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Thursday, September 06, 2007

Jason Furman: The Effect of the 2001-06 Tax Cuts on After-Tax Incomes

With all the debate about tax cuts the last few days, this is timely. Here is Jason Furman testifying before the House Ways and Means Committee today about the impact of the 2001-06 tax cuts on the level and distribution of after-tax incomes. The extent to which the tax cuts helped to pay for themselves is also examined, and the dynamic impacts are almost imperceptible (and may even work in the wrong direction).

But the fact that these tax cuts did not pay for themselves or even offset the costs to any noticeable degree is old news. What's interesting about these estimates is that they imply that the tax-cuts leave nearly three quarters of households with lower after-tax incomes. Why does this occur? Most dynamic economic models that predict tax cuts will lead to higher GDP growth also generally assume that the tax cuts are paid for by reducing benefits or raising other taxes (e.g. replace labor/capital taxes with lump-sum taxes as in the Mankiw-Weinzerl model).

Thus, although tax cuts may result in efficiency gains, which is often one of the main arguments given for tax cuts (e.g. "tax cuts, by reducing deadweight loss ... will be good for the economy"), when you factor in the new taxes and who pays them (or equivalently reductions in benefits like Social Security, Medicare, or food stamps) and look at the resulting distribution of winners and losers, the outcome is one where three quarters of households come out behind. Jason terms this "dynamic distributional analysis":

The Effect of the 2001-06 Tax Cuts on After-Tax Incomes, by Jason Furman[1], Testimony Before the U.S. House Committee on Ways and Means, September 6, 2007 (summary): Mr. Chairman and other members of the Committee, thank you for the invitation to testify today at this hearing on fair and equitable tax policy for America’s working families. I would like to start with a confession: as an economist I have no special expertise in fairness or equity. The members of this committee were elected, in part, to make critical value judgments about these fundamental questions. But in order to make these value judgments you need the understand who is impacted by the tax changes and how they are impacted. And economists do have a special expertise that can help further this understanding and thus inform the debate on the bigger issues.

Evaluating a tax change requires understanding the impact it has on households through three different channels: (1) the direct impact of the tax changes on take-home pay; (2) the economic effects of the tax change on before-tax incomes; and (3) the impact that the associated budgetary changes have on future taxes or government spending on households. All three channels can be usefully summarized in a single variable: the change in the after-tax incomes of households.[2]

Policy analysts and official scorekeepers have made varying degrees of progress on each of these three channels but have seldom integrated them into one comprehensive assessment of tax proposals. My testimony today applies such an integrated approach, potentially termed “dynamic distributional analysis,” to examine the long-run impact of the tax cuts enacted from 2001 to 2006 on the after-tax income of American families.

Some of the key findings of this analysis are:

  • The direct effect of the tax cuts enacted from 2001-06 is to increase after-tax income inequality. Ignoring the effects on the economy and the budget, making the tax cuts permanent would result in a 0.7 percent increase in the after-tax income of the bottom quintile and a 6.7 percent increase in the after-tax income of the top 1 percent. As a result, the gap between these incomes would grow.
  • Economic models generally rule out the possibility of a large, positive impact of the tax cuts on the economy and incomes. In one favorable – but highly unrealistic – scenario the Treasury found that making the tax cuts permanent would be equivalent to raising the growth rate by 0.04 percentage points annually spread out over 20 years. In other words, the growth rate could rise from 3.00 percent to 3.04 percent – a change that would barely be perceptible in quarterly data on the economy. In more realistic scenarios the Treasury found the tax cuts would result in higher debt and lower savings – thus reducing long-run output.
  • Economic models show that the need to eventually finance the tax cuts could result in a large, negative impact on the disposable income of households, for example through reduced Social Security benefits, Medicare benefits, or higher future taxes. This occurs because no economic model finds that tax cuts pay for themselves. The results of dynamic macroeconomic feedback show that the tax cuts are only slightly more expensive or slightly less expensive than shown by the official estimates that ignore such feedback.
  • Taken together, illustrative estimates show that even in the unrealistic best case scenario – in which tax cuts boost incomes and pay for part of their long-run cost through higher economic output – the financing costs of the tax cuts would leave 74 percent of households with lower after-tax incomes. If the increased debt and reduced savings associated with the tax cuts leads to lower incomes, then 76 percent of households would end up with lower after-tax incomes.

    Posted by on Thursday, September 6, 2007 at 01:08 PM in Economics, Income Distribution, Taxes | Permalink  TrackBack (0)  Comments (7)

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