Economic policy ; Public welfare ; Income tax

Randall Pozdena

English

Research Papers in Economics

FABSF
October 12, 1984 WEEKLY LETTER
Fairness in Economics
Economic policies have two broad classes of
effects-those on total outputand those on the
distributionofoutput. A policyhas positiveeffects
on output if, for a given level ofresources and
technological endowments, the marketplace
responds by providing moregoods and services.
Howthose goods and services are distributed
among differentgroups ofpeople is a decision
society must make; Conceivably, an economic
policy may have unambiguously positive effects
on economic efficiency, but have distributional
effects that are undesirable from a social pointof
view.
Such considerations are at the heart ofthe current
debate over the reforms offederal tax and budget
policythatbegan in 1981. Although proponentsof
those policies argue thatthey have contributed to
a significant resurgence in economic activity, in
addition to suppressing inflation and increasing
employment, opponents argue that the benefits
wereachieved attheexpenseofcreatingasociety
thatis considerably less "fair" in its distributionof
the rewards.
This Weekly Letter examines the available data on
the effects ofthe recent policy reforms on the
distribution ofthe tax burden and on the distribu-
tion of income and employment. Isolating the
effects ofthese changes in economic policy proves
to be very difficultbecause the changes occurred
as the economy was slipping into its deepest
recession in nearly fifty years. There is very little
evidence, however, that these reforms have altered
significantlythe underlying "fairness" ofthe dis-
tribution ofeconomic burdens and rewards.
The tax reform
Let us turn first to the effects ofthe federal individ-
ual income tax cuts that were initiated in 1981.
The basic features ofthose tax cuts included a
25-percent reduction in the marginal tax rate
applied to all income brackets, to be phased in
overa period ofthree years, and indexingofmar-
ginal tax rates to avoid inflation-generated in-
creases in effective tax rates ("bracketcreep").
These tax reform features together were to be
phased in overa four-year period. In addition,
there was an immediate reduction in the top mar-
ginal rate from seventy to fifty percent. Finally,
there were a varietyofother tax policy changes,
including reduction ofthe "marriage tax" bias
introduced by differenttax schedules for single
and married taxpayers, liberalizationofIndividual
Retirement Account (IRA) deductions, and reduc-
tions in medical expense deductions.
Two broad criticisms have been directed atthetax
reforms. The first is thatthe tax cuts altered the
distribution ofthe tax burden among households
to the disadvantage ofthe poor and to the advan-
tage ofthe rich. This alleged effect cannot be due
to the across-the-board reduction in marginal tax
rates. Itcan be shown with simple mathematics
that such a cut, by itself, leaves the tax share paid
by each income bracket unaltered. We, therefore,
do notexpectto see a majorimpactonthe shares
oftaxes paid although there may be some effect
generated bythe other provisions ofthe tax
reforms, such as the change in the "marriagetax."
The data available thus far on tax shares isconsis-
tent with this expectation. As Chart 1 illustrates,
the share offederal individual income taxes paid
byeach incomequintile in 1982 was virtually
identical tothatpaid bythesamequintilein 1980.
The second criticism ofthe reforms is thatthey
redistributed incometo the rich. It is true that
because ofthe progressive natureofourtax system,
the cut in marginal rates will alterthe after-tax
income distribution. In the extreme, for example,
a cut in tax rates has noeffecton the after-tax
incomeofa household already paying notax,
whereas itwould increase the after-tax incomeof
atax-paying household. The change in the distri-
bution ofafter-tax incomethatwould follow,
however, is notachieved atthe "expense"oflower
income households. Indeed, all households would
be at least as well offas they were before the cuts.
Moreover, the resultant after-tax income distribu-
tion is unlikelyto depart radically from historical
distributional outcomes. In some sense, the tax
reforms initiated in 1981 represent only a partial
unravellingofthe upward "creep" in all marginal
tax rates that occurred since the 1960s mostly as
the result ofinflation. (Between 1970 and 1980,FRBSF
the "average" marginal individual tax rate rose by
almost 50 percent to 30.5 percent, accordingto
economist Robert Barro.) A reversal ofthis process
thus cannot be viewed as a dramatic reversal of
distributional policy.
The availabledataon after-tax income as of1982,
suggeststhatthe distribution of income has not
been altered regressively. In fact, ifanything, the
richest20 percent oftaxpayers appear to have
suffered a decrease in their share ofafter-tax
income, with middle quintile taxpayers gaining
and the lowestincometaxpayers remaining large-
ly unaffected.
