Effects of the EGTRRA: Individual Income Tax Rate Structure Changes. Matthew Boeer. Dr. Dirk Early. Public Economics

Transcription

1 Effects of the EGTRRA: Individual Income Tax Rate Structure Changes Matthew Boeer Dr. Dirk Early Public Economics April 21, 2004

2 1 Effects of the EGTRRA: Individual Income Tax Rate Structure Changes Introduction President Bush proposed the Economic Growth and Tax Reform Reconciliation Act of 2001 to help sustain and uplift an ailing economy. The administration intended it to work partially through the reduction of marginal tax rates, which would place more money in the hands of American taxpayers. The increased after-tax wages should have increased consumer confidence and purchasing power, helping to prod the economy into a recovery. In reality, the cuts had little success in achieving these aims. This paper will look at the theory behind the tax cuts, analyze the estimated effects of the tax cuts on income redistribution, and examine other unintended, or at least unmentioned, consequences of the tax cuts. It is difficult to assess the impact of the EGTRRA because Congress has made subsequent changes to the tax code and large-scale events have occurred that affect the economy greatly, but this paper will attempt to deal with the ramifications of the EGTRRA specifically. The changes to the individual tax rate structure made by the EGTRRA are regressive (a condition that will only worsen as rates for upper tax payers continue to fall). Tax cuts may not have been the best solution for the economy, yet assuming cuts were in order, the size and structure of these cuts lead them to be largely ineffectual, particularly when viewed against the uncertainty caused by the ballooning deficit. Overview of EGTRRA The EGTRRA has many provisions, yet for this paper will focus on those affecting the individual income tax rate structure. The most publicized feature of the act carves a new ten percent bracket out of the existing 15% bracket for the first $6,000 of

3 2 taxable income for individuals, $10,000 for heads of households, and $12,000 for married couples filing jointly (Joint 2001). Thus, at maximum, taxpayers gain $300 (five percent of $6,000) from the creation of the new bracket. While the 28, 31, 36 and 39.6% brackets received rate reductions that increase over time, the 15% bracket did not. A single percentage point reduction in the fifteen percent bracket, before the formation of the 10 percent bracket, could result in a maximum gain of $279.50, yet this lacks the political visibility of the creation of a ten percent bracket. As mentioned briefly, the act would provide the top four brackets with a reduction of a single percentage point for the calendar years , another point in , and a final point for 2006 and later. In the highest income bracket, the final reduction comes not as a single percentage point, but as a 2.6% reduction, bringing the top bracket from its original 39.6% rate in 2000 to 35% in 2006 (Joint 2001). If the lowest bracket had received the same 4.6% rate reduction afforded the upper bracket, it would yield a maximum gain of $ in a single year to taxpayers, eclipsing the paltry $300 that the new ten-percent bracket provides. A tax rate reduction comparable to the one received by the top bracket provide greater benefits than the creation of the new ten-percent bracket to many in the fifteenpercent bracket. Table 1 shows the after-tax income from several sample single wage earners under the current program containing a ten percent wage bracket but no further rate reduction in the 15% bracket. The table compares this with a scenario containing a single bracket for income under $27,950 that has been reduced 4.6% to 10.4% (a reduction comparable to the one experienced by the highest wage bracket). The final column shows the difference between the two. Any single worker earning above $6,522

4 3 would benefit from the implementation of the second plan. While the creation of a tenpercent bracket does provide greater benefit to those earning less than $6,522, the benefit is slight (only $24 at the $6,000 level). This inequity seems more palatable because the new bracket became effective immediately, while the 4.6% reduction in the top bracket does not fully phase in until Thus, the American people will not see the true shape of the tax cuts for several years. The credit resulting from the creation of the ten percent bracket came to many taxpayers in the form of a check from the government (Joint 2001). This injected new money quickly into the economy. I will discuss the amounts and effects of the new money on the economy later in the paper. Other equity issues arise with the provisions to phase-out the overall limitations on itemized deductions. One-third of the phase-out will occur in 2006 and 2007, followed by an additional third in 2008 and 2009, and the final third after December 31, 2009 (Joint 2001). In 2003, the limitation, or cutback adjustment, on itemized deductions began with persons whose adjusted gross incomes exceeded $139,500 (Hoffman 2004). Obviously, only those with earnings in excess of the adjusted gross income limit would benefit from this repeal. In addition, the act calls for the phase-out of restrictions on personal exemptions on a time schedule similar to the phase-out of restrictions on itemized deductions. This also, would only benefit taxpayers with an adjusted gross income that exceeds $139,500. Distributional Effects The structure of the tax cuts has important effects on the distribution of wealth in America. Table 2 shows the distribution of income tax change by percentile in 2002.

