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Article Excerpt
INTRODUCTION
Distributional analysis has long been a central element in discussions of tax policy. However, standard methods of estimating the distributional effects of tax changes omit two potentially important factors: the financing of the tax changes, and the implications of behavioral responses for economic growth, incomes, and well-being. In this paper we reexamine the distributional effects of the 2001 and 2003 tax cuts, incorporating these two factors. Compared with the standard analysis, this "dynamic distributional analysis" shows that the benefits of these tax cuts were much smaller, on average, and much more skewed toward people with higher incomes.
There is no doubt that the 2001 and 2003 tax cuts will need to be financed in some manner. As the Congressional Budget Office (CBO, 2007) recently reminded policymakers, "... under any plausible scenario, the federal budget is on an unsustainable path." Therefore, the revenue loss from these tax cuts (after accounting for revenue increases due to feedback effects) will need to be offset by future tax increases or government spending reductions. Ignoring the burden of these financing choices overstates the aggregate benefits of the tax cuts and likely distorts the analysis of the distribution of those benefits as well.
There is also no doubt that the 2001 and 2003 tax cuts will affect economic behavior in ways that are not incorporated in the standard distributional analysis and revenue scoring of tax changes. Of course, there is considerable uncertainty about the magnitude of the behavioral responses and even, after allowing for higher near-term federal debt and future financing, whether the net effect is higher or lower total output and income. But ignoring these effects is not an adequate substitute for considering the sensitivity of estimated distributional effects to different plausible responses.
We present three sets of results regarding the distributional effects of the 2001 and 2003 tax cuts. First, we reproduce familiar tables based on the standard approach to distributional analysis. Using this approach, almost all households are at least as well off after the tax cut, and the biggest percentage and absolute increases in after-tax income go to households with the highest pre-tax incomes.
Second, we add the financing of the tax cuts under two alternative scenarios. In both scenarios, the total amount of financing exactly offsets the tax cuts when fully phased in, so the net effect on the budget is zero. The first scenario assumes that each household pays an equal dollar amount, while the second assumes that each household pays the same percentage of income. Under either scenario, about three-quarters of households are worse off because of the tax cuts, and after-tax income falls for the bottom four quintiles of the income distribution but increases for the top quintile. To be sure, if one assumes that the financing occurs entirely through spending reductions and that the foregone spending is worthless to individuals, then the standard distributional analysis applies. However, despite decades of stump speeches about unnecessary government spending, the political process has been persistently unable to identify significant outlays that voters will blithely forego.
Third, we incorporate behavioral responses, including not only the induced increase in after-tax incomes but also the opportunity cost of the income gains. The central issue is that behaviorally induced increases in taxable incomes overstate welfare gains because the lost leisure, foregone fringe benefits, and other concomitants of the rise in taxable incomes all generate some decline in well-being. We develop a novel methodology for undertaking welfare-based distributional analysis, beginning with an illustrative example to demonstrate the logic of our approach and then generalizing the formula for broad application. Our results show that the 2001 and 2003 tax cuts raised the well-being of only one-third of households and that more than half of those better-off households are in the top quintile of the income distribution.
These results strongly confirm the importance of undertaking dynamic distributional analysis--that is, of extending the distributional analysis of tax changes to include both the financing of the changes and the welfare consequences of behavioral responses to the changes. These financing and behavioral responses are unavoidable consequences of tax changes, and their incorporation in distributional analyses can significantly alter the results. Excluding these factors, the 2001 and 2003 tax cuts appear to have made most U.S. households better off, albeit with the largest percentage and absolute increases in after-tax income at the top of the income distribution. Including these factors, the 2001 and 2003 tax cuts made most U.S. households worse off, although large percentage and absolute increases in after-tax income are still apparent at the top of the income distribution.
The next section of the paper describes our approach to conducting dynamic distributional analysis, and the following section presents our results. A final section briefly concludes.
METHODOLOGY FOR DYNAMIC DISTRIBUTIONAL ANALYSIS
We begin our discussion of methodology by briefly reviewing the 2001 and 2003 tax law changes and discussing alternative measures of the distributional effects of tax changes. Then we turn to the challenges of incorporating financing and making distributional analysis fully dynamic.
The 2001 and 2003 Tax Changes
The tax cuts enacted between 2001 and 2006 contain a host of large and small changes to the tax code. The tax cuts of 2001, 2003, 2004, 2005, and 2006 built on one another, with many of the bills passed after 2001 serving to extend provisions in earlier bills. The 2001 tax cut was especially sweeping; two of its most prominent changes were a phased-in reduction in income tax rates and a reduction and eventual repeal (for 2010 only) of the estate tax. It also provided a wide range of tax breaks for education, families with children, married couples, and contributions to certain kinds of savings accounts. The 2003 bill cut taxes on dividends and capital gains and accelerated the schedule for phasing in most of the other tax cuts enacted in 2001.
In this paper we examine the distributional effect of the most significant policies introduced in 2001 and 2003. The first of these policies is a reduction in the marginal tax rates on individual income, including a cut in the top marginal tax rate from 39.6 percent to 35.0 percent and a three percentage point reduction in the 36 percent, 31 percent, and 28 percent marginal tax rates to 33 percent, 28 percent, and 25 percent. The 2001 and 2003 tax acts also created a new ten percent tax bracket carved out of the 15 percent bracket.
These tax laws also repealed the estate tax and modified the gift tax. While current law allows for a one-year repeal of the estate tax, we assume full repeal in the simulations. The 2001 and 2003 cuts also doubled the child tax credit from $500 to $1,000 and made the credit refundable at a rate of 15 percent above an inflation-indexed threshold. The tax cuts included reductions in the "marriage penalty," which involved raising the standard deduction for married couples and increasing the threshold on the 15 percent tax rate to be twice the level for single tilers. The 2001 and 2003 tax cuts also implemented several smaller changes to the tax code, including an expansion of the child and dependent care credit, repeal of the Personal Exemption Phaseout (PEP) and Pease provisions (these provisions limited the ability of high-income taxpayers to take advantage of personal exemptions and itemized deductions), and an increase in the Earned Income Tax Credit (EITC) phaseout range for married filers.
Moreover, the 2003 cuts lowered tax rates on dividends and capital gains. Tax rates on realized capital gains received by individual shareholders were reduced from ten percent (in brackets where the ordinary income tax rate was 15 percent or below) and 20 percent (in brackets where the ordinary income tax was higher than 15 percent) to zero and 15...
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