Ten Miles Square

March/ April 2013 The Congress-Does-Nothing Deficit Reduction Plan

How “bracket creep” (the good kind) could make the long-term fiscal outlook better than everyone thinks.

By David Kamin

Round after round of budget negotiations have made one thing clear: Republicans and Democrats have a very hard time agreeing on much of anything, especially tax increases. With lots of luck, they may manage to eke out an agreement that would be enough to stabilize the debt for the time being—requiring new (if relatively modest) tax increases and spending cuts—but the long-term fiscal dilemma continues
to loom.

With the Baby Boomers retiring and health care costs rising, it’s inevitable that government spending will grow considerably as a share of the economy. That is, unless the country abandons its commitments to retirees, or radically shrinks the rest of the federal government—neither of which is likely or desirable. So that leaves us in a pickle: if we want to avoid gaping deficits in the long run, then—drum roll, please—our only option is significantly higher taxes.

But it turns out that the pickle might not be as bad as almost everyone in Washington thinks.

Because of some long-standing elements of our system as well as clever provisions in the Affordable Care Act, taxes will actually go up as a share of Americans’ incomes in the decades ahead—without Congress so much as lifting a finger. And that could be a huge deal. Over the long term, the effect of these measures would be much, much larger than the recent tax increases on highest-income Americans that everyone’s been hearing so much about.

Behind much of this unheralded inflow of future tax revenues is a phenomenon known as “bracket creep.” But this isn’t your father’s kind of bracket creep. Bracket creep occurs, over time, as people are pushed into higher tax brackets by inflation or higher incomes or both. It got a bad name in the 1970s and early ’80s, when Americans were incensed at finding themselves paying higher taxes due to the effects of sky-high inflation. That anger helped propel Ronald Reagan into the White House. Washington responded by cutting taxes and indexing much of the income tax code to inflation.

Those actions slowed down the kind of bracket creep that comes solely from lamentably high inflation, but it did not eliminate the other kind, which comes as a result of the laudable process of people’s incomes rising faster than inflation. In our progressive tax system, which taxes higher levels of income at higher rates (and now indexes the brackets to inflation), people pay more as a share of their income when their earnings grow in real terms. While that largely hasn’t been the case for median earnings since the ’70s, it has been for the affluent. And if higher-end incomes continue to rise—or, better yet, if we can get all real incomes rising across the board—bracket creep will bring an extra measure of revenue into the Treasury for years to come. That is, again, so long as tax rates aren’t cut.

Under the new tax law, passed in January, the code got even more progressive, with a new higher bracket on annual taxable incomes above $400,000 for individuals and $450,000 for families. That means that, so long as the affluent continue to make more, as they have for decades, there should be even more federal revenue from bracket creep.

And that’s no small thing. After this decade ends, bracket creep—in combination with other factors like withdrawals from retirement accounts—is projected to push revenues up by roughly half of a percent of GDP by the 2030s, and by about 1 percent by around 2050.

These numbers are based on long-term Congressional Budget Office (CBO) projections (which, truth be told, are guesstimates, like any long-term projection) made before Obamacare became law. But that law, too, provides opportunities for bracket creep. Starting this year, Obamacare applies a new surtax on high-income individuals. That’s a 0.9 percent tax on incomes above $250,000, plus another 3.8 percent on investment income. Importantly, that $250,000 threshold is not indexed to inflation at all, and so as both incomes and inflation rise, this tax will apply to more and more people—hence producing more and more revenue.

An even bigger source of future federal revenue comes from Obamacare’s excise tax on “Cadillac” health insurance plans. That tax is scheduled to start in 2018 and apply a 40 percent tax on plans above certain, very high thresholds. (We’re talking family plans at $27,500 a year and more.) The threshold for the tax is indexed to a broad measure of inflation, which means that, as with bracket creep, if health care costs grow faster than inflation (and most experts expect that they will), more and more plans would eventually fall under the excise tax.

The upshot? This excise tax is essentially a way of gradually ratcheting down the tax exclusion for employer-provided health insurance—one of the code’s largest tax expenditures. People might pay the excise tax, or, more likely, employers might shift from compensating their employees with pricey tax-
advantaged health care policies to paying them higher wages and salaries, which are taxable. Either way, federal revenues would surge.

Soon after Obamacare became law, the CBO released another annual long-term outlook and outlined the effect of the law on the federal budget in the decades ahead. The CBO figures suggest that Obamacare will go from raising revenue equal to about a half a percent of GDP at the end of this decade to raising about 1 percent of GDP by the mid-2030s—and then continue to climb from there. By 2050, Obamacare is projected to raise over 2 percent of GDP. Since Obamacare’s spending cuts are projected to roughly cover its spending increases over the long term, this revenue could go toward deficit reduction.

Putting this extra revenue from Obamacare together with other additional revenue derived from a combination of overall bracket creep and this January’s tax increase, and the picture becomes clear: even as spending rises as a share of the economy, so will revenue. Based on the budget deal so far, revenues would start at around 19 percent of GDP at the end of the decade, and rise to roughly 22 percent by 2050. Seventy-five years from now, revenues could reach in the neighborhood of 25 percent of GDP. To put it in perspective, the much-ballyhooed January tax increase on highest-income Americans would raise revenues by less than 0.4 percent of GDP across this decade.

Taken together, this “automatic” revenue growth would reduce the long-term deficit, as projected by the CBO, by roughly one-third over the next seventy-five years. Again, that’s with no congressional action whatsoever. Moreover, it’s based on what’s probably too pessimistic a scenario that, among other things, assumes no ramp-down in the wars abroad, a return to higher historical levels of both defense and nondefense annual appropriations, and a partial repeal of Obamacare’s controls on
health spending.

To be clear, we’re still in a pickle. If long-term budget projections are to be believed, we will need additional long-term deficit reduction. It’s just that this pickle is not as bad as it’s often made out to be.

David Kamin an assistant professor of law at New York University School of Law, served in the Obama White House as special assistant to the president for economic policy.