Across-the-Board Tax Cuts: Economic Issues
Released: 2001-09-24T00:00:00

Brief Overview of the Current Tax Structure

Before describing tax cut proposals, some highlights of the current system prior to H.R. 1836 are in order. The current individual income tax systemallows personal exemptions (of $2,800 in 2000) and a standard deduction, along with $500 child tax credits thatcurrently exempt the equivalent of $25,217 fromincome tax for a married couple with two children. Individuals may itemize deductions for mortgage interest, moststate and local taxes, charitable contributionsand some other items. Only 30% of returns itemized deductions according to preliminary data for 1998. (1) Wages and salaries, interest, dividends, capital gains,rents and profits from businesses are taxed.

There are a variety of special tax benefits such as deductions or exemptions for individual retirement accountsand credits for child care and college tuition. Animportant benefit for lower income individuals is a refundable earned income tax credit (which raises the exemptlevel for a family of four to about $31,000). Individuals are also subject to an alternative minimum tax (AMT). Many tax benefits are phased out as incomerises.

There are separate rate schedules for singles, married couples (joint returns), heads-of-households, and married couples filing separate returns. About 44% of taxreturns are joint, and about 43% are single, with most of the remainder (11%) head- of-household. (There is rarelyan advantage to filing a married separatereturn). Standard deductions also vary: they are $7,350 for joint returns, $4,300 for single returns, and $6,350 forhead-of-household returns.

About a quarter of all returns had no tax liability in 1998. However, these shares varied across filing types. In 1997, the latest year that disaggregated data areavailable, 76% of returns had tax liability, representing 86% of joint returns, 77% of single returns and 42% ofhead-of-household returns. Some of the roughly25% of returns with no tax liability would be eligible for tax cuts because their lack of tax liability is due to theearned income tax credit which is refundable andshould not be taken into account for considering eligibility for rate reductions. Overall, 81% of all returns had taxliability before credits including 88% of jointreturns, 79% of single returns, and 65% of head of household. The share eligible for tax cuts would fall betweenthose numbers because some credits are notrefundable (e.g. child care credit, dependent care credit).

Tax rates apply to taxable income at 15%, 28%, 31%, 36% and 39.6 %. Capital gains rates are lower than ordinary rates. As shown in Table 1, tax brackets arewidest for married couples and most narrow for single returns, with head of household returns falling in between.

Table 1. Tax Bracket Widths, 2000

As shown in Table 2, about 70% of taxpayers with some tax liability before credits fall into the lowest taxbracket, and about 90% fall into the 28% bracket orlower. (About 5% ultimately had no tax liability after credits). Despite the wider brackets and larger standarddeductions for joint returns, the higher incomes ofmarried couples place them in slightly higher average brackets: about 60% fall into the 15% bracket and about 85%in the 28% bracket. Unmarried heads ofhousehold returns are most concentrated in lower brackets with 89% falling in the 15% bracket and 98% in the 28%or less bracket. The singles distribution fallsin between these. Some income is taxed at capital gains rates, but in general, very few returns (about 5%) fall intothe higher rate brackets of 31%, 36% or 39.6%.

Table 2. Distribution of Tax Returns By Highest Marginal Tax Rate

Source: Internal Revenue Service Statistics of Income, Individual Income Taxes and Shares, 1997, SOI Bulletin , Spring 2000.

The distribution of income and income taxes paid is, however, quite different. Returns taxed at rates no higher than 15% account for 70% of tax returns, but only19% of tax liability, and the 90% of returns that fall in the 15% or 28% bracket account for 45% of tax liability. The 5% of returns falling into the three highestbrackets account for 46% of tax liability.

This pattern of the concentration of the population in the lower brackets and the concentration of income tax liability and, to a lesser extent, income in the higherbrackets is the crucial underlying reason for the distributional characteristics of alternative tax cut proposals. Thesepatterns are also shown in Table 3. Income inthe United States has become increasingly concentrated in higher income brackets, so that the top fifth of thepopulation received 57% of the income. (Between1977 and 1995, according to figures from the Congressional Budget Office, real income in the highest quintileincreased by 27% while real income in the lowestquintile decreased by 21%.) It is the concentration of income in these higher levels that is most responsible for theconcentration of taxes, although the individualincome tax, and to a lesser extent, total federal taxes, are progressive. This progressivity has increased in the lowerbrackets because of legislation, as well, namelythe child credit enacted in 1997 and the expansion in the earned income credit in 1993.

