The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FABSF
WEEKLY LETTER
October 12, 1984
Fairness in Economics
Economic policies have two broad classes of
effects-those on total output and those on the
distribution of output. A policy has positive effects
on output if, for a given level of resources and
technological endowments, the marketplace
responds by providing more goods and services.
How those goods and services are distributed
among different groups of people 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 point of
view.
Such considerations are at the heart of the current
debate over the reforms of federal tax and budget
policy that began in 1981. Although proponents of
those policies argue that they have contributed to
a significant resurgence in economic activity, in
addition to suppressing inflation and increasing
employment, opponents argue that the benefits
were achieved at the expense of creating a society
that is considerably less "fair" in its distribution of
the rewards.
This Weekly Letter examines the available data on
the effects of the recent policy reforms on the
distribution of the tax burden and on the distribution of income and employment. Isolating the
effects of these changes in economic policy proves
to be very difficult because 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
significantly the underlying "fairness" of the distribution of economic burdens and rewards.
The tax reform
Let us turn first to the effects of the federal individual income tax cuts that were initiated in 1981.
The basic features of those tax cuts included a
25-percent reduction in the marginal tax rate
applied to all income brackets, to be phased in
over a period of three years, and indexing of marginal tax rates to avoid inflation-generated increases in effective tax rates ("bracket creep").
These tax reform features together were to be
phased in over a 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 variety of other tax policy changes,
including reduction of the "marriage tax" bias
introduced by differenttax schedules for single
and married taxpayers, liberalization of Individual
Retirement Account (IRA) deductions, and reductions in medical expense deductions.
Two broad criticisms have been di rected at the tax
reforms. The first is that the tax cuts altered the
distribution of the tax burden among households
to the disadvantage of the poor and to the advantage of the rich. This alleged effect cannot be due
to the across-the-board reduction in marginal tax
rates. It can be shown with simple mathematics
that such a cut, by itself, leaves the tax share paid
by each income bracket unaltered. We, therefore,
do not expect to see a major impact on the shares
of taxes paid although there may be some effect
generated by the other provisions of the tax
reforms, such as the change in the "marriage tax."
The data available thus far on tax shares isconsistent with this expectation. As Chart 1 illustrates,
the share of federal individual income taxes paid
by each income quintile in 1982 was virtually
identical to that paid bythesamequintile in 1980.
The second criticism of the reforms is that they
redistributed income to the rich. It is true that
because of the progressive nature of our tax system,
the cut in marginal rates will alter the after-tax
income distribution. In the extreme, for example,
a cut in tax rates has no effect on the after-tax
income of a household already paying no tax,
whereas it would increase the after-tax income of
a tax-paying household. The change in the distribution of after-tax income that would follow,
however, is not ach ieved at the "expense" of lower
income households. Indeed, all households would
be at least as well off as they were before the cuts.
Moreover, the resultant after-tax income distribution is unlikely to depart radically from historical
distributional outcomes. In some sense, the tax
reforms initiated in 1981 represent only a partial
unravelling of the upward "creep" in all marginal
tax rates that occurred since the 1960s mostly as
the result of inflation. (Between 1970 and 1980,
FRBSF
the "average" marginal individual tax rate rose by
almost 50 percent to 30.5 percent, according to
economist Robert Barro.) A reversal of this process
thus cannot be viewed as a dramatic reversal of
distributional policy.
The available data on after-tax income as of 1982,
suggests that the distribution of income has not
been altered regressively. In fact, if anything, the
richest20 percent of taxpayers appear to have
suffered a decrease in their share of after-tax
income, with middle quintile taxpayers gaining
and the lowest income taxpayers remaining largely unaffected.
A major qual ification that must be applied to these
results, of course, is the fact that not all of the
features ofthe tax cuts were in place by tax year
1982 (the last year for which detailed tax receipts
data exists). It seems unlikely, however, that further
major changes inthe distributions will occur to
alter these conclusions sil')ce 1982 was a year in
which the tax cuts were skewed most heavily in
favor of the well-to-do. This was because the
reduction in the top marginal tax rate to 50 percent
was put in place before cuts in the rates applying
to other brackets. It is possible, therefore, that the
share of taxes paid in 1982 represents a close
estimate of the share that would be paid by the
wealthiest taxpayers after the full cuts become
available to other taxpayers.