5 4 48.2% of the cuts go to the top quintile, compared with less than one percentage point going to the lowest quartile. While this is not surprising, considering how large a share of the nation s income the top quintile receives, the increase in disparity over time is alarming. As mentioned previously, many of the cuts that benefit the wealthy become active only in later years. Table 3 estimates the effects on income distribution in the year The top quintile s share of the tax change has increases to 57.2% while the share belonging to the lowest quintile decreases slightly to.6%. The most startling change is the increase experienced by the top 1% of taxpayers, whose percentage share of the tax change leaps from 11.2% to 34.1%. In actual percentage increase in after-tax wages, the cuts fail to give equal treatment to lower-income taxpayers. A distributionally neutral tax cut does not change the distribution of wealth and provides all households with the same percentage change in after-tax income. Table 4 shows that while households in the lowest quintile gain 0.8% in after-tax income, the top 1% gain 6.3%. Thus, the change in tax rates is a regressive one, actually increasing the disparity between the rich and the poor in America. If the intent was to increase spending, the cuts do not seem to distribute resources efficiently, given the fact that lower income households are more likely to spend a greater percentage of their income. Figure 1 shows the effect of distributionally neutral tax cut on the level of consumption during a present period (C 0 ) and during a future period (C 1 ), assuming no second period income, for two people, Rich and Poor. The inside budget constraint, demarcated by line AB, represents the after-tax income of both Rich and Poor in percentage terms, not in absolute dollars. Rich and Poor do not have the same after-tax income in absolute dollar amounts. Hence, they can share the same constraint because it

6 5 merely signifies consumption of 100% of after-tax income in the current period where it intercepts the X-axis. The Y intercept represents the entirety of income being set aside for future consumption. For simplicity, we assume both parties invest in tax-exempt municipal bonds. Thus, the Y intercept is valued at 100 percent of after-tax income multiplied by 1 plus the interest rate received from savings [100 % * (1+r)] or simply one plus r. Line CD represents the budget constraint after the tax cut or, alternatively, the original after-tax wage plus a distributionally neutral reduction in tax burden, which produces a parallel outward shift in the budget constraint. Both Rich and Poor are proportionally equally better off. If the new tax cuts represent a five-percent increase in after-tax income for both individuals (not necessarily a five-percent reduction in their respective marginal tax rates), the X-intercept of line CD would be 105% and the Y- intercept would be 105% * (1 + r). Let us also say that Rich values later consumption more than Poor who must consume most of his or her income in the present period. Thus, Rich s indifference curve, represented as IC R, would be less steep than that of Poor, represented as IC P. Given the parallel shift of the budget constraint, Rich would choose to save more of the extra income than he would spend, while Poor would do the opposite. Thus, money rebated to Poor would result in a higher percentage increase in consumption than would money rebated to Rich. With the current distribution, the tax cuts will likely have a small effect on economic growth in the short term (Gale and Potter 2002). At the same cost in lost revenue, the government could have received much greater benefit from allocating a larger portion of the tax cut to lower income taxpayers. Thus, the tax cuts fail to meet the definition of efficient.

7 6 As mentioned previously, the government immediately sent taxpayers the rebate resulting from the creation of the ten-percent bracket in the form of a check. The administration intended the check to have immediate effects on personal consumption expenditures. Yet, the rebate only represented 0.4% of GDP and 75% of households in the bottom quintile and 33% in the second quintile did not receive the rebate. The diminutive size of the rebate, coupled with its distribution, helped to raise personal consumption expenditures by only 0.1 percent, even though personal disposable income rose by 1.9 percent (Gale and Potter 2002). Thus, the changes made to the individual income tax rate structure by the Economic Growth and Tax Reform Reconciliation Act of 2001 disproportionately benefit the wealthy. The new ten-percent bracket provides immediate relief to many, which seems compatible, at least at face value, with President Bush s plan to spur the economy. The benefits to the wealthy seem to have another purpose, as many do not occur until a later date when the economy may not need extra stimulation. The new bracket creation provides a Trojan horse for other tax cuts that will primarily benefit the wealthy. For the reasons listed previously, it would appear that, for the goals given by the administration, the tax cuts are neither efficient nor equitable. Effect on Number of Hours Worked Another proposed benefit of tax cuts would be an increase in hours worked by individuals. Given that workers will be taking home more out of every dollar than before the cuts, it would seem obvious that they would choose to work more. Yet, conflicting forces do exist. With a proportional increase in after-tax wage resulting from the tax cut, the opportunity cost of leisure will rise as now they give up more wages for every hour of