Table 3. Distribution of Incomes and Taxes by Population Shares, 2000

Source: U.S. Treasury Distributional Analysis Methodology, by Julie-Anne Cronin, U.S. Department of Treasury, OTA Paper 85, September 1999.

Note that the top of the first four quintiles corresponds to incomes of $17,988, $34,844, $59,019, and $100,7676. The top 10% has incomes between $140,581and $189,835; the top 5% income between $189,835 and $462,053. The income concept is an expanded one thatincludes accrued as well as cash income, but theshare distribution is very close to the distribution for cash income. The dollar limits differ, particularly at highincome levels. For the cash income measures, thetop of the first four quintiles correspond to incomes of $16,426, $30,964, $49,862, and $81,967. The top 10% hasincomes between $115,239 and $154,900; thetop 5% income between $154,900 and $346,555. There are 115.2 million families.

Proposals that are targeted at tax cuts in the lower brackets can benefit a large number of people at a lower cost, while tax cuts that benefit the higher brackets cancost a great deal to benefit relatively few individuals. These effects are the result of the existing distribution ofincome and of the tax burden.

Recent Proposals for Across-the-Board Tax Cuts

Initial tax cut proposals made in the House in 1999 included a flat 10% across-the-board tax rate cut. That is,the 15% rate would be cut by 1.5 percentage points,the 28% rate by 2.8 percentage points, and so forth. The Senate proposed a quite different form of tax reduction:a reduction of the 15% rate to 14% and anexpansion (albeit small) in the 14% bracket. The Conference Committee plan ultimately decided to reduce all taxrates by one percentage point; it also agreed toincrease the standard deduction and increase the width of the first rate bracket slightly. Senate Democrats offereda proposal to expand the standard deduction. Theproposals also included separate marriage penalty relief provisions that provided general tax cuts for joint returns.

The general rate reductions in the House bill cost more than in the Senate bill and by the year 2009 the annual cost was estimated at that time to be twice as largeas that in the Senate bill ($112 billion versus $47 billion) if the expansion of the 14% rate for joint returns isincluded and $112 billion versus $27 billion if theexpansion of the bracket is excluded; the Senate version targeted a larger share of its benefits to married couples. Combined with all marriage penalty reliefwhich also affects the rate structure, the House bill's provisions would have cost $117 billion in 2009 while theSenate bill would have cost $96 billion. Revenueestimates do not allow these distinctions for the Conference agreement which was, for procedural reasons, sunsetted, but in 2008, before the sunset, there was anestimated $57 billion revenue loss from the percentage point rate reduction plus an increase in the 14% bracketby for non-joint returns, that appears to accountfor about $13 billion of the total. Increases in the standard deduction and the size of the first bracket joint returnsto make them twice the size of singles wouldhave added a total of $28 billion, for a total of $85 billion.

These bills also modified the Alternative Minimum (AMT) Tax to allow the use of personal credits to offset AMT tax liability.

President Bush's tax proposal has been estimated to cost $1.6 billion over the first ten years (from FY2002-FY2011). He proposed to replace the current structureof taxes with new rate brackets and a 10%, 15%, 25% and 33% rate structure. (Thus current 28% and 31% bracketswould be combined into the 25% bracket) The child tax credit would be doubled to $1000 and the phase-out of the credit will be increased from $110,000 to$200,000 for married couples and from $75,000to $200,000 for single parents. The marriage penalty would be reduced by allowing a 10% deduction for the secondearner (up to $3000). In addition, theproposal (and others announced subsequently) would eliminate estate and gift taxes, and make a number of otherchanges in the tax structure.