A majorqualificationthatmustbe appliedtothese
results, ofcourse, is the fact that not all ofthe
features ofthetax cuts were in place by tax year
1982 (the last year for which detailed tax receipts
data exists). Itseems unlikely, however, that further
majorchanges inthe distributions will occur to
alter these conclusions sil')ce 1982 was a year in
which the tax cuts were skewed mostheavily in
favorofthe well-to-do. This was because the
reduction in thetopmarginal tax rate to50 percent
was put in place before cuts in the rates applying
to other brackets. It is possible, therefore, that the
share oftaxes paid in 1982 represents aclose
estimateofthe share thatwould bepaid bythe
wealthiesttaxpayers after the full cuts become
availableto other taxpayers.
Families in poverty
Othersourcesofpotential distributional unfair-
ness arethe budgetaryand social welfare program
policy changes that were instituted along with the
taxcuts. Attheriskofoversimplifyingthe natureof
the budgetary changes thathave occurred, there
appearto have been two major purposes behind
the recent budgetary reforms. First, there was a
desire to increase the relative share ofthe budget
devoted to defense as opposed to civilian expen-
diture programs. In 1981, defense expenditures
were approximately 22 percentoftotal federal
expenditures. These were programmed to rise to
35 percent by 1989.
The second apparent aim ofthe budget reforms
was to restrain the growth ofsocial programs.
Between 1960 and 1980, for example, the so-
called "safety-net" programs-programs such as
Aid to Families with DependentChildren (AFDC),
Medicaid and Food Stamps-grew in real terms
by over 700 percent.
The budget reforms instituted in 1981 were varied
and complex. However, the three program
changes that are mostfrequently viewed as intro-
ducing new "unfairness" intothe economic sys-
tem involvethe AFDC and Food Stamp programs
and theeliminationofpublicserviceemployment
programs under.the Comprehensive Employment
TrainingAct (CETA). Critics charge that these pro-
gram changes were inherently regressive in their
effect on income distribution. In fact, it is not
possible to extrapolate directlyfrom the program
changestheireffects on incomedistribution in the
economy.
Let us examine, forexample, the changes made in
the AFDC program, the cornerstone ofthe U.s.
"welfare" system. The majorprogram change was
to increasethe "payback" rate-the rate atwhich
welfare support payments are reduced as earned
income increases-to 100 percent. Theory sug-
gests that this change could induceeither an in-
crease or a decrease in the income ofaffected
families. The highertake-back rate would discour-
age additionalwork on the margin, butthe reduc-
tion in welfaresupport above a certain earned
incomecould induceadditional workand increase
income.
A similar comment could be made about the
changes that tightened eligibility criteria for re-
ceiving food stamp subsidies. Although the impli-
cit increase in the price offood that results for the
disenfranchised food stamp recipients has the ef-
fectofreducingtheir in-kind income, itmay induce
an offsetting increase in labor supply and, hence,
earned income.
Finally, criticsofthe elimination ofCETA argued
thatdoingawaywith mostpublicserviceemploy-
ment (job creation) programs ofthe federal gov-
ernmentwould put lowincome households at a
further disadvantage. For importanttheoretical
reasons (see Weekly Letter, May 22, 1981), the
abilityofjob creation programs to improve the
long-term earnings oremployment prospects of
targeted households has been called into question.
The ineffectiveness ofthese programs now appears
to be supported by a large-scale study ofthe com-
parative workhistories of3,000 individuals who
gained public service employment under CETA
and 3,000 matched "controls"who did not. The
study, byeconomistTerry Johnson of Battelle, finds
nosignificantenhancementofjobprospects as the
result ofCETA programs. In fact, adult male work-ers associated with CETA jobs programs had a 15
percent lowerwage after returning to marketem-
ployment than a matchedcontrol group without
CETA experience. Johnson also found that on-the-
jobtraining and workexperience programs (sup-
portforwhich remained in thefederal budget) also
had insignificantor negative effects on post-
program earnings.
Othercriticsofthepolicychanges use dataon the
numberoffamilies living under officially defined
conditions ofpoverty in oureconomy. They point
outthatthe numberoffamilies living underthe
poverty line increased between 1979and 1983 by
over2 million. However, itis hazardoustoascribe
this increasetothe recent budgetreforms because
the economywas in its deepestrecession in nearly
fifty years at the time. Increases in poverty are a
common effectofrecessions quiteapartfrom bud-
get changes, as was the case in 1969-70and
1974-75. In addition, a large portion ofthe in-
crease in poverty occurred during 1980, before
any ofthe budgetary reforms were in place.
