How the Bush-Era Tax Cuts Work


President George W. Bush issues a call for further tax cuts at the White House Rose Garden, in April 2003.
President George W. Bush issues a call for further tax cuts at the White House Rose Garden, in April 2003.
Alex Wong/Getty Images

In 2001 and 2003, President George W. Bush signed two different tax bills into law. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) squeaked through Congress as a budget reconciliation measure, the only way it could be protected from a Democratic filibuster [source: The New York Times]. The 2003 tax law, called the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), was deadlocked in a 50-50 tie in the Senate until Vice President Dick Cheney cast the winning vote. These tax reform laws are collectively known as the Bush-era tax cuts -- and have become one of the most divisive issues in American politics and economic policy.

When President Bush took office in 2001, he inherited a $230 billion budget surplus accrued during the 1990s boom years [source: Couric]. At that time, the highest earners in the country were taxed at 39.6 percent of their normal earned income, 38.6 percent on dividend income and 20 percent on long-term capital gains like investments [source: Petruno]. In a February 2001 speech to Congress, President Bush said that that the American people "have been overcharged, and, on their behalf, I'm here asking for a refund" [source: Couric].

The Republican-led Congress responded with a bill that lowered tax rates in all income tax brackets by 3 to 5 percent, created a new 10 percent tax bracket for the lowest-earning households, doubled the child tax credit, erased the "marriage penalty" and blunted the impact of the estate tax [source: Gale and Harris]. Since the Senate didn't have the votes to pass these cuts as a regular bill, the measure was crafted as a budget reconciliation, which can't be filibustered. However, it did come with an expiration date. No budget reconciliation can add to the federal deficit for more than 10 years, so the tax cuts included a "sunset clause" that made these cuts revert to 2001 levels at the end of 2010 [source: The New York Times]. The same expiration date applied to the 2003 cuts in capital gains and dividend taxes.

Critics of these cuts, including President Barack Obama, blamed them for the swelling budget deficit, calculating that the federal government lost at least $1.5 trillion in revenue during the Bush presidency [source: Kessler]. Democratic legislators who opposed the bills also warned that the tax cuts would favor the wealthy and shift the tax burden onto the middle class [source: Couric]. While campaigning for the presidency, Obama vowed to extend the cuts for the middle class and let rates for the wealthiest 2 percent of households return to pre-2001 levels.

After the 2010 mid-term elections, newly empowered anti-tax Republicans refused to budge on the tax cut issue, forcing a contentious debate over the best way to reduce the deficit: taxes or spending cuts. As the 2010 expiration date loomed, the tax cuts were extended for all taxpayers through 2012, rather than let some middle-class households see their taxes leap as much as 113 percent in April [source: Wingfield].

We'll delve into the political fallout from the Bush-era tax cuts later in the article. But first, let's examine how these cuts changed tax law.

The 2001 and 2003 Tax Laws

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was signed on Memorial Day in 2001. Business activity reached a peak in the United States in March 2001, two months before the first tax cuts were made [source: CNN Money]. However, few predicted the oncoming recession that would shrink the economy over eight months in 2001, and no one foresaw the devastating 9/11 attacks that would slow recovery even further. As Congress drafted the law, the Congressional Budget Office was predicting $5.6 trillion budget surplus over the next ten years [source: Kessler].

With ample money in the coffers, Congress proposed widespread tax relief. The 2001 tax law called for rate cuts in every tax bracket and the creation of a new 10 percent tax bracket for the lowest earning households, those making zero to $12,000 in taxable income. Beforehand, the lowest rate had been 15 percent.

As it was written, the 2001 law called for rate reductions to occur in stages over several years. For example, the highest tax rate in 2000 was 39.6 percent for the top-earning households. The 2001 law lowered the rate to 35 percent, but not until 2006. Until then, it would be lowered incrementally over each tax year. The same was true with the 28 percent, 31 percent and 36 percent tax brackets, which were each scheduled to lower by three points by 2006, but in small increments [source: Gale and Harris].

After the 2001 cuts passed, reality hit. The country was in far worse economic shape than Congress had believed. This prompted calls for even more tax cuts to spur investment and job growth. Congress responded with the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). The 2003 law accelerated many of the rate changes in the 2001 law, to be phased in over a number of years.

The biggest tax cuts in the 2003 law applied to dividends and long-term capital gains. Dividends used to be taxed at the same rate as normal earned income. The 2003 law taxed dividends at a flat 15 percent across all tax brackets. As for income earned from selling investments -- stocks, bonds, investment real estate -- the rate fell from 20 percent to 15 percent for those in higher tax brackets, and from 10 percent to 5 percent (and to zero by 2009) for those in the 15 percent tax bracket and below [source: Gale and Harris].

Economic Effects of Bush-Era Tax Cuts

President George W. Bush speaks out in support of his tax cut proposal in Omaha, Neb., in May 2003.
President George W. Bush speaks out in support of his tax cut proposal in Omaha, Neb., in May 2003.
Eric Francis/Getty Images

In theory, tax cuts are supposed to stimulate economic growth by leaving more cash in the pockets of the American taxpayer. Americans will then spend that money on consumer goods or invest it. The 2003 cuts in dividend and capital gains taxes were designed to reward risk and encourage investment in American enterprise, which would, in turn, create more jobs. Bush's Treasury Secretary John Snow said that the 2003 law would "have a profoundly positive effect on job creation" [source: Petruno].

