Bush Administration Tax Policy: Distributional Effects

Introduction

This article evaluates the distributional effects of the 2001 and 2003 tax cuts and is the second article in a series that summarizes and evaluates tax policy in the Bush administration.1 A central issue in any tax change is who wins and who loses. Both the optimal degree of redistribution and the best way to measure that redistribution are controversial. We obtain several key results:

· The tax cuts enacted to date increase the disparity in after-tax income; most households would receive a direct tax cut, but after-tax income would rise by a larger percentage for high-income households than for low-income households.

· Once the eventual financing of the tax cuts is taken into account, the distributional effects will likely be even more regressive. For example, if the eventual financing is proportional to income, about 80 percent of households, including a large majority of households in every income quintile, will end up worse off after the tax cuts plus financing than before.

· Likewise, although advocates routinely describe the tax cuts as pro-family and pro-small-business, we show that most families (that is, with children) and most taxpayers with small-business income will be worse off once the financing is included.

· Even if the tax cuts raise economic growth by a significant amount (relative to existing estimates of the growth effects), most households will end up worse off after the tax cuts, the growth effect, and the financing are considered than they would have been if the tax cuts had not taken place.

· Incorporating the eventual financing of the tax cut into the distributional analysis is a key innovation in the analysis. It is consistent with the fact that the tax cuts must be paid for eventually with either spending cuts or other tax increases. It is consistent with the differential (revenue-neutral) incidence analysis that is the standard in academic treatments of tax incidence. And it makes moot the distracting and misleading debates about which of a variety of distributional measures are most appropriate: In analyses that ignore financing, the alternative measures give different results, but when plausible methods of financing are included, all of the measures yield the same qualitative results.

Section II discusses alternative measures of the distribution of tax changes. Section III provides estimates of the distributional effects of the 2001 and 2003 tax cuts, if they are made permanent, ignoring how the tax cuts will be financed. Section IV discusses alternative methods of financing the tax cuts and incorporates those methods in the distributional analysis. Section V examines a variety of criticisms of distributional analysis, our responses, and a discussion of how those criticisms affect the results presented here.