Leonard E. Burman 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.
© TAX ANALYSTS. Reprinted with permission.Note: This report is available in its entirety in the Portable Document Format (PDF).
Summary
The House of Representatives has passed variants on four provisions in President Bush's FY2005 Budget: marriage penalty relief (H.R. 4181), a temporary increase in the AMT exemption (H.R. 4227), an increase in the 10-percent tax bracket thresholds (H.R. 4275), and an increase in the child credit and making it available to taxpayers with higher incomes (H.R. 4359). This paper discusses the potential implications of those bills on revenues, the distribution of tax liabilities, and the economy.2
With the exception of AMT relief, the other three bills would expand on provisions enacted in 2001. The 2001 legislation, the Economic Growth and Taxpayer Relief Reconciliation Act of 2001 (EGTRRA), phased in all three provisions, but would "sunset" all the relief after 2010-meaning that they would return to the levels specified by pre-EGTRRA law. Legislation enacted in 2003, the Jobs and Growth Taxpayer Relief Reconciliation ACT of 2003 (JGTRRA), increased all three provisions to their fully phased in levels, but only for 2003 and 2004, after which the EGTRRA phase-in schedule resumes. The House-passed legislation would make permanent the temporary increases enacted in JGTRRA and would eliminate the sunset after 2010. (See Table 1.) It would also expand eligibility for the child tax credit to many high-income taxpayers and index the AMT exemption level for inflation, but only for one year.
Revenue. Overall, the four bills would reduce federal tax revenues by $531 billion over the next 10 years, assuming that AMT relief is allowed to expire on schedule. (See Table 2.) That scenario however, seems very unlikely, given that, without relief, nearly 30 million people would become subject to the AMT by 2010.3 In fact, the four bills together would actually increase the number of people subject to the AMT compared with current law, unless the temporary AMT provision is extended. But indexing the AMT permanently would increase the 10-year cost of the tax measures to almost $1 trillion.
Because all of the provisions made permanent were set to expire in 2010, the cost of the package grows dramatically after 2010. About 70 percent of the cost is incurred in the last four years. The costs for the whole package decline modestly after 2011, as more and more taxpayers become subject to the AMT. AMT taxpayers receive no benefit from the 10-percent bracket expansion or marriage penalty relief (although the child credit provision is explicitly exempted from the AMT and thus continues to increase in cost over time). But if AMT relief is made permanent, its cost is made significantly larger by the other provisions. The cost of AMT relief grows over time much faster than the overall economy because AMT parameters are not indexed for inflation under current law, which means that more and more people are set to fall prey to the AMT and the average tax rate under the AMT increases as inflation pushes more people into the higher AMT tax brackets.4
Distributional Effects. The four bills have been called middle-class tax relief, but that is a misnomer. With the exception of the expansion of the 10-percent tax bracket, all of these provisions would yield more than half of their benefits to the 20 percent of households with the highest incomes. (See Figure 1.) Overall, in 2005, the top quintile would get 73 percent of the benefits while only 27 percent would go to the middle three quintiles. Less than 0.1 percent goes to the bottom quintile.
AMT relief is the most skewed component. Over 95 percent of the benefits would accrue to the top 20 percent. More than 71 percent of marriage penalty relief would go to that group—largely because the expansion of the 15-percent bracket for married couples only aids those who are in higher brackets. Although increasing the child credit from $700 to $1,000 provides a substantial benefit to middle-class households, the largest gainers on a per capita basis are those with high incomes who become newly eligible for the entire $1,000 credit. As a result, more than half of the benefits of the child credit increase go to the top 20 percent. Only the 10-percent bracket expansion benefits primarily middle-income families. Almost two-thirds of benefits of that provision would accrue to the middle three-fifths of the income distribution.
These distributional estimates implicitly assume that as much as $1 trillion of revenues may be forgone over the next decade with no effect on the level of future taxes or the supply of government services that citizens value. In fact, the tax cuts will have to be paid for, which mean that, over the long term, there will be both winners and losers. The actual incidence of the net change in benefits depends on exactly how the lost revenues are made up, but many apparent beneficiaries of this package, which would be the fourth major tax cut in as many years, could end up worse off over the long term.
Economic Effects. Tax cuts have often been rationalized on the grounds that they would stimulate long-run economic growth, but that argument is implausible for this package. Relatively few taxpayers would see a reduction in their marginal tax rate beyond 2005 when the temporary AMT relief is set to expire. As a result, there would be negligible effect on incentives to work, save, or invest in unproductive tax shelters. Moreover, by adding to the burgeoning budget deficits, the tax cuts would raise interest rates and discourage investment by businesses and purchases of homes and cars by consumers. These responses would tend to stifle economic growth.
Notes from this section
1. I am grateful to Joel Friedman, Bill Gale, Bob Greenstein, Jeff Rohaly, and Isaac Shapiro for helpful comments and to Troy Kravitz and Adeel Saleem for excellent research assistance. Views expressed are the author's alone and should not be attributed to the Tax Policy Center or the Urban Institute, its board, or its funders.
2. For a discussion of the House tax cuts and their budgetary implications, see Joel Friedman and Isaac Shapiro, "Who Would Pay for the House's "Free Lunch" Tax Cuts?", Center on Budget and Policy Priorities, May 18, 2004.
3. See Leonard E. Burman, William G. Gale, and Jeffrey Rohaly, "The AMT: Projections and Problems," Tax Notes, July 7, 2003, 105-117, for a discussion. Estimates presented in Table 1 have been updated to reflect current assumptions about inflation rates and income growth.
4. Although the AMT nominally has only two rates, 26 and 28 percent, the AMT exemption phases out over a range of income. This phase-out creates an implicit surtax of 25 percent of the AMT rate, effectively producing two additional tax brackets of 32.5 and 35 percent. Since the phase-out range is not indexed for inflation, increases in price levels can substantially increase average tax liabilities by pushing people into these phantom tax brackets. See Burman, Gale, and Rohaly, "The AMT," for further discussion.
Note: This report is available in its entirety in the Portable Document Format (PDF).
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