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Economic Effects of Making the 2001 and 2003 Tax Cuts Permanent

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Document date: October 15, 2004
Released online: October 15, 2004

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.

TPC Discussion Paper No. 17

Note: This report is available in its entirety in the Portable Document Format (PDF).

Tax policy has played a central role in the Bush administration's economic policy. The 2001 tax cut phased in lower income tax rates, gradually reduced and will eventually repeal the estate tax, and provided additional subsidies for taxpayers who contribute to tax-preferred saving accounts, acquire education, are married, or have children. The 2003 tax cut provided new tax cuts for individuals' dividend and capital gains income, and accelerated the implementation of many changes enacted in 2001.1 All the provisions of these tax cuts, however, expire by the end of 2010, and some expire earlier. The administration has repeatedly called for making almost all of the 2001 and 2003 tax cuts permanent.

This paper examines the consequences of making the tax cuts permanent.2 The background section briefly describes the recent tax cuts and the proposals to make them permanent. It also discusses two issues that must be addressed in evaluating permanent tax options: the alternative minimum tax (AMT), and the need to finance permanent tax cuts at some point with either spending cuts or other tax increases.

The "Revenue and Budget Issues" section examines the tax cuts in the context of overall federal fiscal policy. Even without making the tax cuts permanent, reasonable projections imply that the federal government faces sizable deficits over the next decade and an unsustainable budget path over longer periods. Making the tax cuts permanent would significantly exacerbate these problems, reducing revenues over the next 75 years by an amount significantly larger than the projected shortfall in the Social Security trust fund over the same period. Although the administration has not proposed any specific way to pay for the tax cuts, some simple calculations show that the required spending cuts or revenue increases are substantial and well beyond the range of any recent policy discussion.

The third section examines distributional effects. Making the tax cuts permanent would increase the disparity in after-tax income; most households would receive a direct tax cut, but after-tax income would rise by a larger percentage for high-income households than low-income households. Once the financing of the tax cuts is taken into account, however, the distributional effects will likely be even more regressive. For example, if the eventual policy adjustments made to finance the tax cuts impose burdens proportional to income, about 80 percent of households, including a large majority of households in every income quintile, will end up worse off after the tax cuts plus financing than before.

The fourth section examines the effects on long-term economic growth. The tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But the tax cuts also create income effects that reduce the need to engage in productive economic activity, and they subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity. In addition, making the tax cuts permanent would raise the deficit over the medium term, in the absence of any short-term financing. The increase in the deficit will reduce national saving—and with it the capital stock owned by Americans and future national income—and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain. Several studies have quantified the various effects noted above in different ways and used different models, yet all have come to the same conclusion: Making the tax cuts permanent is likely to reduce, not increase, national income in the long term unless the reduction in revenues is matched by an equal reduction in government consumption. And even in that case, a positive impact on long-term growth occurs only if the spending cuts occur contemporaneously, which has decidedly not occurred, or if models with implausible features (like short-term Ricardian Equivalence) are employed.

The fifth section provides additional perspectives on making the tax cuts permanent by comparing the features of, and economic environment surrounding, the Reagan tax cuts to those currently in place. These comparisons suggest that the nation is much less able to sustain permanent tax cuts now than it was in the 1980s.

The concluding section summarizes the key results. Most of the conclusions hinge on how and when permanent tax cuts would eventually be financed. The longer financing is postponed, the larger the decline in national saving and future national income. The more that tax cuts are financed through cuts in government consumption, the more advantageous the effect on economic growth in most economic models, although reductions in some types of spending (e.g., on education) may harm long-term growth. Further, the greater the reliance on spending reductions to finance the tax cuts, the more regressive the tax cuts plus financing will likely be. We show that even if the tax cuts raise the size of the economy by 1 percent, which is large relative to all existing growth estimates, most households will still end up worse off after the financing of the tax cuts is considered than they would have been if the tax cuts had never taken place. Our focus on paying for the tax cuts, and the links between financing, fiscal policy, distributional effects, and growth, serve to reinforce the standard notion that there is no free lunch.

Notes from this section

1 The Job Creation and Worker Assistance Act of 2002 provided substantial temporary incentives for new business investment (Joint Committee on Taxation [JCT] 2002). These incentives were expanded slightly in the 2003 tax act, and are scheduled to expire at the end of 2004. Because these provisions were explicitly intended to be temporary, and are not included in the administration's proposal to make the tax cuts permanent (Office of Management and Budget 2004), we do not examine the implications of making the 2002 tax cuts permanent.

2 For other assessments of the Bush administration's tax policies and the effects of making the tax cuts permanent, see Bartlett (2004), Rosen (2004), and Shapiro and Friedman (2004).

Note: This report is available in its entirety in the Portable Document Format (PDF).

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