The House adopted most of the provisions of the President's plan, including the rate structure, but provided an expansion of the standard deduction and first ratebracket instead of the second-earner deduction. The Senate passed a bill that would not have combined old ratebracket, with keep the original rate brackets, withrates of 10%, 15%, 25%, 28%, 33% and 36%, which roughly involved a three percentage point reduction in thehigher brackets. The Senate bill also eliminatedthe phase out of the itemized deductions and personal exemptions (the equivalent of a percentage point reduction). The final bill ( H.R. 1836 )followed the rates in the Senate bill, except that the top rate was reduced to 35%'s proposal, but the rate bracketswere

How to Assess Progressivity and Distribution

Reports of the distributional effects of tax cuts sometimes appear to depict the same tax change very differently. This difference in how the cut is perceived fordistributional purposes arises from the choice of distributional measure. Some of the measures that have beenpresented include: (1) the share of taxpayersbenefitted that fall below an income level; (2) the percentage reduction in taxes paid, (3) the tax cut as a percentageof income (both pre-tax and disposable), (4)the distribution of the tax cut by income class and (5) the average tax cut. The first of these measures is most likelyto tend to depict a tax change as favoringlower income individuals relative to higher income ones; the second measure is next most likely, and so forth.

To illustrate this point, consider a 10% across-the-board tax cut (all positive net tax liabilities reduced by 10%). Assuming that the bottom quintile of thedistribution does not have tax liability, one could describe this tax cut as one in which three quarters of thebeneficiaries have income below $50,000, which mightmake the cut to appear not to be particularly targeted to high income individuals. Almost any tax cut that is a generalone will benefit, in numbers, those outsidethe high income taxpayers, because high income taxpayers are, by definition, not very numerous. But this descriptionof the tax cut does not tell us anything abouthow much of a tax cut different groups receive. Table 4 illustrates how such quantitative measures of the typesdescribed above would look assuming everyone ineach quintile and group has the same average income (an assumption that allows the calculation of measures in thelower brackets where some individuals havenegative tax liability because of the earned income tax credit). (Note, however, that this table does not account fora number of other features of the tax law, asdiscussed in the following section.)

Based on percentage changes reported in the second column, the tax cut as a percentage of income tax liabilities, the tax cut may appear to be fairly equal acrossthe income classes (except for the lowest group). But that measure does not really tell us very much aboutdistribution, because people in the lower incomecategories may have extremely small tax liabilities and a tiny change in tax could result in a very big percentage. Even expanding the measure to a percentagereduction in all taxes shows that a proportional cut in income taxes reduces total taxes proportionally more for highincome individuals. Moreover, even in thiscase, measuring the percentage reduction in tax liability has not shown us anything about the effect on incomeequality; it merely shows us that individual incometaxes are more progressive than total taxes.

Table 4. Alternative Measures of Distribution for a Ten PercentAcross-the-Board Rate Cut

Source: Calculated based on data from U.S. Treasury Distributional Analysis Methodology, by Julie-Anne Cronin, U.S. Department of Treasury, OTA Paper 85,September 1999. The term "Total Tax Liability" refers to all federal taxes plus state and local income taxes.

In discussing these measures that do relate to effects on income inequality, it first is important to distinguish between absolute measures and relative measures. For example, average tax reductions per unit provide information on the absolute size of a tax benefit across theincome classes, which is a straightforwardmeasure, and is shown in the last column of Table 4. In this example, the second quintile has a tax cut of $23 perperson and the highest quintile a cut of $2,841.

Another way of examining this same effect is to compare the distribution of the tax benefit with the distribution of the population, in the next to last column ofTable 4. If each proportion of the population is getting the same share of the benefit, then the benefits are equal. But the 10% tax cut distributes benefitsproportionally to higher income individuals, indicating that incomes are becoming more unequal on an absolutebasis. Both of these measures can inform us abouthow a tax cut is changing income without being misleading, although it is important to remember that existingincome and tax payments are more concentratedamong high income individuals. Thus there is a tendency for absolute measures to show most across-the-board taxcuts as favoring higher income individuals -because these individuals have a large proportion of the income and pay an even larger fraction of the income tax. Moreover, unless a tax provision is refundable,it will have little benefit for the bottom fifth of the population.

A different type of measure is a relative one that tries to examine how the tax benefit is changing the overall relative distribution of income in the country -- thatis, is it making income shares more equal or less equal? In this case, a tax change that does not alter distributionprovides tax benefits to different income classesin proportion to some measure of income. (Higher income individuals would still receive high absolute tax cutsbut not higher tax cuts as a percentage ofincome.) In general, the best method for measuring this type of effect on inequality is to examine the percentagechange in disposable (after-tax) income. If thepercentage change is equal, then the tax change is not making incomes shares more equal or less equal. If thepercentages are higher among higher incomeindividuals the change is making incomes shares less equal. Clearly, the across-the-board proportional tax cut isincreasing inequality measured by the relativeconcept: incomes in the lower brackets are increased by considerably less than 1%, while incomes in the higherbrackets are increased by 2% or more.

