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Designing Tax Cuts to Benefit Low-Income Families
No. 1 in the Series, "Tax Policy Issues and Options"
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With support from the Bush administration, the Federal Reserve Board Chairman, and Congress, a major cut in the federal income tax is almost certain. The question now is what type of cut it should be. Proponents often speak as though all tax cuts would benefit all groups. Not all income tax cuts are alike, however. Many popular options in fact provide no benefit to low-income families.
The reason is simple. Low-income families pay little or no income tax and thus would receive little help from proposals that reduce only positive income tax liabilities. Although most low-income families do not pay federal income taxes, they do work and pay federal payroll and excise taxes, as well as substantial state and local taxes in many jurisdictions. Fairness does not dictate that all tax relief should go to low-income families, but neither should they be totally left out.
Comparing the relative benefits of different types of tax cuts to families at varying income levels helps shed light on how tax relief can, indeed, benefit all families. The discussion here compares five types of tax cuts that are representative of recent proposals:
The comparison reveals that the most important feature of tax relief, if it is to benefit low-income Americans, is full refundability (e.g., that the benefit not be limited by a taxpayer's income tax liability). Of the proposals analyzed here, the two that would benefit low-income families most are an expanded EITC and a refundable payroll tax credit. Over 40 percent of the benefits of either option would go to households with incomes below $30,000 a year.
A more generous child credit would provide limited benefit to low-income families, even if it were refundable for all families (it is currently refundable only for families with three or more children), because the child credit's refundability is limited to the amount by which a family's payroll tax liability exceeds any EITC.1 About 60 percent of the benefits from both the child credit options analyzed here would go to households with incomes between $30,000 and $75,000.
Almost 40 percent of the benefits from an increased standard deduction and a widening of the lowest tax bracket would go to the 15 percent of people in households with incomes over $100,000; over 50 percent of the benefits of an across-the-board income tax rate cut of 5 percent would go to those households.
Measuring the Relative Benefit from Tax Cuts
The five tax cut comparisons discussed here are displayed in table 1, along with the provisions of current law that would be changed. Each option is simulated as if it were law in l998the latest year for which data were availableusing the Urban Institute's Transfer Income Model (TRIM).2
TABLE 1. The Simulated Federal Tax Cut Options
To accurately measure the tax-payer benefits of tax cut options appropriately, two requirements must be met. First, the options being compared should have equal overall implications for the federal budget: Because tax cuts can reduce the money available for federal programs, many of which benefit low-income families, a fair analysis should ensure that any reductions in these benefits be equal across tax cut proposals. The options assessed here would each reduce 1998 federal revenues by about $34 billion.
The second requirement is that the measured benefit reflect the tax cut's impact on economic well-beingthe income the family has to spend. Many analyses violate this requirement by measuring the benefit as the percent change in a house-hold's tax liability, making it seem that low-income families derive the most benefit from income tax cuts because they pay so little tax to begin with. For example, suppose a tax cut reduces the tax liability of a family with income of $20,000 from $200 to $0 and the liability of a family with income of $200,000 from $40,000 to $32,000. The low-income family's tax is cut by 100 percent, the high-income family's by 20 percent, but while the lower-income family's after-tax income has increased by 1 percent, the higher-income family's has by 5 percent. Most people would not think the low-income family in this example had in fact benefited more than its high-income counterpart.
Two measures are used here to capture changes in economic well-being. The first is the change in the average tax rate (i.e., the fraction of each dollar of income that goes in tax) facing different income groups.3 This measures the tax cut as a percentage of the family's pre-tax income. The greater the reduction in an income group's average tax rate, the greater their benefit. The second measure is the percentage change in after-tax income. Again, those income groups with larger percentage increases in after-tax income receive larger relative benefits from the tax cut.
