Policy makers often act like tax cuts are free lunches that can make everyone better off. But over the long run, tax cuts must be offset by increases in other taxes, reduced spending, or both. This budget constraint is particularly important today, as government spending under current policy will significantly exceed government revenue even if taxes are maintained at current levels.
To be sure, well-crafted tax reform could cause behavioral changes – increased labor supply, more saving, and more productive investment – that raise overall future economic growth and hence future tax revenues. In addition, tax cuts may lower tax avoidance and evasion. However, even when well designed, these indirect revenue responses offset only a portion of the direct costs of most tax cuts.
In a new paper, Surachai Khitatrakun, Aaron Krupkin, and I examine the distributional effects of tax proposals consistent with those the Trump Administration produced in April.
We document the standard distributional effects – without the financing necessary to fully pay for the tax cuts – and then we show distributional effects that include alternative ways of financing the cuts. (We do not adjust for overall economic growth effects because the Tax Policy Center analysis suggests that such effects are small. The impact on future U.S. economic growth is small and positive in the first few years and small and negative thereafter.)
Using Tax Policy Center estimates, we show that the aggregate proposals consistent with the Trump Administration outline would reduce taxes for most households, even when including all the limited “pay fors” (revenue raisers) mentioned by the Trump Administration or by the Trump campaign. Most of the gains and the largest percentage increases in after-tax income would go to the households with the highest pre-tax incomes.
The “pay fors” offered by the Administration, however, do not come close to paying for the whole tax cut. Factoring in the need for financing can dramatically alter the distributional results.
There are an infinite number of ways to fully finance the proposed tax cut. In the paper, we estimate the effects of three specific options:
• Equal-per-household financing: This is the least progressive of the three financing options that we formally analyze.
• Proportional-to-income financing: This would be more progressive than equal-per-household financing, but less progressive than the third option, proportional increases in income taxes.
• Proportional-to-income-taxes financing: This would be the most progressive of the three options.
Note that these three options do not span – in progressivity terms – the range of possible financing options. A scenario more regressive than equal-per-household financing would most accurately characterize the policy preferences embedded in recent proposals by the Trump Administration and the Congressional majority – for example, the Trump Administration’s budget, the recent budget proposal adopted by the House Budget Committee, and the House’s passage of deep Medicaid cuts as part of efforts to bring about health care reform and provide a variety of tax cuts.
We find that, under the first two financing scenarios, the vast majority of households, especially low- and middle-income households, would be worse off (i.e., would have lower after-tax income) under the proposals consistent with the Trump Administration’s outline than under the status quo.
For example, households in the bottom quintile would lose an average of $2,250 under equal-per-household financing and $320 under proportional-to-income financing. Households in the middle quintile would lose an average of $1,540 and $910, respectively, under the two financing options. Even households in the fourth quintile would lose out – seeing net losses of $690 and $1,270, respectively. The big winners would be households in the top 1 percent of the income distribution, especially those in the top 0.1 percent, who would gain more than $935,000 per household on average under equal-per-household financing and more than $674,000 per household under proportional-to-income financing. Overall, 84 percent of households would experience a net tax increase under equal-per-household financing, while 82 percent of households would experience a net tax increase under proportional-to-income financing. Both proportions are several times larger than the 19 percent of households who are found to pay more in taxes under the tax proposal consistent with the Trump Administration outline in combination with the limited revenue offsets implied in the campaign proposals.
Results under the third scenario are a little more mixed. If financing is proportional to income taxes, about 36 percent of households would face net tax increases. As before, the top 1 percent, especially the top 0.1 percent, would receive the largest increases in after-tax income.
The stark differences (a) among the proposals with full financing, and (b) between the proposals with full financing and the proposal consistent with the Trump Administration outline (which is not fully financed) show how important the precise method of financing is to understanding the ultimate distributional effects of any tax proposal. And these differences highlight the importance to the public debate of articulating future financing mechanisms.
