Wealth Manager

Tax policy, as always, will remain a widely
discussed and passionately debated subject.
Yet legislative changes of any substance
are likely to be on hold until next year, once
the new President and Congress have had a
chance to settle in. But that doesn’t alter the
expectation that the tax code will be tweaked
in 2009—perhaps dramatically.

Whatever comes, it’s hard to imagine
that the status quo will triumph. One example
of the mounting political forces
pushing for change came last November,
when House Ways & Means Chairman
Charles B. Rangel (D-NY) announced an
ambitious bill that would, among other
things, lower the corporate tax rate, eliminate
the alternative minimum tax, provide
new breaks for lower- and middle-income
workers and raise rates on wealthy individuals.
Even though Washington pundits
claimed that the legislation had no chance
of becoming law before the election, political
opponents wasted no time attacking
the details. One partisan columnist
charged that Rangel’s bill amounted to a
“tax war” declaration.

But it’s not about tax increases versus tax
cuts, opined Gene Sperling when economic
advisors to the presidential candidates convened
a forum recently. “It’s about smart
tax policy,” explained the former Clinton
administration official who’s currently
working for Sen. Clinton’s campaign.

An admirable view, although much depends
on the details. On that point there
was some dispute at the economic debate
last November at the National Press Club
in Washington. With most of the economic
advisors to the leading presidential candidates
in attendance, the conversation was
as much about numbers and policy as it
was about political posturing. In fact, no
subject stirred more passion on the dais
than taxes. Predictably, the panelists explored
a range of priorities that generally
tracked party lines. Sperling, for instance,
made a case for letting the Bush tax cuts
fade away in 2010. As he put it: “Should we
be giving an extra $120 billion to people in
the top 1 percent?”

Meanwhile, Rudolph Giuliani’s advisor,
Michael Boskin, a veteran of the Reagan
and Bush I administrations, insisted
that the economic notions favored by the
Democratic candidates would only bring
higher tax rates and “a European-style social
welfare state.”

All of which raises the question: What is
the state of America’s taxes? In particular,
the just-give-me-the-facts-and-leave-thepolitics-
aside state of taxes? Although there
can never be absolute clarity—much less
agreement—on such a politically loaded
matter, at least we can quote the historical
facts. And as we head into the elections, a bit
of perspective may be just the thing to counter
some of the political spin that’s sure to go
into overdrive in the months ahead.

Let’s start with the size of the tax bite
relative to the U.S. economy. In 2006, the
government collected tax revenues worth
18.4 percent of the $13 trillion-plus U.S.
gross domestic product (GDP), according
to the Congressional Budget Office (CBO).
Depending on which candidate is giving
the stump speech du jour, 18 percent may
be labeled “excessive,” “inadequate” or
“just right.” Statistically speaking, the figure
looks middling, based on the past 45
years, as Chart 1 below shows.

An obvious follow-up question: What
are the major sources for the tax revenue?
The single-largest font of payments to
the IRS comes from individuals, who collectively
accounted for about 43 percent
of the total revenues in 2006. That’s about
average since the early 1960s, as Chart
No. 2 below illustrates.

The second-largest revenue source
comes from social insurance taxes, which
include paycheck deductions for Social
Security and Medicare. In fact, these taxes
have been rising as a share of total revenues.
In 1962, social insurance taxes represented
17 percent of payments to the IRS;
in 2006, the share had surged to almost 35
percent. In a not unrelated trend, corporate
taxes over that span have fallen, from
around 21 percent of the revenue pie in
1962 to just under 15 percent by 2006.

Collecting taxes is, of course, only a
prelude to spending, which falls into two
broad categories. On one side is what’s
known as discretionary spending, a domain
that exists at the mercy of Congress
by way of its annual budget negotiations.
Everything from funding the defense department
to launching a new government
study on the sex life of the bald eagle is
subject to approval each year.

Then there’s mandatory spending,
which comprises the other major chunk
of government expenditures. As the
name implies, this is recurring spending
that’s outside the usual budgetary review.
Spending on Social Security and Medicare,
for example, are mandatory programs. Although
Congress ultimately decides the
fate of mandatory spending, it tends to be
enduring, in part because of politics and
the fact that this slice of government largesse
isn’t subject to the whims of the annual
appropriations process that dictate
discretionary spending.

Comparing the two categories in terms
of their respective shares of the economy
reveals that discretionary has been losing
ground to mandatory, as our third chart
below shows. Mandatory programs
have slowly but relentlessly come
to dominate federal government spending.
As a result, to the extent that Social
Security, Medicare and other mandatory
programs require more funding due to
inflation and other causes, higher government
spending is predestined.

Finally, there’s the ever-contentious
subject of tax rates for household incomes.
We offer three perspectives: First up is the
big picture as defined by the highest marginal
income tax rates through time. As
the fourth chart below depicts, the
highest rate for households has wandered
over the years. Back in the 1950s and 1960s,
the wealthiest Americans were hit with
rates as high as 91 percent. By that standard,
the top rate of 35 percent for 2006
looked like a bargain.

Chart No. 5 below considers the
total effective Federal tax rates for households
in the upper levels in recent history.
(Effective tax rates are calculated by dividing
taxes by comprehensive household
income.) The effective Federal tax rate for
households in the top 1 percent, for example,
was 31.1 percent in 2004—just barely
below its average since 1979, according to
the Tax Policy Center, a Washington think
tank.

Finally, to round out our statistical tour
of taxes, consider households at the bottom
income levels. The effective Federal
tax rates for the lowest quintile in 2004
was at its nadir for recent history, as you
can see from Chart No. 6 below. The
same is true for the middle quintile.

All of which leads to the question of
what’s in store for tax rates in 2009 and beyond?
This much, at least, seems clear: Individuals
will surely continue suffering the
heavy lifting in terms of sending checks to
the IRS. The great debate, once again, centers
on the case for changing, if at all, the
burden among the various income brackets.
How progressive, in other words, should
America’s tax system be? We predict a tidal
wave of politically motivated responses
coming over the next nine months.