8 7 leisure taken. Based on this effect (substitution), the taxpayer will decrease their consumption of leisure, which by definition increases their level of work. The income effect also influences the decision to alter hours worked. The income effect states that as real income rises (because of the tax cut), the taxpayer will consume more leisure (assuming leisure is a normal good). The increased consumption of leisure necessitates a decrease in hours worked. Thus, depending on the relative strength of the two effects and personal tastes for work and leisure (as shown in indifference curves), work may increase or decrease with a proportional increase in after-tax earnings. In Figure 2, the hours of work actually increase with the increase in after-tax earnings. In this figure, line TH represents the original after-tax budget constraint, and line TD represents the budget constraint s shift after a reduction in the marginal tax rate. The indifference curves (representing the tastes of the taxpayer) shift up and left with the introduction of the new budget constraint. Figure 3 depicts the other alternative. The shape of the indifference curves cause the level of work to increase with the increase in after-tax wages. Rosen (2002) confirms that variables affecting the positioning of the budget constraint and the shape of the indifference curves determine whether work is increased or decreased with a tax cut (Rosen 2002). Some estimates place the level of work increase at 0.5 percent more hours by the year 2011 (Gale and Potter). Certainly not an impressive increase, which is not surprising considering studies have found that changes in net wage produce little effect on the hours worked, except perhaps among married women (qtd. in Rosen 2002).

9 8 Fiscal Discipline The budget balance affects the desired results of the tax cuts (stimulating the economy). Auerbach (2003) believes that agents in the private sector remain aware of the long-term budget outlook and alter their short-term decisions accordingly. This could weaken or reverse the desired effects of the tax cuts as private agents view the large projected deficit as a sign that the cuts are unsustainable. Thus, the spending increases and uncertainty regarding the costs from the war on terrorism (which very often fail to make it into official budgets) could worsen the way private agents view the long-term health of the government. The increasing size of the public debt also raises interest rates, which in turn lowers investments activity. Some estimates predict that the EGTRRA alone (notwithstanding the spending increases) will raise interest rates seventy-five basis points in the next ten years (Gale and Potter 2002). This contrasts the positive effects of lower tax rates on investment activity. Gale and Potter also find that increases in interest rates, even though they may be small, can overpower the effect of the tax cuts. These studies all suggest that the fiscal balance does have pervasive and lasting effects. This could argue for better budgetary discipline, perhaps as a precursor to tax cuts. Expenditure cuts could improve the fiscal health of the government. Turnovsky (1999) believes that a tax cut without a paired spending cut will not improve the longterm fiscal balance. A tax cut alone cannot accomplish this feat because the labor supply lacks the necessary elasticity in regards to the after-tax wage to compensate the lost revenue of the cuts, a fact asserted earlier in the paper. Indeed, governmental fiscal policy produces large-scale economic effects that possess at least as large and perhaps even

10 9 larger responsiveness to spending cuts as they are to tax cuts (Knoop 1999). I argue neither for nor against spending cuts. I mention them as another alternative that could have produced better results than the current tax cut at least in the achievement of a more balanced budget. Some argue as if the tax cut is paired by definition with an expenditure cut. The logic may seem simple. If the government has less in revenues, they will spend less. Yet, that has not always been the case in the past. Historically, the tax cuts of 1964 and 1981 failed to reduce government spending for any significant length of time (Gale and Potter 2002). The tax cuts do not seem to have had much of an influence on governmental outlays, which have increased from $1.8 trillion in 2000 to $2.2 trillion in This increase, coupled with decreased inflows (from $2 trillion to $1.8 trillion over the same time span), has caused the government to move from a $236 billion surplus to a $375 billion deficit (CBO 2004). Gale and Potter (2002) issue a caveat, warning that cuts in government spending could result in an unfair reduction of services that primarily benefit the low and middle-income households. Permanency of EGTRRA The Bush administration has argued for the elimination of the sunset provisions included in the EGTRRA. The administration asserts that this as a way to increase certainty and, consequently, the effectiveness of the tax cuts. As mentioned previously, a great deal of uncertainty already exists from the decrease in revenues and increase in outlays that have produced the enormous deficit. Gale and Hall (2004) confirm this and believe that permanency will not increase certainty when private agents view the cuts as unsustainable. If private agents knew that the sunset provisions would expire at their