Families in poverty
Othersources of potential distributional unfairness are the budgetary and social welfare program
policy changes that were instituted along with the
tax cuts. Atthe risk of oversimplifying the natureof
the budgetary changes that have occurred, there
appear to have been two major purposes behind
the recent budgetary reforms. First, there was a
desire to increase the relative share of the budget
devoted to defense as opposed to civilian expenditure programs. In 1981, defense expenditu res
were approximately 22 percent of total federal
expenditures. These were programmed to rise to
35 percent by 1989.
The second apparent aim of the budget reforms
was to restrain the growth of social programs.
Between 1960 and 1980, for example, the socalled "safety-net" programs-programs such as
Aid to Families with Dependent Children (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 most frequently viewed as introducing new "unfairness" into the economic system involve the AFDC and Food Stamp programs
and theelimination of public service employment
programs under.the Comprehensive Employment
Training Act (CETA). Critics charge that these program changes were inherently regressive in their
effect on income distribution. In fact, it is not
possible to extrapolate directly from the program
changes their effects on income distribution in the
economy.
Let us examine, for example, the changes made in
the AFDC program, the cornerstone of the U.s.
"welfare" system. The major program change was
to increase the "payback" rate-the rate atwhich
welfare support payments are reduced as earned
income increases-to 100 percent. Theory suggests that this change could induce either an increase or a decrease in the income of affected
families. The higher take-back rate would discourage additional work on the margin, but the reduction in welfare support above a certain earned
income could induce additional work and increase
income.
A similar comment could be made about the
changes that tightened eligibility criteria for receiving food stamp subsidies. Although the implicit increase in the price of food that results for the
disenfranchised food stamp recipients has the effectof reducingtheir in-kind income, it may induce
an offsetting increase in labor supply and, hence,
earned income.
Finally, critics of the elimination of CETA argued
that doing away with most public service employment (job creation) programs of the federal government would put low income households at a
further disadvantage. For important theoretical
reasons (see Weekly Letter, May 22, 1981), the
ability of job creation programs to improve the
long-term earnings or employment prospects of
targeted households has been called into question.
The ineffectiveness of these programs now appears
to be supported by a large-scale study of the comparative work histories of 3,000 individuals who
gained public service employment under CETA
and 3,000 matched "controls" who did not. The
study, by economist Terry Johnson of Battelle, finds
no significant enhancement of job prospects as the
result ofCETA programs. In fact, adult male work-
Chart 1
Tax Share by Income Class
1980·1982
Chart 2
After-Tax Income Distribution
% Afte,.T.x
1980-1982
% Tolal
Income Tax
Adjusted
Gross Income
get changes, as was the case in 1969-70 and
1974-75. In addition, a large portion of the increase in poverty occurred during 1980, before
any of the budgetary reforms were in place.
60
40
1980
1982
50
1980
30
1982
40
30
20
20
10
10
OL....ll=-~L..WI<~I<::.Uik:.L._
(,)010
~olo
~olo. ~olo
~olo
()olo
~olo
~olo
~olo
~olo
lIl''lJ '}.... ~ ~\.E> ",\.'IJ '0\,\<:)
.
Lowest
Highest
lIl''lJ '}.\'~ ~....E> ",\.'li '0....\<:)
Lowest
Highest
Adjusted Gross Income Class
Percent Returns Filed Ranked by Income
ers associated with CETA jobs programs had a 15
percent lower wage after retu rn ing to market employment than a matched control group without
CETA experience. Johnson also found that on-thejob training and work experience programs (support for which remained in the federal budget) also
had insignificant or negative effects on postprogram earnings.
