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Friday, January 28, 2011

Redistribution Effects of Federal Taxes and Selected Tax Provisions

Thomas L. Hungerford
Specialist in Public Finance

Several policy makers and analysts have voiced concern over federal budget deficits and growing federal debt. Publicly held federal debt as a percentage of GDP stood at 53% at the end of FY2009; the Congressional Budget Office’s (CBO’s) baseline projection has it growing to 66% by 2011. CBO’s projection of the President’s budget has debt as a percentage of GDP growing to 90% by 2020. The 112th Congress will likely face several tax issues. Congress passed the Statutory Pay-As-You-Go Act, which would enact PAYGO into law, and the President signed it into law on February 12, 2010 (P.L. 111-139). The recently extended Bush tax cuts expire at the end of 2012 and the alternative minimum tax relief expires at the end of 2011. Furthermore, the National Commission on Fiscal Responsibility and Reform has recommended changes to the tax code to help achieve fiscal sustainability. Each of these will likely affect federal revenues and redistribute income among families.

The redistributive effect of a policy can be decomposed into a progressivity effect (a vertical effect) and a reranking effect (a horizontal effect). The progressivity effect measures how individuals in the income distribution are pushed together or pulled apart (without changing relative positions in the distribution). The reranking effect captures the extent to which individuals are moved above or below others in the distribution as a result of a policy. This reranking is often perceived as unfair and reduces the public’s confidence in the fairness of the tax system or policy proposal. These two effects can work together or in opposite directions to affect income inequality.

The results highlight the trade-offs policy makers could face in developing policies to raise revenue, reduce income inequality, and reform the tax system. Overall, the results show that U.S. taxes reduce income inequality. The redistributive effect, however, could be larger if the reranking effect were reduced or eliminated. In addition, the individual tax provisions have small but important effects on income inequality. Reranking is more severe for some tax provisions than for other provisions. The method used in this study can very easily be applied to any tax provision to determine how the provision would affect income inequality and where in the income distribution the impact would be most felt.

Date of Report: January 11, 2011
Number of Pages: 15
Order Number: R40671
Price: $29.95

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