At the request ofCongress, investigators from the
Congressional Research Service (CRS) attempted
to distinguish the effects ofthe recession from the
effects ofthe budgetary reforms on the increase in
poverty. They concluded that only about 25 per-
centofthe increase was attributable directlyto
changes in key social welfare programs. It is
importantto pointout, however, that the metho-
dologyemployed in this study, too, was a"simula-
tion" ofthe effects ofthe budgetary reforms and
does not incorporate the possibility, emphasized
above, thattherewouId be offsetting responses by
those affected bythe program changes.
Randall Pozdena
The effects ofearlier recessions on poverty also
suggest that the CRS findings overstate the effects
ofbudget reforms on the poor. Examining the
statistical relationship between changes in the
overall unemployment rate and the economy and
changes in the incidence ofpoverty indicate that
an unusually large increase in poverty associated
with the unusually large recent recession should
nothave been surprising. In particular,ifthe statis-
tical relationship between unemployment rates
and the incidenceofpoverty that held in the past
were extrapolated to the 1980 to 1983 period,
poverty should have increased byexactly the
amountthat actually has been observed. In any
case, itseems clearthatwhatevertheeffectsofthe
budgetary reforms on distributional equity, they
are dwarfed bythe effects ofgeneral economic
conditions.
Conclusions
The continuing challenge ofmodern economic
policymaking is to devise policies that can achieve
desirableeffects on overall economic well-being
with compatible distributional effects. The recent
incometax and budgetary reforms wiII continueto
be evaluated in these terms. Atthe present time,
there is little evidence beyond simulations to sug-
gest that these policies have altered significantly
the distribution ofthe burdens and rewards ofour
economy.
1982
1980
40
30
20
10
OL....ll=-~L..WI<~I<::.Uik:.L._
()olo ~olo ~olo ~olo ~olo
lIl''lJ '}.\'~ ~ ....E> ",\.'li '0....\<:)
Lowest Highest
Percent Returns Filed Ranked by Income
Chart 2
After-Tax Income Distribution
% Afte,.T.x 1980-1982
Adjusted
Gross Income
60
1980 1982 50
30
10
20
40
Chart 1
Tax Share by Income Class
1980·1982
Overall effects
Whatthen were the effects ofthe budget changes
on theeconomicwell-beingofvarious segments
ofour society? One widely reported study by The
Urban Institutefound thatbetween 1980and 1984,
the lowest incomequintile families had suffered a
decrease in real after-tax incomeofabouteight
percent while the richest quintile had enjoyed an
increase ofa similar magnitude. This study suffers
from the serious disadvantage, however, that it
simulated the impactofthe various tax and pro-
gram reforms instead ofusing actual data. Itthus
necessarily makes assumptions aboutthe response
ofindividuals to the reforms that mayormay not
be consistentwith actual behavior.
% Tolal
Income Tax
(,)010 ~olo ~olo. ~olo ~olo
lIl''lJ '}. ....~ ~\.E> ",\.'IJ '0\,\<:)
Lowest Highest
Adjusted Gross Income Class
Opinions expressed in this newsletterdonot necessarily reflect theviews of the managementofthe Federal Reserve Bank ofSan
Francisco,orofthe BoardofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor....Freecopiesof Federal Reserve publications
can beobtained from the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone(415) 974-2246.BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
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ZSL: ·ON 11Wlt:ld
OIVd :J~V1SOd ·S·O
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aUlIOS:JlId
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
9/26/84
Change
from
9/16/84
uo~6U!4S0m 4o~n U060JO 0P0!l0U
040PI !!omoH O!UJ01!10) ouozPl::J 0l1soll::J
O)SI)UOJ~ UOS
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aAJaSa~ IOJapa~
~uaw~Jodaa 4)Joasa~
Change from 12/28/83
Percent
Dollar Annualized
Loans, Leases and Investments1 2 182,833 - 100 6,808 5.1
Loans and Leases1 6 163,828 - 143 8,473 7.2
Commercial and Industrial 49,097 158 3,134 09.0
Real estate 60,954 7 2,055 4.6
Loans to Individuals 30,089 178 3,438 17.2
Leases 5,046 - 4 - 17 - 0.4
U.S. Treasury and Agency Securities2 11,807 20 - 700 - 7.4
OtherSecurities2 7,198 23 - 965 - 15.7
Total Deposits 187,801 -1,185 - 3,196 - 2.2
Demand Deposits 43,223 - 784 - 6,014 - 16.2
Demand Deposits Adjusted3 28,492 - 636 - 2,839 - 12.0
OtherTransaction Balances4 11,899 - 268 - 876 - 9.1
Total Non-Transaction Balances6 132,679 - 132 3,694 3.8
MoneyMarketDeposit
Accounts-Total 37,527 - 144 - 2,070 - 6.9
Time Deposits in Amounts of
$100,000or more 41,111 200 2,946 10.2
Otherliabilities for Borrowed MoneyS 22,905 990 - 102 - 0.5
Weekly Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+l/Deficiency(-)
Borrowings
Netfree reserves (+l/Net borrowed(-)
Period ended
9/24/84
105
47
58
Period ended
9/10/84
23
39
15
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately

Fairness in economics

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