Worsening Inequality

Jonathan Weiss/Shutterstock

This article appears in the Summer 2018 issue of The American Prospect magazine. Subscribe here

Proponents of the 2017 Tax Act claimed that the legislation would deliver higher incomes—before taxes—for everyday Americans. There are two primary mechanisms by which this happens: Lower tax rates mean that Americans will now choose to work more hours and businesses will choose to invest more. Combined, these changes in people’s behavior would temporarily elevate the rate of economic growth.

However, this is not nearly the whole story, because the direct effect of the structure of the tax cuts is to sharply increase inequality in after-tax incomes. Moreover, whether or not the tax cuts spur meaningful growth (a debatable question) once all of the direct and indirect effects are accounted for—including the need to address the resulting revenue gap in the years to come—most Americans will be worse off, and inequality will be even greater.

The Congressional Budget Office estimates that the legislation will increase annual gross domestic product by about 0.7 percent on average over the next decade. However, overall GDP growth is ill-suited to assess the impact of legislation like the 2017 Tax Act on living standards because it focuses on production in the United States rather than income accruing to U.S. residents, and because it does not account for depreciation—the decline in the value of houses, office buildings, cars, and other types of assets due to wear and tear over time. The CBO estimates that gross national product (GNP), which measures income accruing to U.S. residents rather than all domestic production, will increase by 0.4 percent rather than 0.7 percent and suggests that net national product (which reflects the increase in depreciation) will grow by slightly less than that.

 

MORE FUNDAMENTALLY, however, changes in pre-tax incomes can offer a misleading picture of the impact of the legislation on economic well-being. Looking at the change in pre-tax incomes alone is like looking at only one side of the cost-benefit calculation—ignoring many of the costs of generating income, such as putting in more hours of work. Moreover, it ignores the direct effect of the tax cuts themselves. Indeed, under standard economic assumptions, the direct effect of the tax cuts on different taxpayers (i.e., paying varying amounts less in taxes) provides a reasonable approximation to the effect of the tax cuts on economic well-being.

The direct effects of the 2017 Tax Act paint a troubling picture. The tax cuts are severely regressive, with higher-income families receiving larger tax cuts both in absolute terms and as a share of incomes (see top chart). In 2018, families in the bottom quintile receive a tax cut of only 0.4 percent of income, families in the middle quintile receive a tax cut of 1.6 percent of income, and families in the top quintile receive 2.9 percent of income. After accounting for the repeal of the Affordable Care Act’s mandate to purchase health insurance, which is excluded from these figures, many low-income families were likely made worse off by the legislation.

At the same time, the legislation added nearly $2 trillion to budget deficits over the next decade, more if expiring provisions of the legislation are extended. The full effects of the Tax Act can be known only once policymakers decide how to close this revenue gap. Republican legislators and President Trump have already proposed that federal deficits be closed by imposing large, regressive cuts in public programs. Their recent budgets suggest some of the specifics, such as the president’s proposal to cut the Supplemental Nutrition Assistance Program (formerly food stamps) and many more, only in vague terms. Indeed, the health-care bill Republicans advanced in 2017 combined regressive tax cuts and regressive cuts to Medicaid.

 
 

Even a seemingly more neutral method for closing the gap would have a regressive impact. If policymakers close the gap with policies that have a distributional profile similar to what economists refer to as a lump-sum payment per tax return—the same amount for every family regardless of income—families in the bottom three quintiles of the income distribution will be made worse off (middle chart). Had these policies been implemented contemporaneously with the tax legislation, families in the lowest quintile would see income reductions of nearly 8 percent in 2018 and families in the middle quintile reductions of 0.3 percent. However, families in the top quintile would still be better off than before the bill became law, with tax cuts only slightly smaller than what is scheduled without further changes: 2.5 percent rather than 2.9 percent. Notably, these estimates reflect a back-of-the-envelope calculation of the gains of growth based on CBO’s analysis.

What’s more, if the revenue gap were closed with a tax proportional to income—or similarly distributed spending cuts—families in the bottom four-fifths of the income distribution would be worse off (bottom chart). Families at the bottom would face smaller losses, but families higher up in the income distribution would also face losses, and the gains from growth would likely be smaller.

Policymakers do not need to choose between economic growth and increases in well-being for working and middle-class families. Tax reforms that restore adequate revenues and make the sources of those taxes fairer and more efficient would deliver on both those goals. In contrast, the 2017 Tax Act reduced revenues while increasing inequality, and these two features in combination will make most Americans worse off in the long run. Had the drafters stuck to a do-no-harm attitude on inequality and the deficit, a far better outcome would have been nearly guaranteed. 

You may also like

Advertisement