Revised September 28, 2004

MANY MIDDLE-CLASS FAMILIES LIKELY WILL WIND UP
AS NET LOSERS FROM THE "MIDDLE-CLASS" TAX CUT LEGISLATION

by Robert Greenstein and

PDF of this analysis

Related Fact Sheet:
Would Extending The "Middle-Class" Tax Cuts Benefit The Middle Class?

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Several tax-cut measures often termed “middle-class tax cuts” are scheduled to expire on December 31.  On September 23, Congress passed legislation to extend these tax cuts.  The legislation did not offset the tax cuts’ costs.

As a result of this action to extend the tax cuts, most middle-class families will have lower tax bills over the next several years than they would have if the tax cuts were allowed to expire.  Yet it is far from clear that middle-class families will be better off over the longer term.  To the contrary, there is reason to believe that a majority of middle-class families could end up worse off, for two related reasons:

To date, all of the tax cuts enacted since 2001 have been financed by borrowing, which has contributed to higher deficits.  But financial markets will not indefinitely tolerate large, persistent deficits of the type that the nation is projected to face.  As Federal Reserve Board Chairman Alan Greenspan recently warned, “If you’re going to lower taxes, you shouldn’t be borrowing essentially the tax cut.  And that over the long run is not a stable fiscal situation.”[2]  Simply stated, funds that are borrowed must eventually be paid back.

Whether middle-class households ultimately come out ahead or behind from the legislation will depend on whether they lose more from the measures that eventually are adopted to pay for the tax cuts than they gain from the tax cuts themselves.  The precise results will depend on the specific measures adopted.  According to Tax Policy Center data, however, most households that do not have high incomes are likely to be net losers under most approaches to financing the tax cuts, particularly approaches that rely heavily on program cuts rather than progressive tax increases.  Since more of the tax-cut gains from the legislation will go to high-income than to middle-class households, only under an approach that targets the top fifth of households for a large share of the financing burden will middle-income households not end up worse off.

Congress Could Have Ensured that the Middle Class Would Come Out Ahead

An approach was available under which middle-class households would have been certain to benefit from the tax-cut package over time, as well as immediately.  The alternative was to incorporate into the legislation various revenue-raising measures that the Senate or House has approved this year as part of corporate tax bills.  These measures consist in large part of steps to crack down on abusive corporate tax shelters.  The revenues from such measures could have been used to finance the extension of the middle-class tax cuts.

Tax Policy Center data indicate that if the costs of the tax package were offset through corporate tax-reform savings, most middle-class households would gain more from the tax cuts than they would lose from the revenue-raising measures.

This, however, is not what Congress did.  Instead, Congress leaders made a decision to use the corporate tax-reform savings largely to finance an array of new tax breaks for corporations and other special interests, and to push through the middle-class tax package without paying for it.  This approach will force Congress at some future time to adopt other financing measures for the middle-class package, which (as noted above) are likely to more than cancel out the tax-cut benefits for many middle- and lower-income families.

Using the revenue from the corporate tax reforms to finance narrow corporate tax breaks also is unsound from an economic standpoint.  The corporate tax preferences that would be created would narrow the tax base and make the “playing field” less level for business investments, causing some investments that are more profitable than others on a before-tax basis to be less profitable on an after-tax basis.  When that occurs, investment decisions are distorted, and the economy does not perform as well as it should.

The remainder of this analysis examines these issues in more detail.

 

To Whom Will the “Middle-Class” Tax Cuts Go?

In 2003, Congress enacted legislation accelerating implementation of most of the elements of the 2001 tax cut.  Several of these tax-cut accelerations — those related to the expansion of the 10-percent tax bracket, the increase in the child tax credit to $1,000 per child, and two tax cuts for married filers — are scheduled to expire on December 31, 2004.  The middle-class tax package that the House and Senate approved on September 23 extends these expiring provisions.  The tax package also extends relief from the Alternative Minimum Tax for one year, a measure sometimes described as necessary to ensure that middle-class taxpayers are not snared by the AMT.  Furthermore, in a last-minute addition, the package includes $13 billion in corporate tax-cut extensions.

Altogether, the package results in revenue losses of $146 billion over ten years, according to the Joint Committee on Taxation.  And when the costs of the increased interest payments on the national debt that the legislation will engender are taken into account, the overall effect of the bill is to increase the deficit by $211 billion over ten years.

Although the broad middle class will benefit from these provisions, it is not well understood that higher-income households will gain more.  For example, 72 percent of the benefits from the “marriage penalty” provisions of the package will go to the top 20 percent of households.[3]  Some 96 percent of the benefits from extending AMT relief will go to the top 20 percent of households.

