Tuesday, February 10, 2009

“Making Work Pay” Credit: The Flawed Tax Cut in the Stimulus Bill

The final stimulus bill will almost certainly include President Obama’s “Making Work Pay” tax credit of $500 for an individual and $1,000 for a family in 2009 and 2010. The credit, included in both the House and Senate versions of the bill, is to be refundable, which means that individuals without any income tax liability will also receive the tax credit as an offset of an employee’s share of the first $8,100 of the social security payroll tax levied on wages and salaries. The full credit will be limited to individuals making $70,000-75,000 (double that for two-earner households) or less, gradually phased out for higher incomes. Some prominent economists on both the right and left are calling for this tax cut to be made permanent.

There is danger lurking in this measure. The vast majority of federal income taxes is being paid by fewer and fewer households. The share of federal income taxes paid by the top 20% of all households has increased from 64.9% in 1979 to 86.3% in 2005. (That of the top 1% rose from 25.8% to 39.4% during 1986-2005, the top 5% from 43.9% to 59.7%, and the top 10% from 55.7% to 70.3%.) The share paid by the bottom 40% fell from 4.1% to -3.8% (negative tax) during 1979-2005. Negative tax means that the government is topping up household incomes with an earned income tax credit, cash, payable to low-income households. The share of the top 60% declined from 10.7% to 4.4%.

In 2003, there were 138,959,000 tax unit households in the United States. Of these, 18,131,000 (13%) were non-filers. Nontaxable returns including those with refunds, amounted to 33,544,000 (24.1%). The two categories sum to 37.1%. Those subject to income tax of $500 or less numbered 8,372,000 (6%), of which single heads of households constituted the bulk at 5,985,000.

The shares of social insurance taxes rose or fell less dramatically during 1979-2005 because social insurance taxes are paid from the first dollar of earnings. The share paid by the bottom 60% fell from 36% to 31.1% while that of the top 20% rose from 35.9% to 43.6%.

On these numbers, a refundable tax credit against employee social insurance earnings would remove more than another 8 million tax units (5.8%) from federal tax liabilities, putting the share of non-taxpaying units around 49%.

If the “Making Work Pay” credit were to become permanent, and if Congress were to raise the offset to a higher percentage of the payroll tax, the 49% of households without any federal tax liability will quickly surpass 50%. When that happens, a non-taxpaying political majority will find itself in the enviable position of being able to vote tax increases on a minority of taxpayers (thereby financing benefits for themselves) without having to pay any of the increase. The models used by economists to estimate the economic gains of making the “Making Work Pay” tax credit permanent do not include this political outcome and its implications for U.S. democracy.

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