Alternative Proposals

There are many types of across-the board tax cuts. In addition to the proportional rate cut discussed previously,possible tax cuts include equal percentage pointreductions in all brackets, larger percentage point reductions in the lower brackets, increases in standard deductionsand the width of brackets, increases in credits,and making existing credits refundable or introducing new refundable credits.

Tables 5 and 6 use two measures: absolute change in tax liability and relative change in disposable income, to illustrate the consequences of alternative taxproposals on an illustrative family (married couple with two children). Illustrations are shown for incomes atapproximately the 25th, 50 th, , 75 th, 90th, 95thand 99thpercentile. Four proposals that are estimated to involve roughly the same magnitude of cost are considered: a 10%cut in rates, a 2.15 percentage point reductionin all rates, a 3.8 percentage point reduction in the lowest (15%) bracket, and an expansion of the 15% bracketthrough 93% of the existing 28% bracket. Each typeof proposal has been considered recently in tax legislation (although the magnitudes were different). TheHouse-passed version of the 1999 tax cut bill containeda 10% cut in rates; the Senate Finance Committee version contained a one percentage point cut in the bottom rate;an amendment on the Senate floor extended thelowest rate bracket, and the final version included a one percentage point reduction in all rates. (Note that thedistributional effects of the overall bills, whichcontained many other provisions, including some broad changes for joint returns, cannot be inferred by comparingthe single provisions.)

Table 5 shows the dollar tax cut for each type of proposal. In the very highest percentile, the largest tax cut comes from the 10% across the board tax cut. Thisresult is not surprising, since a 10% tax cut would cut the top rate by 3.96 percentage points, the next lower by 3.6percentage points, and so forth. The tax cutmost favorable to lower income and moderate income individuals (all the way through the 75thpercentile) is cutting the bottom bracket rate. An equal percentagepoint cut in rates falls in between these two. The extension of the 15% bracket provides no benefit for more thanhalf of taxpayers, because most of them do notfall in the 28 percent bracket, but it is most beneficial for high income individuals except the very wealthy.

Table 5. Effects of Alternative Tax Cuts on Tax Liability, 2000, Joint Returns, Two Children

Source: CRS calculations, assumes itemized deductions equal to 18.8% of income, all income is ordinary income. Does not incorporate the Alternative MinimumTax. The percentiles correspond to adjusted gross incomes of $27,000, $49,000, $75,000, $126,000, $180,000 and$500,000, based on Treasury data.

Table 6 provides a measure of relative equality by examining the percentage change in disposable income. The 10% cut in rates clearly redistributes after taxincome to favor high income individuals. The equal percentage point tax cut also redistributes income to favorhigher income individuals, although not to thedegree of the 10% tax cut. Extending the 15% bracket also tends to make incomes more equal except at extremelyhigh incomes. Only the 3.8 percentage pointcut in the lowest rate tends to favor middle and lower income individuals. Note that no change (short of increasinga refundable credit) could have a larger effecton the half-median (25th percentile taxpayer) because their tax liability is eliminated by the rate cut(because of the $1000 in child credits).

Table 6. Percentage Change in After Tax Income, AlternativeTax Proposals, 2000, Joint Returns, TwoChildren

Source: CRS calculations, assumes itemized deductions equal to 18.8% of income, all incomeis ordinary income. Does not incorporate the Alternative MinimumTax. The percentiles correspond to adjusted gross incomes of $27,000, $49,000, $75,000, $126,000, $180,000 and$500,000, based on Treasury data cited earlier. Data on taxes other than income taxes are also taken from Treasury estimates cited earlier.

What sort of income tax cut would be required to be neutral with respect to the distribution of disposable income? Increases in the standard deduction coupledwith an equal percentage increase in rates would probably be most likely to accomplish this effect althoughindividuals that are excluded from the tax wouldrequire an increase in a refundable credit (such as the earned income tax credit). Rate cuts that reduce lower bracketrates by larger percentage points that higherbracket rates would also tend to be more neutral across the income classes.

