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Distributional Effects of the 2001 and 2003 Tax Cuts and Their Financing

William G. Gale, Peter Orszag, Isaac Shapiro

Published: June 03, 2004
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The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Note: This report is available in its entirety in the Portable Document Format (PDF).


I. Introduction

Popular discourse about tax cuts frequently ignores a simple truism: someone, somewhere, at some time will have to pay for them. The payment may be in the form of increases in other taxes or reductions in government programs; it may occur now or later; it may be transparent or hidden. But iron laws of arithmetic and fiscal solvency imply that the payment has to occur.

To date, the tax cuts enacted in 2001 and 2003 have been funded with increased borrowing. This postpones but does not eliminate the required payments. It can also create the misleading impression that tax cuts make almost everyone better off because the direct tax-cut benefits are immediate and quantifiable, but the ultimate costs are delayed and disguised and thus often ignored.

The central goal of this analysis is to correct the misleading impression that these tax cuts make everyone better off. We estimate not only who benefits directly and immediately from the recent tax cuts, but also who benefits and who loses once the financing of the tax cuts is considered.

Specifically, we examine the distribution of the 2001 and 2003 tax cuts (when fully in effect and reflecting the President's proposal to make most of the tax cuts permanent) combined with the costs of paying for those tax cuts. We therefore examine the "net effects" of the tax cuts, accounting for both the direct benefits and the costs of financing those benefits.

Because there is uncertainty about how the tax cuts will ultimately be financed, we examine two hypothetical scenarios. In both scenarios, the burdens are set so that the annual cost of the tax cuts (when fully phased in) would be paid for fully — so that the net effect of the tax cuts that year on the budget thus would be zero.

The first scenario assumes that each household pays an equal dollar amount each year to finance the tax cuts. Under this scenario, each household receives a direct tax cut based on the 2001 and 2003 legislation, but it also "pays" $1,520 per year in some combination of reductions in benefits from government spending or increases in other taxes to finance the 2001 and 2003 tax cuts. Something close to this scenario could occur if the tax cuts were financed largely or entirely through spending cuts. We refer to this as "equal-dollar" financing.

The second scenario assumes each household pays the same percentage of income to finance the tax cuts. In this case, each household receives a direct tax cut based on the 2001 and 2003 laws, but also pays 2.6 percent of its income each year. Something close to this scenario could occur if the tax cuts were financed through a combination of spending cuts and progressive tax increases. We refer to this as "proportional financing." Our principal findings include:

  • Once the financing is included, the 2001 and 2003 "tax cuts" are best seen as net tax cuts for about 20-25 percent of households, financed by net tax increases or benefit reductions for the remaining 75-80 percent of the population. Not surprisingly, equal-dollar financing is significantly more regressive than proportional financing.
  • Under either financing scenario, more than 75 percent of tax filing units would be worse off: they lose more from the financing than they gain directly from the tax cuts. The "losers" would be concentrated among low- and middle-income households. Under equal-dollar financing, the losers include 90 percent of households in the middle fifth of the income distribution and nearly all households in the bottom 40 percent.
  • The annual net transfer of resources from low- and middle-income households to high-income households would be sizable. The annual transfer from the 80 percent of households with incomes below $76,400 to the top 20 percent of households with incomes above that level would be $113 billion under equal-dollar financing and $27 billion under proportional financing. The annual transfer to households with incomes above $1 million would be $35 billion under equal-dollar financing and $15 billion under the proportional scenario.
  • Middle-income households would be losers under both scenarios, but would fare worse under equal-dollar financing. Under equal-dollar financing, households in the middle quintile would average losses of $869 per year, 3.1 percent of after-tax income. With proportional financing, the loss would be $228, or 0.8 percent of after-tax income.
  • Low-income households would be worse off under either scenario, but would face enormous costs under equal-dollar financing. Under equal-dollar financing, households in the bottom quintile lose an average of $1,500 a year, or 21 percent of their income. Under proportional financing, they lose 2.5 percent of after-tax income.
  • High-income households would be net winners, and the gains among the highest-income households would be large. People with annual incomes above $1 million would gain an average of $59,600 a year, or 3.1 percent of after-tax income, under proportional financing and $135,000 a year, or 7 percent of after-tax income, under equal-dollar financing.

The tax cuts are often portrayed by their supporters as painless and simply "giving people their money back." But the numbers presented above indicate that the substantial majority of American households ultimately will be made worse off by the tax cuts, because the tax cuts ultimately will have to be financed. Different methods of financing would generate variation in the particular results, but the basic findings — that most households end up being worse off and transfers would flow from low- and middle-income households to more affluent households — are likely to continue to hold unless a significant portion of the tax cuts themselves are repealed. The reason is that the tax cuts scale back or eliminate many of the most progressive elements of the federal tax system, including the estate tax, the taxation of capital gains and dividends, the top income tax rates, and the phase-outs of certain exemptions and deductions for households with high incomes. It is unlikely that any method of financing those changes, other than repeal of the tax cuts, will be as progressive as the tax provisions that have been scaled back.

Section II provides conventional distributional analysis of the tax cuts, ignoring the financing. Section III discusses the seemingly obvious point that tax cuts need to be financed. Section IV examines the distributional effects under alternative methods of financing. Section V discusses the robustness of the results and provides concluding remarks.

Note: This report is available in its entirety in the Portable Document Format (PDF).


William G. Gale is the Arjay and Frances Fearing Miller Chair in Federal Economic Policy at the Brookings Institution and Co-Director of the Tax Policy Center. Peter R. Orszag is the Joseph A. Pechman Senior Fellow at Brookings and Co-Director of the Tax Policy Center. Isaac Shapiro is a Senior Fellow at the Center on Budget and Policy Priorities. We thank Len Burman, Joel Friedman, Robert Greenstein, Matt Hall, David Kamin, Richard Kogan, and Arloc Sherman for their contributions to this analysis.