The Federal Tax Burden on Low-Income Americans
The federal income tax system is progressive: The higher a family's income, the higher its taxes as a percentage of income. Most low-income families currently pay little or no federal income tax. Two changes have contributed the most to reducing low-income families' federal taxes. First, increases in the personal exemption and standard deductions, enacted in 1986, removed many low-income families from the tax rolls. The level of inflation-adjusted income at which a family of four begins to pay tax is nearly double what it was before 1986 and is significantly above the federal poverty level (FPL). Second, several tax bills, especially in 1990 and 1993, greatly increased the EITC, a tax credit applied to low-income families' wages that phases out as income rises above a certain level. It provides the largest benefits to workers with children, but a small credit is also available to childless workers. Because the EITC is specifically designed to assist low-income working families, the recent expansions of the credit have had profound effects on the overall tax burdens faced by such families. About 19 million tax-payers now receive the EITC, claiming nearly $30 billion in credits. About $23 billion of the EITC represents net refunds (credits in excess of positive income tax liabilities).
The child credit enacted in 1997, in contrast, provides little tax relief for many low-income families with children because it is generally not refundable. Only families with three or more eligible children can receive a refund if their total credit exceeds their income tax, and even then the refund is limited to the amount by which their payroll taxes exceed any EITC. Thus, families with no income tax liability and fewer than three children receive no benefit from the credit, while families with low income tax liability receive only a partial benefit. In 1998, only about two-thirds (25 million) of families that filed a tax return and had at least one child under age 17 claimed full or partial child credits; these totaled over $15 billion. Of the approximately one-third of families with children that received no credit, most (11.5 million) were low-income families who had no income tax liability. Only about 700,000 families benefited from the credit's refundability provision.
In sharp contrast to the progressive rate structure of the federal income tax, the payroll tax is levied at a single rate, paid by both workers and their employers, that is currently 6.2 percent of earnings for Old Age, Survivor, and Disability Insurance (OASDI), and 1.45 percent for the Hospital Insurance program (Medicare). Low-income families actually pay a higher proportion of income in payroll taxes than do high-income families, for two reasons: The tax is levied only on earnings (not on investment income), and the OASDI portion of the tax exempts earnings above a certain level ($76,200 in 2000).4
Although almost all working Americans pay positive payroll taxes, and three-quarters of U.S. families pay more in payroll taxes than in income taxes, many low-income families receive more in refunds than they owe in taxes, because their EITC exceeds the sum of their payroll and income tax liabilities. As shown in the top panel of table 2, for example, a married couple with two children and income equal to the FPL would have received a net income tax refund of about $2,882 in 1999. Since they would have paid payroll taxes of $1,292 in that year (assuming that all their income is earnings, and counting only the employee-paid portion of the payroll tax), they would have received a net refund of $1,590 on their federal taxes.5
Relative Benefits of Different Tax Cut Options
A good way to see the relative impacts of different tax cut options is to look at the percent of the total benefit going to different income groups. To provide context for this discussion, the share of current federal income tax and of current income and payroll taxes is also shown in table 3.
The only options with appreciable benefit shares going to the lowest income groups are options IV and Vthe increased EITC and the payroll tax credit (table 3). Most of the benefits for both (46 percent and 41 percent, respectively) go to families with incomes of less than $30,000 a year.
TABLE 2. Federal Income and Payroll Taxes Paid by Low-Income Families, 1999
Source: Urban Institute calculations. For details see Sammartino (2001, table 1).
Increasing the child credit (options IIIa and IIIb) would provide about 60 percent of the benefits to families with incomes between $30,000 and $75,000. A slightly higher share would go to families with income at and just below the lower end of that income range if smaller families were made eligible for the credit's limited refundability.
Options I and II would do little for low-income families. Over 60 percent of the benefits from raising the standard deduction and increasing the income range for the 15 percent tax bracket would go to households with incomes over $75,000. Only the 25 percent of taxpayers currently facing statutory rates greater than 15 percent would benefit if the income range for the 15 percent bracket were increased. Furthermore, those tax-payers at the low end of the 28 percent income bracket, who have a small portion of their income taxed at that rate, would receive only a small benefit from the bracket widening.