It can also be difficult to evaluate a tax cut that simultaneously changes rates and brackets and does not change them in a proportional way. For example, theproposal of President Bush would substitute a rates of 10, 15, 25 and 33 for the existing brackets of 15, 28, 31, 36and 39.6. However, the 10% bracket (cuttingthe 15% bracket by a third, or five percentage points) would apply to only the first $12,000 (about a fourth) of theexisting 15% bracket; remaining income in thatbracket would receive no tax cut. The 25% rate would cut the existing 28% rate by 3 percentage points, but theexisting 31% rate by 6 percentage points. The 33% rate would cut the 36% bracket by 3 % and the 39.6% bracket by 6.6%. Based on the incomes reflected in thetable above, the tax cuts arising from the ratechanges would be (beginning with the lowest percentile), $268, $600, $776, $2,017, $4,972, and $14,207. Thepercentage increases in after-tax income would be1.1, 1.5, 1.3, 2.2, 4.2 and 4.7%. Basically, the percentage increase at the bottom is smaller because only part ofincome is taxed and there is a limit to tax liability. The percentage change in after tax income would rise (to around 2% as the new $12,000 bracket is exhausted ataround $30,000 of income,) then fall again to abottom of 1.1% for those currently at the top of the existing 15 % bracket at around $69,000, then rise again,reaching a peak at the top of the 31% rate bracket ataround $200,000 and then falling again and then rising. (Note that this analysis also does not include other featuresof the Bush proposal.)

The illustrations provided in this section are designed to illustrate the general nature of the distributional effectsof various types of tax cuts. These examples aresimplified because they do not account for a number of other features. Three of the most important ones are capitalgains, the AMT, and the child care credit.

For high income people, a significant fraction of income is received in capital gains, which are taxed at lower rates. If capital gains tax rates are cut along with therest of the tax rate structure, dollar reductions will be nevertheless be smaller at higher income levels than presentedin Table 5; they will be even smaller if capitalgains tax rates are not cut. In Table 6 the percentage changes will be smaller at higher income levels. Omitting thiseffect does not alter the overall conclusionsderived from Table 5 regarding inequality, but it does change the magnitudes.

Only a small portion of the population overall pays the minimum tax, although rates are higher in high income classes. However, the coverage of the tax wasprojected to be rising due to the expiring of provisions allowing personal credits to offset the AMT and the continualerosion of the AMT exemption. Currently,1.3% of taxpayers are projected to fall under the AMT in 2000, although over 15% of taxpayers in the $100,000 to$200,000 income class are AMT taxpayers. These shares will increase substantially, to an overall share of 15.7% and as much as 64% in some high incomebrackets. (2) ( H.R. 1836 , however,made the credit offset against the AMT permanent for the child credit). Thus the distributional consequences of anytax cut will depend on whether and howmuch these rates are cut (or exemptions changed). If AMT rules are not revised, tax cuts for higher incomeindividuals or individuals with certain types ofcharacteristics (families with many children) will be smaller than indicated in the tables.

The final provision is the dependent care credit. This credit increases the exempt level for families who use it and means tax reductions are less likely to benefitlower income individuals. For example, the tax burdens of the 25th percentile taxpayer could be easilyeliminated through this provision, which is particularlyimportant for married working couples and heads-of-households. In the latter case, there are many tax returnsconcentrated at these lower income levels.

Distributional Effects of Recent Tax Legislation

This analysis compares the distributional effects of the various versions of the tax cut proposal, using estimatesmade by a private group, Citizens for TaxJustice. (3) This organization is the only one that hasprovided consistent estimates or provided the underlying information necessary to calculate the tax as apercentage of income, a relative distribution measure, and that also includes the impact of repealing the estate tax- an important element of the proposals.

The two basic types of distributional measures discussed above are shown, one absolute and the other relative. The absolute measure is the same one discussedabove, and indicates that most of the tax cut is received by the highest income classes, and that benefits in thePresident's proposal and the House proposal aremore concentrated in the higher classes than is the Senate proposal, while the conference proposal falls in between.This effect occurs primarily because ofdifferences in the rate cuts, which are largest at higher income levels in the President's proposal and the House billsand smallest in the Senate proposal.

