How Changes in the Distribution of Earnings Affect the Federal Deficit: Working Paper 2021-12

Working Paper Series

Congressional Budget Office

Washington, D.C.

How Changes in the Distribution of Earnings

Affect the Federal Deficit

Brooks Pierce

Congressional Budget Office

[e-mail]

Working Paper 2021-12

October 2021

To enhance the transparency of the work of the Congressional Budget Office and to encourage external review of that work, CBO's working paper series includes papers that provide technical descriptions of official CBO analyses as well as papers that represent independent research by CBO analysts. Papers in this series are available at http://go.usa.gov/xUzd7.

Several CBO colleagues produced estimates for this paper and commented on earlier drafts. Edward Harris and James Pearce provided tax revenue estimates. Ben Hopkins, Geena Kim (formerly of CBO), Eamon Molloy, Romain Parsad, Allison Percy, and Carolyn Ugolino provided estimates of federal subsidies for health insurance coverage. Jennifer Gray and Justin Latus provided estimates for SNAP and SSI expenditures, respectively. For helpful comments and suggestions, I also thank William Carrington, Sheila Dacey, Molly Dahl, Mark Doms, Wendy Edelberg (formerly of CBO), Justin Falk, Rebecca Heller, Nadia Karamcheva, Joseph Kile, Jeffrey Kling, Sarah Masi, John McClelland, Alexandra Minicozzi, Xiaotong Niu, Julie Topoleski, and Chapin White. Gary Burtless of the Brookings Institution and James C. Capretta of the American Enterprise Institute also provided useful comments and suggestions. Julia Heinzel was the fact- checker. Elizabeth Schwinn was the editor.

www.cbo.gov/publication/57217

Abstract

This paper by the Congressional Budget Office examines how the federal budget deficit would have differed in 2018 under four scenarios that vary the distribution of labor earnings while leaving aggregate earnings unchanged. The scenarios were constructed to isolate the budgetary effects of changes in the distribution of earnings and do not reflect an assessment of policies that would change the distribution of earnings.

CBO estimates that substantial changes in the distribution of earnings would have relatively modest effects on the deficit because of the offsetting effects on revenues and outlays. Under the two scenarios that decrease earnings inequality, the reduction in income tax revenues would be partially offset by an increase in payroll tax revenues and a reduction in federal spending (including federal subsidies for health insurance, spending on the Supplemental Nutrition Assistance Program, and spending on the Supplemental Security Income program). Increasing earnings inequality would have the opposite effect on revenues and spending. On net, the federal deficit would rise with a decrease in inequality and fall with an increase in inequality. Larger changes in inequality would result in larger changes in the deficit.

Under the scenario that decreases inequality by 14 percent (as measured by the standard deviation of the logarithm of earnings), the federal deficit would increase by $13 billion, or 1.7 percent. In the scenario in which inequality is reduced by 5 percent, the deficit would increase by a smaller amount, $4 billion. When inequality varies in the other direction, the scenario that increases inequality by 5 percent would lower the deficit by $7 billion, and the scenario with a 14 percent increase in inequality would decrease the deficit by $26 billion.

Keywords: earnings inequality, means-tested programs, income tax, payroll tax, budget deficit

JEL Classification: D30, H24, H53

Notes

Unless this report indicates otherwise, all years referred to are federal fiscal years, which run from October 1 to September 30 and are designated by the calendar year in which they end.

Numbers in the text, tables, and figures may not add to totals because of rounding.

This report presents historical earnings in 2018 dollars. To convert amounts, the Congressional Budget Office used the Bureau of Economic Analysis's price index for personal consumer expenditures.

The federal poverty guidelines, commonly referred to as the federal poverty level, are a set of income benchmarks used administratively to determine a household's financial eligibility for certain federal and state assistance programs. The guidelines, which vary according to the size and geographic location of a household, are developed by the Department of Health and Human Services. They are based on poverty thresholds determined by the Census Bureau in its calculations of official poverty rates.

Contents
Summary .........................................................................................................................................	1
What Scenarios Did CBO Examine? ..........................................................................................	1
How Would Changes in the Distribution of Earnings Affect Revenues and Outlays? ..............	2
Four Scenarios That Change the Distribution of Earnings .............................................................	3
Revenues .........................................................................................................................................	5
How Tax Rates Differ Across the Income Distribution..............................................................	6
How CBO Estimated Changes in Tax Revenues........................................................................	6
How Changes in the Distribution of Earnings Affect Revenues ................................................	7
Outlays ............................................................................................................................................	8
Federal Subsidies for Health Insurance ......................................................................................	9
The Supplemental Nutrition Assistance Program.....................................................................	12
The Supplemental Security Income Program ...........................................................................	13
Refundable Tax Credits ............................................................................................................	14
Conclusion ....................................................................................................................................	14
Figures...........................................................................................................................................	16
Tables............................................................................................................................................	20

Summary

Twice yearly, the Congressional Budget Office prepares forecasts of economic variables that underlie its projections of the federal budget. Those economic variables include measures of capital investment, labor force participation, and labor earnings. This paper shows how changes in the distribution of labor earnings would affect the federal deficit if total earnings from labor were unchanged. (Labor earnings include wages and salary and exclude self-employment income.)

CBO analyzed the effect on tax revenues and outlays under four scenarios in which people's labor earnings in 2018 were distributed either more or less equally than was actually the case. CBO's analysis focused on the budget items that are most directly affected by workers' earnings: revenues collected through income and payroll taxes, federal subsidies for health insurance coverage (including tax benefits for employment-based coverage), and spending on the Supplemental Nutrition Assistance Program (SNAP) and the Supplemental Security Income program (SSI).

CBO estimates that substantial changes in the distribution of earnings would have relatively modest budgetary implications because of the offsetting effects of those changes on revenues and outlays. More equally distributed earnings would result in lower outlays on federal subsidies for health insurance, lower outlays on certain means-tested programs, and lower tax revenues. In the scenarios that CBO analyzed, the effect on revenues would be larger than the effect on outlays. Accordingly, a decrease in earnings inequality would increase the federal deficit. The opposite is true when earnings are less equally distributed: The net effect on the deficit is greater for larger changes in the earnings distribution.

What Scenarios Did CBO Examine?

CBO analyzed four illustrative scenarios to determine how the distribution of labor earnings affects the budget. The scenarios are based on alternative distributions of labor earnings among low- and high-income people in 2018; they hold fixed both the aggregate labor earnings in the economy and the number of people with positive earnings. Labor earnings affect family income. Because both income tax revenues and eligibility and benefits for many government programs depend on family income, changing the distribution of labor earnings would affect the federal deficit.

The scenarios were constructed to isolate the budgetary effects of the distribution of earnings, and do not reflect an assessment of specific policies that would change the distribution of earnings. Such policies would probably change the total amount of earnings as well, and the analysis of such policies is beyond the scope of this work.

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