TABLE 3. Percent Share of Baseline Income Taxes and Payroll Taxes and Simulated Tax Cuts, by Income Level (All Households, 1998)
Source: Urban Institute TRIM microsimulation model. For details see Sammartino (2001, table 10).
Over 50 percent of the benefits from a 5 percent across-the-board cut in tax rates would go to households with incomes of $100,000 or more (representing only 15 percent of the population). This benefit share is less than their current share of federal income taxes but more than their cur-rent share of combined income and payroll taxes.
Measured as the percentage increase in after-tax income, neither the across-the-board cut in tax rates nor the increase in standard deductions and the widening of the bottom tax bracket are progressive changes in taxes. The percentage gain in after-tax income increases with family income; in the case of the across-the-board cut in tax rates, the largest increases are for families with the highest incomes (table 4). The refundable payroll tax credit is the most progressive option, with the lowest-income families seeing the largest percentage gains in after-tax income.
Table 5 shows how the different options would affect low-income families with children by comparing the average income tax rates currently faced by two-parent families with children under 18 with the rates they would face under the various tax cut options. The impact of the child credit's refundability limit is again clear. The proposals to increase the EITC or to create a new refundable payroll tax credit would have the biggest impact on low-income families, boosting those families' refunds. Both credits apply only to families with earnings, so the impact on families with children is much greater than the impact on other low-income families and individuals, about 40 to 50 percent of whom are elderly. Families with children and income below $20,000 would see an average increase in their net refunds of 5 to 6 percent of family income from the increased EITC, and a somewhat smaller increase from the payroll tax credit. Families with incomes of $20,000 to $30,000 would see an increase of about 9 percent of income from the EITC option, and about 2.5 percent from the payroll tax credit.
TABLE 4. Percentage Change in Average Income after Tax, by Income Level (All Households, 1998)
Source: Urban Institute TRIM microsimulation model. For details see Sammartino (2001, table 13).
Whether or not a tax reduction disproportionately benefits low- or high-income families is only one criterion by which to judge its merits. Other goals, such as economic efficiency, tax simplicity, and reduction of taxpayers' compliance burdens, are important as well. Proposals aimed at helping low-income families do not necessarily advance these other goals and may detract from them. When benefits are targeted to particular taxpayers, there must be rules determining who is eligible, increasing tax complexity and creating opportunities for errors and abuse.
In deciding how to take advantage of the opportunity represented by budget surpluses, Congress must first compare tax relief with other options, such as paying down the federal debt or addressing the future insolvency of Social Security and Medicare. If a tax cut is the best option, lawmakers must consider the merits of targeting relatively more tax relief to higher-income families, who have enjoyed extraordinary prosperity over the past decade, when there are many other families who work and pay taxes but do not enjoy the same economic security.
TABLE 5. Average Federal Tax Rates before and after Simulated Tax Cuts, by Income Level (Two-Adult Families with Children, 1998)
Source: Urban Institute TRIM microsimulation model. For details see Sammartino (2001, tables 8 and 9).
1. A number of proposals under consideration by Congress would dramatically change the current limits on refundability of the child credit. If enacted, those proposals would provide substantial benefits to low-income families.
Sammartino, F. J. 2001. Federal Income Tax Cuts and Low-Income Families. http://www.urban.org.
About the Author
Frank J. Sammartino is a principal research associate at the Urban Institute, with research interests in tax policy, retirement, and income security. He is an expert in the use of microsimulation models to forecast and analyze tax and transfer policies. Prior to joining the Urban Institute in 1999, Mr. Sammartino served as deputy assistant director for tax analysis at the Congressional Budget Office, where he directed tax policy research and was one of the two architects of the models the agency used to project individual income tax revenues and to analyze the distribution of federal taxes among families.
About the Series
The Tax Policy Issues and Options Series is part of a new program at the Urban Institute to carry out objective, timely, and comprehensive research of a broad range of tax policy issues. The program's output will include short-term analyses of tax proposals pending before Congress and longer-term analyses of systemic tax and related spending issues.
The program has received funding from the Annie E. Casey Foundation, The George Gund Foundation, and the Smith Richardson Foundation.