The U.S. budget cuts bear large economic and political risks for U.S. citizens as they will aggravate income inequality. This is the conclusion of researchers of the Institute for the Study of Labor (IZA) who analyzed the effects of past tax reforms on the income distribution. They find that tax reforms of the last 30 years did not compensate for the rising inequality in market incomes. Against this background, the researchers suggest not to extend the 2001 tax cuts for high income families and caution about a further increase in income inequality caused by the announced cuts in discretionary spending.
The U.S. budget cut imposed by the debt ceiling contain two core elements – taxes are not to be raised, whereas spending is to be reduced. A new IZA discussion paper by Olivier Bargain, Mathias Dolls, Herwig Immervoll, Dirk Neumann, Andreas Peichl, Nico Pestel and Sebastian Siegloch shows that the deal will heavily affect the income distribution in the United States.
The team of researchers of IZA and the World Bank has analyzed the effect of U.S. tax reforms on the income distribution from 1978 to 2009. They show that the Bush tax cuts from 2001 and 2003 had an inequality-increasing effect. If these tax cuts are not withdrawn and transfers to the poor are additionally reduced, as it is discussed at the moment, income inequality will significantly increase. Given that the United States is among the industrialized countries recording the largest levels and increases in inequality, a further rise could – at some point – put at risk the solidarity among U.S. citizens.
Methodologically, the researchers separate the pure redistributive effect resulting from tax reforms from effects due to changes in the pre-tax income distribution. This distinction is of crucial importance as tax burdens and their impact on the income distribution are determined by both tax schedule and tax base. For instance, a given progressive income tax schedule redistributes more when the distribution of taxable incomes becomes more dispersed, and very little if everybody earns about the same. By conducting detailed simulations, the researchers are able to isolate the direct impact of U.S. tax policy of the last 30 years on inequality.
An important result is that over the whole time period U.S. tax policy did very little to alleviate the increase in inequality. The Reagan reforms in the 1980s favored in particular high income families, whereas the reforms in 1990 and 1993 under George Bush Sr. and Bill Clinton counteracted the trend of growing inequality. In contrast, the Bush Jr. tax cuts from 2001 and 2003 again had an inequality-increasing effect. Finally, provisions of the American Recovery and Reinvestment Act 2009 to some extent mitigated the strong increase in pre-tax inequality caused by the Great Recession. Thus, the researchers detect large differences in partisan politics. Under Democratic administrations tax policy mainly had an equalizing effect, whereas under Republican ones it was primarily disequalizing due to tax cuts for high income families.
Against the background of current debt cuts, the authors argue that a phase out of the 2001/2003 tax cuts would have beneficial effects not only for revenues, but also with regard to inequality. This effect should not be neglected as a large part of the spending cuts will be placed on poor and middle-class households.