Overall effects
What then were the effects of the budget changes
on theeconom icwell-being of various segments
of our society? One widely reported study by The
Urban Institute found that between 1980and 1984,
the lowest income quintile families had suffered a
decrease in real after-tax income of about eight
percent while the richest quintile had enjoyed an
increase of a similar magnitude. This study suffers
from the serious disadvantage, however, that it
simulated the impact of the various tax and program reforms instead of using actual data. It thus
necessarily makes assumptions about the response
of individuals to the reforms that mayor may not
be consistent with actual behavior.
Other critics ofthe policy changes use data on the
number of families living under officially defined
conditions of poverty in our economy. They point
outthatthe number offamilies living under the
poverty line increased between 1979 and 1983 by
over 2 million. However, it is hazardous to ascribe
this increase to the recent budget reforms because
the economy was in its deepest recession in nearly
fifty years at the time. Increases in poverty are a
common effect of recessions qu ite apart from bud-
At the request of Congress, investigators from the
Congressional Research Service (CRS) attempted
to distinguish the effects of the recession from the
effects of the budgetary reforms on the increase in
poverty. They concluded that only about 25 percent of the increase was attributable directly to
changes in key social welfare programs. It is
important to point out, however, that the methodology employed in this study, too, was a "simulation" of the effects of the budgetary reforms and
does not incorporate the possibility, emphasized
above, that there wou Id be offsetti ng responses by
those affected by the program changes.
The effects of earlier recessions on poverty also
suggest that the CRS findings overstate the effects
of budget reforms on the poor. Examining the
statistical relationship between changes in the
overall unemployment rate and the economy and
changes in the incidence of poverty indicate that
an unusually large increase in poverty associated
with the unusually large recent recession should
not have been surprising. In particular, if the statistical relationship between unemployment rates
and the incidence of poverty that held in the past
were extrapolated to the 1980 to 1983 period,
poverty should have increased by exactly the
amount that actually has been observed. In any
case, it seems clear that whatever the effects of the
budgetary reforms on distributional equity, they
are dwarfed by the effects of general economic
conditions.
Conclusions
The continuing challenge of modern economic
policymaking is to devise policies that can achieve
desirable effects on overall economic well-being
with compatible distributional effects. The recent
income tax and budgetary reforms wi II conti nue to
be evaluated in these terms. At the present time,
there is little evidence beyond simulations to suggest that these policies have altered significantly
the distribution of the burdens and rewards of our
economy.
Randall Pozdena
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.
uo~6U!4S0m 4o~n
040 PI
!!omoH
O!UJ01!10)
U060JO
0P0!l0U
ouozPl::J
O)SI)UOJ~
0l1soll::J
UOS
JO }oj U08
·m!!::> 'o:>spU!!J:I U!!S
ZSL: ·ON 11Wlt:ld
OIVd :J~V1SOd ·S·O
llVW ssvn 1SlIl:I
aUlIOS:JlId
aAJaSa~ IOJapa~
~uaw~Jodaa 4)Joasa~
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Otherliabilities for Borrowed MoneyS
Weekly Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ l/Deficiency (-)
Borrowings
Net free reserves (+ l/Net borrowed( -)
Amount
Outstanding
9/26/84
182,833
163,828
49,097
60,954
30,089
5,046
11,807
7,198
187,801
43,223
28,492
11,899
132,679
Change from 12/28/83
Percent
Dollar
Annualized
Change
from
9/16/84
100
- 143
158
7
178
4
20
23
-1,185
- 784
636
- 268
132
37,527
41,111
22,905
-
-
-
6,808
8,473
3,134
2,055
3,438
17
700
965
3,196
6,014
2,839
876
3,694
5.1
7.2
09.0
4.6
17.2
- 0.4
7.4
- 15.7
- 2.2
- 16.2
- 12.0
9.1
3.8
144
-
2,070
-
6.9
200
990
-
2,946
102
-
10.2
0.5
Period ended
Period ended
9/24/84
9/10/84
105
47
58
23
39
15
1 Includes loss reserves, unearned income, excludes interbank loans
2
Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
@FedFRASER