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COLUMN RIGHT / MARTIN FELDSTEIN / KATHLEEN FELDSTEIN : How the Rich Will Botch Clinton's Plan : Faced with big tax rate jumps, they'll shift and shelter income, slashing revenue gains.

March 21, 1993|MARTIN FELDSTEIN and KATHLEEN FELDSTEIN | Martin Feldstein is a former chairman of the presidential Council of Economic Advisers. Kathleen Feldstein is an economist.

High-income taxpayers are spending more time these days talking to their accountants, lawyers and other tax advisers. The tax-shelter industry that became moribund after the Tax Reform Act of 1986 is coming back to life. And many high-income households, especially those with two earners, are asking themselves whether life wouldn't be better if they worked a little less and enjoyed a bit more leisure.

These changes are a reaction to President Clinton's plan to raise dramatically the marginal tax rates of high-income taxpayers. Tax-avoidance strategies in response to the higher marginal tax rates weaken the economy and waste scarce investment dollars. And by cutting their taxable incomes to trim their tax bills, these taxpayers would pay much less in taxes than the Clinton Administration is predicting. Clinton's projected deficit reductions are based on the error of assuming that high-income taxpayers won't change their behavior when tax rates rise.

Under the Clinton plan, a high-income couple would see its marginal tax rate jump by 25% on income between $140,000 and $250,000, rising from a 31% rate to 38.9% (including a 2.9% Medicare tax as well as a 36% income tax rate). And couples with incomes over $250,000 would see their marginal tax rate shoot up by 37%, from a 31% tax rate now to 42.5% under the Clinton plan.

Even a relatively small behavior change in response to these sharply higher marginal tax rates would eliminate most of the Administration's predicted gain in tax revenue. To see how this works, think about a couple who now have taxable income of $200,000. If they do nothing to reduce their taxable income, the Clinton plan would raise their income tax bill by $3,000 (the difference between the current 31% tax rate and the proposed 36% rate on the income between $140,000 and $200,000). The additional 2.9% Medicare payroll tax on the income between $135,000 and $200,000 would add another $1,885, so the couple's total tax bill would rise by $4,885 if they don't change their taxable income.

But that's certainly not a realistic assumption. By shifting taxable investments into untaxed municipal bonds, by converting some taxable income to untaxed fringe benefits, by working less, by increasing their mortgage or by more esoteric tax-planning devices, the couple could easily reduce their taxable income from $200,000 to $180,000. The 10% decline in taxable income would eliminate $6,200 that the Treasury now collects at a 31% tax rate. Even though some of that remaining $180,000 would be taxed at higher rates, the net effect would be to reduce the couple's total tax bill by $3,095.

A recent study at the National Bureau of Economic Research by Martin Feldstein and Daniel Feenberg calculated the effect of this part of the Clinton plan under different assumptions about how taxpayers respond to higher tax rates. The study is based on a computer analysis of almost 100,000 anonymous individual income-tax returns. It estimates that the President's plan would raise taxes by a total of $26 billion a year if taxpayers do not respond at all to the sharp rise in marginal tax rates, a figure consistent with the Clinton Administration's estimate and their conclusion that three-quarters of the proposed deficit reduction for 1994 could be achieved by such tax increases.

But if the jump in marginal tax rates causes taxpayers to reduce their taxable income by just 10%, the additional revenue would be only about one fourth as big, or less than $7 billion a year.

To put that in perspective, the Treasury could raise $7 billion a year by hiking the gasoline tax by 7 cents a gallon. That would have none of the adverse incentives of the proposed jump in individual income-tax rates and would have the advantage of improving the environment, reducing road congestion and decreasing traffic fatalities.

The NBER report also reviewed evidence on how taxpayers responded to the tax-rate reduction in the early 1980s. If taxpayers are even half as sensitive to the proposed Clinton hikes as they were when rates were cut, the tax revenue gain would be even less--not even $4 billion a year.

And these calculations make no allowance for the adverse effect on tax revenue of the slower pace of economic activity likely to result as the Clinton plan cuts demand by consumers at all income levels.

It's hard to understand why the Clinton team has not recognized this in its estimated tax revenue. More fundamentally, the harmful effects of higher marginal tax rates on the economy cannot be justified by any corresponding deficit reduction. Congress should reject this part of the Clinton proposal and find another way that really does shrink the deficit.

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