Economic Perspective columnist Gene Steuerle looks at the debate over retroactive income tax increases.
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Increasing income tax rates retroactively to January 1 may have been a bad idea politically. Certainly it seemed to violate a sense of fairness for many individuals. The issue, however, is far more complex than indicated in much of the public debate. Indeed, it is not clear that any alternative could have made anyone much happier or avoided retroactively hurting one group of taxpayers or another. (For further discussion, see Tax Notes, Aug. 23, 1993, p. 1047.)
The traditional standard has been to make tax increases effective as of the date of announcement of a bill. If this standard had been followed, the recent increases would have been effective as of mid-February, not mid-August. Thus, the additional break from avoiding retroactivity might have been fairly modest in any case.
Why shouldn't tax increases be made effective as of the date of enactment? One difficulty is that this alternative standard gives significant benefits to those who optimize their tax planning in the period between announcement and enactment. Not only would income be accelerated to occur earlier in the year, but deductions would be delayed until later. In this way, the income would be taxed at the lowest rate possible and the deductions taken at the highest rate.
The issue is not only one of fairness. If taxpayers know that tax rates will rise in the future, their tax planning will tend to depress a number of worthwhile economic activities. Business expenses and investments are among those deductions that will be delayed until a higher tax rate is available. Charitable deductions also will be deferred.
In practice, moreover, almost any tax bill would have had retroactive features if it had an effective date sometime other than January 1. Let's take a simple example. Suppose that the rate increases were to be made effective as of July 1. Does that mean that income earned after that date would be taxed at a higher rate and income earned before that date at a lower rate? No. To achieve such a precise goal would require all taxpayers to file two complete returns for the year, with all income and expenses divided between the two periods. Since most accounting systems are kept only on an annual basis, these additional reporting requirements would be extraordinarily onerous.
What Congress usually does with midyear rate changes, therefore, is to create blended rates. An "effective" date of July 1, for instance, would really involve a blended rate equal to one-half of the old law rates plus one-half of the new law rates. For a midyear 1993 increase, the old 31-percent tax rate might have been blended with the new 39.6-percent rate to create a temporary rate of 35.3 percent.
Note, however, that income earned before July 1 would have been subject to a higher, retroactive, rate -- just as would income earned after July 1. In the Reagan era tax cuts, a similar device was used. Twice there were tax cuts of 10 percent supposedly taking place in mid-year; in practice, each of these cuts was implemented by a statutory cut of an additional 5 percent for the first year, and then an additional 5 percent for the next year. Wage withholding rates were reduced by 10 percent in mid-year, but these withholding rates had little effect on final liabilities.
Another complicating factor is that almost all tax changes involve significant changes in the value of assets. Accordingly, they are inevitably retroactive in their effect. When Clinton announced much higher marginal tax rates, the value of tax-exempt bonds went up significantly creating large windfall gains based on past investments. Whenever Congress favors one particular type of asset, however, it is almost inevitable that it has decreased the value of other assets. Raising corporate tax rates reduces the value of existing corporate assets. Individuals are penalized by the new law for their past investment activity. One could also argue that investments in education or in acquiring a variety of skills is lessened when the return from those investments is reduced through higher taxes on future wages.
Still other economic effects are retroactive. Legislation affects interest rates, creating winners and losers among creditors and debtors. Running large deficits affects interest, investment, and saving in the economy. Even when Congress enacts retroactive tax cuts or benefit increases -- efforts to which there is usually little political objection -- they change the value of assets and redistribute burdens in ways that are unexpected and often retroactive. Think of the issue this way. When Congress subsidizes past activities without collecting the taxes to pay for those expenditures, it runs up a deficit. That deficit is nothing more than an additional debt to be paid by the population. Therefore, when Congress grants a retroactive tax break to one set of taxpayers, it simultaneously increases the debt and decreases the net worth of other taxpayers.
One strange aspect of the debate over retroactivity in the new tax act is that it creates strange bedfellows. Those opposed to retroactivity find themselves in league with those who want even more tax increases, while those in favor of retroactivity end up on the side of those wanting less deficit reduction. That is, the additional taxes from the retroactive 1993 tax rate increases do little to raise taxes or lower deficits in the long run. If other changes had been made to meet the five-year revenue targets, they probably would have raised the same amount of revenue for the first five years. But, the amount raised would have been greater for later years, implying higher taxes and lower deficits in the long term.
None of these arguments necessarily means that raising tax rates retroactive to January 1 was a good idea. The rationale for the raise was almost entirely political: The constituency that was hit was going to get hit hard anyway. There was little political mileage in providing it any relief. Still, let's not be so naive as to assume that any alternative would have made the public much happier or could have avoided retroactive losses for some taxpayers.
Gene Steuerle is a senior fellow at the Urban Institute and an economic consultant to Tax Notes.
Tax Analysts Information
|Code Section:||Section 1 -- Individual Tax Imposed|
|Index Term:||rates, individual|
|Institutional Author:||Tax Analysts|
|Tax Analysts Electronic Citation: 93 TNT 188-45|