The Effect of the 2001 Tax Cut on Low- and Middle-Income Families and Children

Leonard E. Burman, Elaine Maag, Jeff Rohaly

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.

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The Tax Policy Center (TPC) aims to clarify and analyze the nation's tax policy choices by providing timely and accessible facts, analyses, and commentary to policymakers, journalists, citizens and researchers. TPC's nationally recognized experts in tax, budget and social policy carry out an integrated program of research and communication on four overarching issues: fair, simple and efficient taxation; long-term implications of tax policy choices; social policy in the tax code; and state tax issues.

A joint venture of the Urban Institute and the Brookings Institution, support for the TPC comes from a generous consortium of funders, including the Ford Foundation, the Annie E. Casey Foundation, and the George Gund Foundation.

Views expressed do not necessarily reflect those of the Urban Institute, the Brookings Institution, their board of trustees or their funders.

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CONTENTS

Introduction

Prior Tax Treatment of Low- and Moderate-Income Families

The New Bill's Effect on the Taxation of Families
   Child Tax Credit
   Child and Dependent Care Tax Credit
   Marriage-Penalty Relief
   Reduced Marginal Tax Rates

Effect of EGTRRA on Low- and Moderate-Income Families

Distributional Effects of the Legislation

Effects on Taxpayers with Children

Unresolved Concerns

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Introduction

With astonishing speed, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), legislation based loosely on the blueprint put forward by President Bush in March. This extraordinary act contains several notable features. First, it constitutes the largest tax cut in 20 years and will cost the government $1.35 trillion over 10 years. Second, some provisions do not become fully effective until 2010. Third, the entire tax bill expires in 2011, in theory returning the tax system to its initial state after an experimental ten-year period. Fourth, EGTRRA will eventually repeal the estate tax, an important element of the federal tax system since the enactment of the modern income tax. Fifth, the act substantially expands federal tax assistance for working families with children.

Although all elements of EGTRRA warrant scrutiny, this paper focuses on how the income tax cuts will affect low- and middle-income families with children.¹ Increasingly, lower-income families, in particular, rely on the income tax system for support. For example, the earned income tax credit (EITC), the largest cash assistance program for poor families, has been expanding at a time when direct cash assistance through traditional welfare programs has been contracting. Thus, policymakers and researchers interested in the well-being of people at the bottom rungs of the economic ladder must monitor the tax system to gauge the level of public support.

Unfortunately, the new tax law does not resolve how lower-income families-or anybody else, for that matter-will be taxed in the years to come. As passed, the tax cut phases in gradually and then disappears after 10 years. Although the "sunsetting" of the tax law is a clever budget gimmick, it is very unlikely to remain intact. Indeed, President Bush proposed in his very next budget to make all EGTRRA changes permanent. Furthermore, both the President and some members of Congress have proposed accelerating the high-income tax rate cuts in EGTRRA on the theory that this measure could boost the sagging economy. Accelerating some tax cuts in the package, however, would put more pressure on the remaining provisions, some of which are most likely to help low- and middle-income families. And given the strains on the budget arising from the recession and the aftermath of the September terrorist attacks, every provision in EGTRRA could find its way to the chopping block.

In summary, the main provisions of EGTRRA that will help low- and middle-income families are the following:

• The child tax credit eventually doubles from $500 to $1,000 and becomes refundable for millions of low-income families;
• The amount of child care expenses eligible for the child and dependent care tax credit increases from $2,400 to $3,000, and the credit rate for low-income families increases;
• The earned income tax credit is simplified and increased for many married couples;
• Other "marriage-penalty" relief provisions increase the standard deduction and expand the size of the 15 percent tax bracket for married couples;
• A new 10 percent tax bracket applies to low-income taxpayers.

This paper outlines the main elements of prior tax law that helped low-income families, explains the impact of EGTRRA's changes on low- and moderate-income families, and explores some of the unresolved issues Congress will have to grapple with in the years to come.

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1. For a more comprehensive discussion of EGTRRA, see Gale and Potter (forthcoming).

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