Data from the Urban Institute-Brookings Institution Tax Policy Center indicate that under the legislation that Congress adopted:

 

Middle-Class Households Likely to Lose if the Tax Cuts Are Not Financed Now

Supporters of this legislation praise it as making everyone — and especially middle-class families — better off.[4]   Unfortunately, there is no “free lunch.”  Financing the tax cuts through bigger deficits postpones — but does not eliminate — the need to pay for them.  The situation is analogous to that of a consumer who charges a major purchase to a credit card:  the charge postpones but does not eliminate the need for the ultimate payment.  (For a fuller discussion of why these and other tax cuts, as well as spending increases, eventually have to be offset, see an earlier joint Center on Budget and Policy Priorities/Tax Policy Center study, “The Ultimate Burden of the Tax Cuts,” June 2004.[5])

It cannot be known at this time just how the middle-class tax legislation ultimately will be financed in future years.  To get a sense of the potential effects of such financing measures, we examined two hypothetical scenarios, using data from the Tax Policy Center.[6]

In the first scenario, every household would pay the same dollar amount — $374, as it turns out — to finance the tax cuts for 2005 contained in the legislation.  Something close to this scenario could occur if the tax cuts were financed largely or entirely through program cuts.  In the second scenario, all households would pay the same percentage of income to finance the tax reductions.  This could occur if the tax cuts were financed by a combination of program cuts and progressive tax increases.

Tax Policy Center data show that if each household paid the same dollar amount to pay for the cost of the tax cuts in 2005, the middle fifth of households would experience an average net loss of $212 per household, while the top 20 percent of households would experience an average net gain of $943.

Average Change in Incomes Under the Middle-Class Tax Package Cuts
with Cost of Financing Included, Two Hypothetical Scenarios
(assuming the tax cuts in 2005 are offset by financing)
Income Class

Average net effect, financing with equal dollar burden per household

Average net effect, financing with payments proportional to income

Bottom 20 percent -$372 -$45
Middle 20 percent -$212 -$51
Top 20 percent +$943 +$202
Source: Urban-Brookings Tax Policy Center, September 28, 2004 tabulation.

If each household paid the same percentage of income to pay for the tax cuts, middle-income and low-income households still would be net losers and those at the top net winners, although by smaller amounts.  Under this scenario, the middle fifth of households would lose an average of $51, while those in the top fifth would gain an average of $202.

 

Middle-Class Households Would Be Winners if Corporate Tax-Reform Savings Were Used to Pay for the Bill

Both the House and Senate have passed corporate tax bills this year, which will go to a conference committee at some point.  Both of those bills would eliminate an export subsidy that the World Trade Organization has ruled illegal, raising about $50 billion over the next 10 years.  Both bills also include other revenue-raising measures, many of which would close abusive corporate tax shelters.  Primarily by cracking down on these tax shelters, the Senate bill raises an additional $122 billion over the next ten years.  The House bill raises an additional $59 billion.

Tax Policy Center data show that if the tax-cut extensions Congress just passed were financed by measures to increase the amount of revenue raised through the corporate income tax, such as by closing corporate loopholes, middle-class households would end up net winners:

Unfortunately, the Senate and House corporate tax bills instead use the corporate tax-reform savings to pay for a grab bag of new tax breaks for corporations and other special interests.  Many of these tax breaks are notable more for the votes they seek to secure for the legislation than for their likely positive effects on the economy or tax policy.  Moreover, these new tax breaks would further complicate an already cumbersome tax code.

The House corporate tax bill contains provisions ranging from tax subsidies for corporations that lease out aircraft or import ceiling fans to tax breaks that benefit businesses with certain types of overseas income.  The Senate measure includes large parts of the energy bill that the Senate blocked earlier this year, which was widely criticized for its special-interest tax breaks.[7]

It does not represent sound policy to use the revenues secured by closing corporate loopholes to fund new special-interest corporate tax breaks, especially since corporate tax revenues already are at historically low levels as a share of the economy.  Corporate tax revenues will equal only 1.6 percent of the Gross Domestic Product in 2004, according to new projections issued by the Congressional Budget Office on September 7; that is lower than the average level in every decade from the 1940s to the present.  Moreover, CBO projects that corporate tax receipts will remain low in coming years in historical terms and will equal only about 1.5 percent of GDP in 2014.[8] 

It would have been much better policy — for middle-class families and for the nation as a whole — if Congress had paid for the middle-class tax-cut package with revenues from curbing abusive tax shelters.[9] 