The tax cut as a percentage of income provides information about the effect on progressivity and is similar to the measure discussed above, tax cuts as apercentage of disposable income. Using taxes as a percentage of pre-tax income reduces the percentage change athigher income levels and makes the reduction inprogressivity slightly less, it nevertheless provides a reasonable depiction of the distributional effects. However,it is also not clear if the income measure is ascomprehensive as that in the Treasury study.

While the tax cut is relatively even handed in the middle income classes, the very highest income individuals would receive much larger tax cuts relative toincome. This effect is in part due to the estate and gift tax repeal; about half of the tax cut for the top 1% comesfrom the estate tax repeal. Without that tax cut,the change in taxes as a percent of income would be 2.79% for the President's and House plan, 1.79% for the Senateplan, and 2.57% for the conference plans. All four measures, therefore, in general increase differentials in after-tax income. The average tax cut as a percentof income (shown in the totals row for the lastfour columns) indicates that, in the long run, the conference plan is the largest, with an average cut of 2.43% ofpre-tax income.

Note also that, while the tax cuts at the top arise mostly from rate cuts, or reductions in estate taxes, which benefit all taxpayers in those groups, most of themiddle class tax cut is directed towards particular groups: families with children and married couples. Citizens forTax Justice finds, for example, that in thePresident's plan, the average tax cut is $500, but the average tax cut for families with children is $1,114, the averagetax cut for single parents is $326, and theaverage tax cut for singles is $283. Some of these differences reflect differences in average incomes; however, thevast majority of single individuals with nochildren will receive no more than $300 (the new 10% rate bracket), because there is no tax reduction in the 15%rate bracket, and singles do not receive benefitsfocused on children or joint returns.

Table 7. Distributional Effects of the President's Tax Plan, the House Proposals (H.R.3, H.R. 6, & H.R.8), the Senate Proposal and the Conference Proposal at 2001 Income Levels

Source: Citizens for Tax Justice and CRS calculations based on their data.

* Reflects H.R. 3 (rate cuts), H.R. 6 (marriage penalty and child credit) and H.R. 8 (estateand gift tax), but not H.R. 10 (IRAs and pensions). H.R. 10 would make the size of cuts slightly larger, but would probablynot affect the distribution verymuch.

The Joint Tax Committee has provided distributional numbers for the conference report as well, but their analysis goes only to 2006 when provisions are not fullyphased in and does not include all of the tax provisions, most notably the estate and gift tax reduction. (4) Their analysis also uses different income tax classes. Their analysis permits the calculation of taxes as a percent of income after federal taxes. Their results are, however,consistent with the general findings in Table7: the highest income class ($200,000 and more) has a tax cut equal to 1.7% of income and 2.4% of income net offederal tax; the middle class has a roughlyproportional increase and the lower income classes have smaller increases. Overall, they are distributing a tax cutequal to 1.7% of income. The average of 2.43%in the above table would fall to about 2% with the elimination of the estate and gift tax, and the remainder of thedifference reflects in part the incomplete phasein.

Efficiency, Simplicity, and Stabilization

The central issue in across-the-board tax cuts discussed in this paper is the distributional effect, which finds thatcertain types of across-the-board tax cuts are morelikely to redistribute income in certain directions. The recent tax revisions tend to be relatively even across muchof the middle class, but do favor higher incomeindividuals.

While these distributional effects may concern some, economic theory also suggests that tax cuts that tend to favor higher income individuals are more likely toachieve efficiency gains (reduce distortions in behavior the most) and behavioral responses (increases in savingsand work effort). These tax cuts favoring higherincome individuals have larger reductions in marginal as compared to average rates than do cuts favoring lowerincome individuals The marginal tax rate governsthe substitution effect, where lower tax rates are expected to increase labor supply and savings; the average tax rategoverns the income effect, where lower taxrates tend to decrease labor supply and savings. Thus, as is frequently the case, distributional and efficiencyobjectives may conflict. Those tax cuts that mostfavor lower income individuals, such as reducing the lower bracket rate or increasing the standard deduction, tendto have smaller effects, per dollar of revenueloss, on the marginal tax rate, where cuts might increase savings and labor supply.