The meteoric rise of the Dow Jones Industrial Average may prove that like the Bush-era tax cuts achieved their desired effect of encouraging investment. In the early months of 2003, the Dow Jones languished at a recession-level 7,524 points. Congress passed the 2003 tax bill in May, and Bush signed it into law immediately, lowering the tax on all investment income to 15 percent. By 2007, the market peaked at 14,164 points [source: StockCharts.com]. Many factors fueled the investment craze, including an inflated housing market, but the lowered tax rates were an added boon to investors.

Did those stock market gains translate into explosive job growth over that same period? According to the non-partisan website PolitiFact, employment levels under President Bush grew between 4.5 percent and 7 percent, depending on the employment model you choose from the Bureau of Labor Statistics. When compared with other two-term presidents, that figure represents the slowest job growth since the Eisenhower administration [source: Jacobson].

Unemployment levels were also largely unaffected by the tax cuts. Bush started his presidency with a 4.2 percent unemployment rate in 2001. The recession pushed the rate to 6.1 percent by 2003, but as the stock market doubled in size by 2007, the unemployment rate only fell back to 4.7 percent, higher than when Bush began [source: Bureau of Labor Statistics].

Household income grew modestly from 2002 to 2007, before the economy began its nosedive into a second recession. But it's important to note that over 80 percent of the income gains in those boom years was concentrated in capital gains [source: Congressional Budget Office]. Critics of the Bush-era tax cuts cite this imbalance between investment income and labor income as a sign that the cuts mostly benefitted the wealthy, who earn more of their money from investments.

It is difficult to clearly gauge the success or failure of the economic policies behind the Bush-era tax cuts for a number of reasons. The period following the 2001 cuts was darkened by the shadow of 9/11. And the years after the 2003 cuts were heavily affected by two large wars. On one hand, wars bring an increase in government spending and investment -- which spurs the economy -- but they also drive up national debt. During the housing bubble of the mid-2000s, homeowners saw the equity in their homes rise explosively, spurring many to shift that equity into other investments. In hindsight, the bubble was fueled by questionable banking and lending practices that set the stage for a global financial meltdown.

But of all the issues raised by the Bush-era tax cuts, none is more politically divisive than the effect of the tax cuts on the budget deficit. In the next section, we'll see how the Bush-era tax cuts have become the intractable issue of the budget debates.

Bush-Era Tax Cuts and the Budget Deficit

The battle over the federal budget deficit was thrown into sharp relief when Congress was deadlocked in 2011 over a routine bill to raise the national debt ceiling. The national debt is so high (over $14 trillion at last count), because the U.S. federal government needs to continually borrow money to balance its budget. With an annual budget deficit of over $1 trillion, that's a lot of borrowing. As the debt ceiling debate demonstrated, Democrats and Republicans are deeply divided over how to close the budget gap. Republicans believe large spending cuts are the only answer. Democrats agree to some spending cuts, but argue that budget cuts must be balanced with increased revenue (taxes).

Politics aside for a moment, let's look at the numbers. The Bush-era tax cuts lowered the effective tax rates on the four highest tax brackets, raised the child tax credit, eliminated the marriage penalty, and dramatically lowered tax rates on investments and capital gains. If you calculate the cost of all of those cuts (i.e. the tax dollars that would have been collected if the rates had remained unchanged), the figure is $1.812 trillion over the length of the Bush administration. That is the largest "new cost" to the government under Bush, even larger than the $1.469 trillion spent on the Afghanistan and Iraq wars [source: Tritch]. Even though the cuts were made when the economic outlook was far brighter, the effect on the deficit is undeniable. Bush took office with a $230 billion budget surplus and left with a $1.2 trillion deficit.

The Bush-era tax cuts are still at the center of the budget debate because they were set to expire at the end of 2010. President Obama proposed a compromise with the Republican leadership to extend tax cuts for 97 percent of Americans and let the tax cuts expire for the wealthiest of households, but the Republicans rejected any plan that would raise taxes. The two sides reached a last-minute agreement in December 2010 to extend all tax cuts until the end of 2012.

In the meantime, the president called for a Congressional "super committee" of Republicans and Democrats to find a way to reduce government borrowing by $1.2 trillion over the next decade [source: Ohlemacher]. The super committee talks broke down when the two sides couldn't agree over what to do with the Bush-era tax cuts. Again, the Democrats called for an end to the tax cuts for the wealthiest Americans, while the Republicans insisted that all reductions be made through spending cuts.

The Congressional Budget Office estimates that the budget deficit will grow by $3.9 trillion over the next 10 years if the Bush-era cuts are permanently extended. If all cuts expire at the end of 2012, the budget deficit would drop from $1.1 trillion in 2012 to $585 billion in 2013 and $345 billion in 2014 [source: Pear]. But does the president or Congress have the political will to raise taxes on nearly every American in an election year? Unlikely. And that's why it's increasingly likely that the Bush-era tax cuts are here to stay.

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Sources

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