11 10 appointed time, we could achieve the same degree of certainty as making the cuts permanent. The rate structure in place before the enactment of the EGTRRA had permanency and yet changed dramatically. Tax reform happens at Congressional discretion. Uncertainty seems intrinsic within the system. Inaccurate impressions of certainty, when given by respected leaders to the general populace, only leads to feelings of betrayal and reflexive reactions when change does occur, because they did not remain open to the possibility of change. In my opinion, a substantial degree of certainty can only occur when taxpayers trust the administration to implement sound fiscal policy. Policy Suggestions Assuming tax cuts were the best way to stimulate the economy and achieve the objectives of the administration, President Bush structured them poorly to obtain those aims. Both in terms of efficiency and equity, adjusting the tax cuts to provide greater benefits to the poor would be a better choice than the current scheme. The poor would spend a greater amount of the cuts and the increase in their after-tax wages would leave them better off and perhaps cause, at least those on the margin, to require fewer government services. Rather than having the wealth generated by these regressive changes trickle down to the poor, increasing the well-being of the poor directly (even if by simply instituting a distributionally neutral tax cut) could provide a foundation for the sustainable long-term betterment of society. Spending restraint and creative fiscal policy and programs could also have served the administration better than the tax cuts. By using the term creative, I refer to the use of a scalpel rather than a chainsaw in approaching these problems.

12 11 As mentioned previously, fiscal discipline could also produce positive effects. Looking back to examples in other countries in the 1980s, one can see that fiscal consolidation can actually result in economic expansion. Denmark, Ireland, Belgium, Canada, Italy, Portugal, and Sweden all reduced their deficit while continuing to see positive growth in private consumption. Denmark and Ireland actually saw private consumption increases of 17.7 percent and 14.5 percent respectively (Perotti 1399). These cases are not directly analogous, as all occurred during periods containing substantial deficits, while the US had a budget surplus when President Bush proposed the EGTRRA. Yet, the situations may be more similar than they appear at first glance. The baseline budget ignores some substantial long-term costs, such as Social Security, Medicare and government pension programs (Gale and Potter 2002). Thus, the surplus did not exist to the extent touted by the administration. While this fact may escape the realization of the public, it should not have escaped the notice of the administration. Yet, the administration quoted these figures frequently without qualification, making the time seem right to give the American people their money back. Future Research Vast potential exists for further research on this topic. This paper dealt mainly with changes to the individual income tax rate structure. The EGTRRA also contained provisions regarding tax benefits relating to children, marriage penalty relief and educational incentives. Provisions also exist regarding estate, gift, and generationskipping transfer tax. One could view these provisions as regressive as well. Other provisions include pension and individual retirement arrangements, AMT relief, and other miscellaneous provisions (including corporate estimated tax, postponement of tax

13 12 deadlines for those in disaster, and guidelines for the treatment of restitution for Holocaust victims). National savings did not receive discussion within this paper as many of these other provisions (individual retirement arrangements and estate taxes) could drastically change the anticipated effect of the individual income tax structure changes. These provisions produce a spectrum of effects upon the fiscal balance and the state of the economy. The examination of all of these effects could produce novels. Many of the effects of these policies are difficult to determine with theoretical models and must receive empirical assessment Conclusion. In conclusion, the administration proposed the EGTRRA during a largely exaggerated budget surplus, based on underrepresented pending liabilities, as a means to provide short-term stimulus to the economy, by giving taxpayers their money back. The cuts extend into 2010, if the push to make them permanent does not prevail, and become more regressive as marginal tax rates continue to decrease for some of the brackets. Theoretically and empirically, the cuts do not seem poised to have a great positive effect on short-term economic health and could actually be damaging to long-term well-being. The EGTRRA appears superficially to benefit lower income families and boost the economy, yet, the timing and structure of the tax rate changes leave the EGTRRA likely to worsen the distribution of income within America while producing little positive and probably negative effects on the economy and the budget.