Appendix Table 1
Middle Class Extension Package1
Distribution of Federal Tax Benefits by Cash Income Percentiles

With and Without Financing, 2005

Income Class2

Average Tax Cut, Assuming no Financing

 

Average Net Change in Income

Financing with equal dollar burden per household

Financing with payments proportional to income

Financing through corporate tax increases and reforms

Lowest Quintile

$   2

 

$  -372

$  -45

$  -18

Second Quintile

55

 

-318

-65

1

Middle Quintile

162

 

-212

-51

69

Fourth Quintile

331

 

-43

-43

132

Top Quintile

1,317

 

943

202

-172

All

374

 

0

0

0

 

 

 

 

 

 

           
Source: Urban Institute-Brooking Institution Tax Policy Center
(1) Proposal includes extending the three middle class provisions, relief from the Alternative Minimum Tax, and various corporate tax cuts.
(2) Includes both filing and non-filing tax units.  Tax units that are dependents of other taxpayers are excluded from the analysis.

 

Appendix Table 2
Middle Class Extension Package1
Distribution of Federal Tax Benefits by Cash Income Class

With and Without Financing, 2005

Income Class (thousands of 2003 dollars)2

Percent of Total Tax Unit

Average Tax Cut, Assuming no Financing

 

Average Net Change in Income

 

Financing with equal dollar burden per household

Financing with payments proportional to income

Financing through corporate tax

increases and reforms

Less than 10

14.0%

$   2

 

$  -372

$  -35

$  -14

10-20

18.1%

23

 

-351

-73

-18

20-30

14.1%

112

 

-262

-48

39

30-40

10.8%

167

 

-207

-56

74

40-50

7.9%

242

 

-132

-46

99

50-75

13.8%

353

 

-21

-43

139

75-100

8.1%

763

 

389

208

442

100-200

9.7%

1,342

 

968

485

730

200-500

2.5%

2,390

 

2,014

537

-74

500-1,000

0.4%

1,401

 

1,028

-2,929

-7,043

More than 1,000

0.2%

5,654

 

5,280

-12,716

-55,502

All

100.0%

374

 

0

0

0

 

 

 

 

 

   
Source: Urban Institute-Brooking Institution Tax Policy Center
(1) Proposal includes extending the three middle class provisions, relief from the Alternative Minimum Tax, and various corporate tax cuts.
(2) Includes both filing and non-filing tax units.  Tax units that are dependents of other taxpayers are excluded from the analysis.

End Notes:

[1] The Tax Policy Center analysis reflects the effects of extending the various “middle-class” provisions, relief from the Alternative Minimum Tax, and various corporate tax cuts.  These extensions all are included in the legislation.

[2]  Chairman Alan Greenspan in “U.S. Representative Jim Nussle (R-IA) Holds Hearing on the Budget and the Economy,” FDCH Political Transcripts, September 8, 2004.

[3] Leonard E. Burman, “An Analysis of the 2004 House Tax Cuts,” The Urban Institute and the Tax Policy Center, June 2004.  This is the case because the larger of the two marriage penalty relief provisions in the legislation benefits only households that are in the higher tax brackets.

[4]  It may be noted that tens of millions of households would receive no tax cut.  Those left out tend to be poor, single individuals, and families with children that have earnings of less than about $10,750.

[5]  William G. Gale, Peter R. Orszag, and Isaac Shapiro, “The Ultimate Burden of the Tax Cuts: Once They are Paid For, Low- and Middle-Income Households Likely to be Net Losers, On Average,” Urban-Brookings Tax Policy Center and Center on Budget and Policy Priorities, June 2, 2004.

[6] The scenarios reflect the impact the financing mechanisms would have if they were in place in 2005.

[7] For further discussion of the array of subsidies included in the corporate tax bills, see Jill Barshay, “Corporate Tax Bills Stuffed, Scorned -- and Supported,” CQ Weekly, June 26, 2004, pp. 1540-1543 and Jeffrey H. Birnbaum and Jonathan Weisman, “GE Lobbyists Mold Tax Bill: Firm Saw Subsidy Repeal as Chance to Pay Less,” The Washington Post, July 13, 2004, p. A1.

[8] See Joel Friedman, “The Decline of Corporate Income Tax Revenues,” Center on Budget and Policy Priorities, October 24, 2003.

[9] If the corporate tax-reform savings proved sufficient to pay in full for the middle-class tax extensions, the difference could have been made up by scaling back by a small percentage the tax cuts adopted in 2001 and 2003 for households with the highest incomes.  The Tax Policy Center reports that households with incomes exceeding $1 million are receiving an average tax cut this year of $123,600.