Thanks, Rich People!

By Justin Fox

During the 2004 election campaign, President George W. Bush pledged to halve the federal deficit, which had ballooned during his first term, by the end of his second. Lots of people--among them this particular economic journalist--scoffed.

The doubters were wrong. The Congressional Budget Office predicts that the deficit for the fiscal year that ends in September will be $177 billion--less than half the $413 billion deficit of fiscal 2004. The President will, by all appearances, not only meet his pledge but do so two years early.

He certainly didn't accomplish this by cutting spending--federal expenditures are up 19% since 2004, to a projected $2.7 trillion in fiscal 2007 (on the whole, this has been the most spendthrift Administration since Lyndon Johnson's). The deficit is shrinking, instead, because tax receipts have risen almost twice that fast. The President has offered a simple explanation for this welcome bounty: A strong economy, spurred by tax cuts, has driven up incomes and thus revenue. "Low taxes mean economic vitality," he said in February, "which means more tax revenues."

Not exactly. Tax receipts have actually been growing much faster than the overall economy, which means the tax burden has gone up. Congress, prodded by the President, cut tax rates in 2001 and 2003. Yet you are paying more in taxes. Or at least somebody is.

The last time taxes rose this fast relative to the economy was in the late 1970s and early '80s, when soaring inflation shoved Americans into ever higher tax brackets--resulting in big tax hikes that Congress never had to vote on. That ended in 1984, when income tax brackets were indexed to inflation. The dread alternative minimum tax (AMT) is not indexed, but despite all the bad press the AMT gets, its budgetary impact has so far been minimal. That will change very soon, barring congressional intervention, but it hasn't yet.

So what is it that has driven up tax revenues so dramatically over the past couple of years? "It's actually fairly clear," says the dean of America's tax-policy geeks, the Urban Institute's C. Eugene Steuerle. "It's just the increasingly unequal distribution of income." That is, the federal deficit has been shrinking because the rich have been getting richer. This is not a development the President is likely to brag about the next time he makes a speech about the economy. But, hey, it pays the bills.

When income gains are skewed toward those who pay taxes at the highest marginal rate, which is now 35%, revenues go up faster than if income rose evenly across all tax brackets. And sure enough, the trend toward more uneven income distribution has been boosting the government's bottom line for decades. In 1979 those with incomes in the top 0.1% of American taxpayers (those with $233,539 or more in adjusted gross income) accounted for 3% of income and 7% of tax receipts, according to the IRS. In 2000 the cutoff for the top 0.1% was $1.6 million, and their share had grown to 10% of income and 19% of taxes.

These income and tax shares dropped during the subsequent recession--those on the top rungs of the income ladder get much of their money from stock options, bonuses and other sources more volatile than wages and salaries. But they're climbing again.

The detailed IRS data on this tax swing aren't out yet, but there's plenty of other evidence. For one thing, while income tax revenues are up sharply, Social Security and Medicare tax receipts have remained flat as a share of the economy. "That tells you it isn't the average wage earner whose taxes are going up," says Steuerle. Another sign is that capital-gains taxes, paid mostly by the wealthy, doubled from 2003 to 2006.

The income-distribution shift doesn't explain all the improvement in the government's financial situation: corporate tax receipts have risen a lot since 2003 as well. That gain is the result of a postrecession recovery in corporate profits, plus the expiration of some Bush tax breaks--plus, speculates University of Michigan economist Joel Slemrod, a decrease in corporate tax avoidance in the wake of the scandals of 2002. It's widely assumed that this corporate tax boom will soon tail off.

The personal--income tax windfall from increasingly unequal income distribution, though, could be with us for a while. The President can even take part of the credit for it: lower tax rates on the highest earners give them less incentive to shelter income from taxes. But a similar high-income tax boom happened in the late 1990s, so Bush can't take too much credit. He might not want to: the shift in incomes toward the top may be great for the federal budget. Whether it's a good thing for the U.S. beyond that is an entirely different question.