Depression

In the aftermath of the 2001 recession, the worst outlook for the labor market—which lags behind changes in the real economy—was real GDP falling $212 billion (1.5 percent) below the Congressional Budget Office’s estimate of potential (noninflationary) output in fiscal 2003.1  Closing this “output gap” is the barometer for restoring full employment. For the recently ended 2012 fiscal year, the output gap was $971 billion (5.9 percent of potential output). Based on this broad metric, the economy is performing roughly four times worse than a decade ago. And unlike a decade ago, Congress has been toying around with inducing an austerity recession and a slide into deeper depression. Intrinsically, deficit reduction is inversely related to restoring full employment, and the severity of the persisting jobs crisis means that obsessing with deficits rather than jobs is more misguided today than a decade ago—particularly given the inability of the Federal Reserve to cushion austerity today versus a decade ago (the Fed’s primary policy rate oscillated between 1 percent and 1.25 percent in fiscal 2003, whereas today the Fed Funds rate has been ostensibly floored out at zero since December 2008).

That said, eliminating inefficient tax preferences for businesses and upper-income households is, per dollar, the least economically harmful approach to deficit reduction. To the degree Congress is now misguidedly fixated with enacting deficit reduction (as opposed to Vice President Dick Cheney’s stance that “deficits don’t matter”), substituting repeal of tax expenditures for otherwise deeper spending cuts—and shifting the compositional balance more toward revenue increases—is a net economic positive. In this more nuanced context of tradeoffs, looking toward tax reform is unquestionably merited but should not be mistaken for embracing premature austerity.

Changes in Tax Policy since 2002

When TCF’s Working Group on Tax Expenditures was working on its report, the top statutory income tax rates were 38.6 percent for ordinary income, 38.6 percent for qualified dividends (still taxed as ordinary income), and 20 percent for capital gains. The Jobs and Growth Tax Relief Reconciliation Act of 2003 subsequently cut the top statutory rate on both capital gains and qualified dividends to 15 percent, while the top ordinary income tax rate fell to 35 percent, as already legislated. The Congressional Research Service (CRS) has found that reductions in capital gains and dividends tax rates—and, to a lesser extent, ordinary income rate reductions—have had a statistically significant impact increasing the income share of the top 0.1 percent of earners and the top 0.01 percent, that is, exacerbating inequality. Reductions in these tax rates have also had a statistically significant impact increasing the share of national income accruing to capital—heavily concentrated at the top of the income distribution—at the expense of labor income. CRS also found that the rising share of capital income was the single largest driving force behind widening income inequality over 1996–2006, followed by changes in tax policy. While the increasingly skewed market distribution of income would have increased inequality without any tax or budget changes, regressive tax cuts have exacerbated both pre- and post-tax income inequality.

Today, ameliorating income inequality is more of a policy priority and imperative than in 2002, and the tax policy levers to do so are starker because of the failed experiment with the Bush tax cuts, particularly with respect to capital income. In 2002, the capital gains preferences made the TCF Working Group’s “troublesome ten” list of problematic but partially justifiable expenditures—meriting reevaluation, given recent research—and as noted above the dividends preference did not exist. While the American Taxpayer Relief Act (ATRA) of 2012 (i.e., the lame-duck budget deal) raised the top rate on capital gains and dividends to 20 percent and the top rate on ordinary income to 39.6 percent for households earning above $400,000 ($450,000 for joint filers), the tax code remains less progressive than in 2002 and the market distribution of income is more greatly concentrated among upper-income households, justifying an even more progressive code at the very top of the income distribution. Eliminating numerous tax expenditures can increase revenue and improve progressivity, but the tax preferences for capital gains and dividends are unequivocally the two whose elimination would most directly push back against inequality.

A Lost Decade for the Middle Class

The Bush economic expansion from November 2001 through December 2007 was the weakest economic expansion—as measured by growth in real GDP, nonresidential fixed investment, employment, wages and salaries, compensation—since World War II. The dominant economic policy presiding over the Bush economy—regressive, supply-side tax cuts—produced lackluster, unevenly shared growth. With this precursor to the Great Recession and Lesser Depression, the past decade has not been kind to the middle class. Inflation-adjusted median income for working-age households (under the age of 65) peaked in 2000 at $63,535 in 2000, and has since fallen 12.4 percent to $55,640 (both in constant 2011 dollars); by this most basic indicator of living standards, the middle class has not made real gains since 1994. Excluding volatile capital gains and dividends income, the total share of pre-tax labor income accruing to the bottom 90 percent of the income distribution fell to 53.7 percent in 2010—the lowest share since 1932, and down 3.9 percentage points since 2002. With capital income, the total pre-tax income share of the bottom 90 percent of earners fell to 52.1 percent, down a comparable 4.1 percentage points since 2002. The rising share of income accruing to top earners has effectively crowded-out real middle class wage increases for well over a decade—with changes in tax policy aggravating income shifting away from labor income and further exacerbating post-tax inequality by decreasing progressivity of the tax and transfer system.

Rapidly restoring full employment would be the single most effective policy lever for boosting middle-class living standards and reducing inequality, because excess slack in the labor market exerts downward pressure on real wages—with proportionally bigger decreases lower down the income distribution. The most effective policy lever for doing so remains deficit-financed stimulus spending in the near-term, but to the degree that policymakers are determined to pay for any job creation measures, regressive tax expenditures are ideal offsets. On the other hand, cutting social insurance and income support programs would exacerbate inequality and declining living standards for the vast majority, as government transfer programs have been a key source of income support buoying these measures as the market-based distribution of income has grown more lopsided: over 50 percent of real income gains for the middle income quintile over 1979–2007 came from Medicare, Medicaid, and cash transfers, versus 6 percent from after-tax wages. Increasing progressivity of the tax and transfer system is far from a panacea for ameliorating inequality and restoring shared prosperity, but these central economic challenges may prove insurmountable if tax and budget policy continues exacerbating inequity instead of pushing back against it, everything else being equal.

Tax reform and related deficit reduction must be framed in both economic context and budgetary tradeoffs. While there are many tax expenditures ripe for elimination, the priority must be deficit reduction rather than marginal rate reductions—which are inherently regressive. Tipping the balance of long-term deficit reduction further toward progressive revenue sources, particularly economically inefficient or distortionary preferences, is a net positive for near-term economic recovery, income inequality, and middle class living standards. As Ben’s posts demonstrate, the “dirty dozen” are a great starting point for sensible, evidence-based deficit reduction (or, better yet, stimulus “pay fors”). But as the ATRA underscored by permanently enacting a new preferential rate on dividends (locking in well over half the Bush-era top statutory rate cut), policymakers must also bear in mind the economic and budgetary context of the last decade—which the middle class simply cannot afford to repeat.


1 Fiscal 2003 nominal dollars have been adjusted to fiscal 2012 dollars using CPI-U-RS for an apples-to-apples comparison.