Despite concerns about behavioral responses, most evidence suggests that labor supply and savings are unlikely to be very responsive to tax cuts. There is someevidence that married women's labor supplies are responsive to tax cuts and some theoretical reasons to believe thata shift to a consumption tax could increasesavings, but there are also a number of controversies surrounding these issues. (5)

Reductions in marginal tax rates would also have effects on the composition of investment or consumption, some of which may be desirable and some of whichmay not. For example, present law favors owner-occupied housing as both a consumption and investment good andlower tax rates would reduce that distortion.Present law also favors certain forms of passive investment (e.g. pensions and IRAs) relative to investments nottargeted for retirement living, and a reduction intax rates would reduce that distortion. However, lower individual tax rates would magnify the favorable treatmentof unincorporated businesses relative tocorporate investments. Tax favoritism can also produce allocations that may improve on the market allocation (suchas charitable contributions) and thesebeneficial re-allocations would be reduced.

Simplicity issues do not always involve a tradeoff. On simplicity grounds, across-the-board rate cuts, which do not add complication, are preferable to manytargeted tax provisions that increase tax complexity. There are also a variety of tax cuts that favor either lower orhigher income individuals that could simplifythe tax law. For example, an increase in the standard deduction would direct benefits toward lower and moderateincome individuals, and would also simplify thetax law by increasing the number of individuals who choose not to itemize deductions. For higher incomeindividuals, there are a number of provisions in the taxlaw that are phased out and that complicate the tax law. The tax law would be simplified if tax cuts to higherincome individuals were provided by eliminatingthese phase-outs. Similarly, allowing personal credits to be used against the AMT and increasing AMT exemptionlevels would favor higher income individualsbut would simplify the tax law.

Much of the revenue cost of H.R. 1836 arises from rate reductions. It also eliminates two important phaseouts (itemized deductions and personalexemptions) and allows the child credit to be offset against the AMT. However, the bill also adds a number ofcomplicating provisions or expands some existingtax benefits.

Recently, supporters of tax cuts have argued that cuts are needed in order to stimulate the economy. This interest has increased, following the terrorist attack ofSeptember 11 and the increasing concerns about the economy. A number of reservations had already been raisedby economists about the use of tax cuts foreconomic stimulus: the uncertainty of a pending recession, the potential limited effects of fiscal stimulus in an openeconomy with flexible exchange rates, thepotential superiority of monetary policy where the decision-making apparatus is more flexible, and the possibleconflict of short run stabilization objectives withlong run growth objectives. (6)

However, if tax cuts are to be used for this purpose, tax changes which can be reflected in withholding tables (such as rate cuts and changes in standard deductionsand personal exemptions) would be more effective, as would reductions in taxes by individuals who are more likelyto spend the tax cut. (Most of the tax cut in H.R. 1836 is phased in and does not have an immediate effect on disposable incomes). In this way, thedistributional effects of tax cuts and theirstimulative effects are interrelated. Both economic theory and evidence suggest that tax cuts for higher incomeindividuals have a smaller stimulative effects thattax cuts for lower income individuals. Indeed, some have suggested that tax credits against payroll taxes, whichare more concentrated among lower and moderateincome individuals, be considered. Capital gains tax cuts, which had been discussed, are very concentrated amonghigher income individuals and would beunlikely to provide economic stimulus.

Conclusion

This analysis has indicated that different types of across the board tax cuts can have substantially differenteffects on the distribution of income. Tax proposalsthat cut rates proportionally tend to redistribute income towards higher income individuals whether one isconsidering absolute or relative measures. Taxproposals that cut rates by equal percentage points, also redistribute income towards higher income individuals, butby a lesser degree. Proposals that favor lowerincome individuals include increases in the standard deduction, increases in credits and especially in refundablecredits, and cuts in the lower bracket rates. Proposals that expand the rate bracket width provide no benefits to lower and moderate income individuals.

Tax proposals that favor higher income individuals may involve more efficiency and larger behavioral responses, but most evidence suggests these responses arenot very large. Across the broad tax cuts do not tend to complicate the tax law, but tax cuts for high incomeindividuals could be used to simplify the tax if theywere directed at phase-outs and the AMT rather than rate cuts in higher brackets. Tax cuts may be used forcounter-cyclical purposes, but there are a variety ofreservations about such uses.