14 13 Table 1 Tables and Figures After tax income Income W/ 10% bracket W/ 4.6% reduction Difference $ 1,000 $ 900 $ 896 $ ,800 1, ,000 2,700 2, ,000 5,400 5, ,522 5,843 5,843-7,000 6,250 6,272 (22) 8,000 7,100 7,168 (68) 9,000 7,950 8,064 (114) 12,000 10,500 10,752 (252) 15,000 13,050 13,440 (390) 20,000 17,300 17,920 (620) $ 27,950 $ 24,058 $ 25,043 $ (986) Table 2 Table T EGTRRA: Distribution of Income Tax Change by Percentiles, AGI Class 2 Income Tax Change Dollars Percent (millions) of Total Average Tax Change ($) Percent Change in After-Tax Lowest Quintile Second Quintile -7, Middle Quintile -12, Fourth Quintile -15, Next 10 Percent -11, Next 5 Percent -7, , Next 4 Percent -7, , Top 1 Percent -7, , All -70, Source: Urban-Brookings Tax Policy Center Microsimulation Model. * Less than 0.05 percent. (1) Calendar Year. Includes provisions affecting marginal tax rates, the 10- percent bracket, the child tax credit, the child and dependent care credit, the limitation on itemized deductions, the personal exemption phaseout, the AMT, as well as the standard deduction, 15-percent bracket, and EITC provisions for married couples. Excludes retirement and education provisions. (2) Returns with negative AGI are excluded from the lowest quintile but are included in the totals. November 19, 2002 Source: Tax Policy Center 2002

15 14 Table 3 Table T EGTRRA: Distribution of Income Tax Change by Percentiles, 2010 AGI Class 2 Lowest Quintile Second Quintile -13, Middle Quintile -23, Fourth Quintile -32, , Next 10 Percent -22, , Next 5 Percent -8, , Next 4 Percent -6, , Top 1 Percent -56, , All -165, , Source: Urban-Brookings Tax Policy Center Microsimulation Model. * Less than 0.05 percent. (1) Calendar Year. Includes provisions affecting marginal tax rates, the 10- percent bracket, the child tax credit, the child and dependent care credit, the limitation on itemized deductions, the personal exemption phaseout, the AMT, as well as the standard deduction, 15-percent bracket, and EITC provisions for married couples. Excludes retirement and education provisions. (2) Returns with negative AGI are excluded from the lowest quintile but are included in the totals. November 19, 2002 Income Tax Change Dollars Percent (millions) of Total Source: Tax Policy Center 2002 Average Tax Change ($) Percent Change in After-Tax

16 15 Table 4 Source: Gale and Potter 2002

17 16 C1 Figure 1 D B SR 1 SR 0 IC R 1 IC R 0 SP 1 SP IC IC P P CR 0 CR 1 CP 0 CP 1 C A C 0

18 17 Income per week D H Figure 2 I 1 I 0 IC 1 IC 0 0 H 0 H 1 T Hours of leisure per week

19 18 Income per week D H Figure 3 I 0 I 1 IC 0 IC 1 0 H 0 H 1 T Hours of leisure per week

20 19 Bibliography Alan J. Auerbach. Fiscal Policy, Past and Present. The Brookings Papers on Economic Activity. 1 (2003): Bush, George. For Everyone Willing to Work, a Job. Office of Management and Budget. (2004): 4p. Congressional Budget Office. The Budget and Economic Outlook: Fiscal Years Appendix F. Table 1. January 26, Davies, David G. United States Taxes and Tax Policy. New York: Cambridge, Gale, William and Matthew Hall. Key Points on making the Bush Tax Cuts Permanent. The Brookings Institution. (2004): 4p. Gale, William and Samara Potter. The Bush Tax Cut: One Year Later. The Brookings Institution. (2002): 1-8. Hoffman, William H., ed. West Federal Taxation: Individual Income Taxes ed. Mason: Thomson, Joint Committee on Taxation. Summary of Provisions Contained in the Conference Agreement for H.R. 1836: the Economic Growth and Tax Relief Reconciliation Act of JCX (May 26, 2001). Knopp, Todd A. Growth, Welfare, and the Size of Government. Economic Inquiry. 37:1 (1999): Perotti, Roberto. Fiscal Policy in Good Times and Bad. The Quarterly Journal of Economics. (1999): Rosen, Harvey S. Public Finance. 6 th ed. Boston: McGraw-Hill Irwin, Slemrod, Joel b. Tax Progressivity and Income Inequality. New York: Cambridge, Tax Policy Center. EGTRRA: Distribution of Income Tax Change by Percentiles, Nov Apr < &topic2id=40&topic3id=52&doctypeid=2>. Tax Policy Center. EGTRRA: Distribution of Income Tax Change by Percentiles, Nov Apr < &topic2id=40&topic3id=52&doctypeid=2>.

21 Turnovsky, Stephen J. Budget Balance, Welfare, and the Growth Rate: Dynamic Scoring of the Long-run Government Budget. Journal of Money, Credit and Banking. 31:2 (1999):