Tax Incidence Analysis
There are basically two ways to analyze how the tax burden is distributed. The easiest way is to measure the taxes directly paid by entities, such as households or businesses, classified according to criteria such as household income, business profit levels, etc. These data can be obtained directly from aggregate tax return data published by the Internal Revenue Service (IRS) and from reports from other government agencies. This approach considers only who actually pays the tax to the government. Thus, it would allocate corporate taxes to corporations, excise taxes to manufacturers, sales taxes to consumers, etc.
The second approach, called tax incidence analysis, is more complex yet more meaningful. While taxes are paid by various entities other than individuals, such as corporations, and public service organizations, the burden of all taxes ultimately fall on people. The final incidence of taxation depends on how a specific tax translates into changes in prices and changes in economic behavior among consumers and businesses:
Tax incidence is the study of who bears the economic burden of a tax. More generally, it is the positive analysis of the impact of taxes on the distribution of welfare within a society. It begins with the very basic insight that the person who has the legal obligation to make a tax payment may not be the person whose welfare is reduced by the existence of the tax. The statutory incidence of a tax refers to the distribution of those legal tax payments – based on the statutory obligation to remit taxes to the government...
Economic incidence differs from statutory incidence because of changes in behavior and consequent changes in equilibrium prices. Consumers buy less of a taxed product, so firms produce less and buy fewer inputs – which changes the net price or return to each input. Thus the job of the incidence analyst is to determine how those other prices change, and how those price changes affect different groups of individuals. (Metcalf and Fullerton, 2002, p. 1)
Tax incidence analysis has produced a number of generally accepted conclusions regarding the burden of different tax mechanisms. Remember, for example, that the payroll tax on paper is split equally between employer and employee:
So, who really pays the payroll tax? Is the payroll tax reflected in reduced profits for the employer or in reduced wages for the worker? ...there is generally universal agreement that the real burden of the tax falls almost entirely on the worker. Basically, an employer will only hire a worker if the cost to the employer of hiring that worker is no more than the value that worker can add. So, a worker is paid roughly what he or she adds to the value of production, minus the payroll tax; in effect, the whole tax is deducted from wages... to repeat, this is not a controversial view; it is the view of the vast majority of analysts...
The most common assumption made regarding the incidence of corporate taxes is that the burden of these taxes falls almost exclusively on the owners of capital investments like stocks and bonds. Given the mobility of investments, the burden is not limited to owners of corporate capital but extends to owners of all capital. This result is primarily a theoretical finding – in reality some portion of the corporate tax burden likely falls on workers (through lower wages) and consumers (through higher prices).
Excise taxes, although directly paid by manufacturers, are generally attributed entirely to consumers according to their consumption patterns. This result is based on an assumption of perfect competition in the affected industries. Real-world markets, however, are not perfectly competitive. The actual incidence of excise taxes will depend on the degree of competition in an industry. For example, imperfectly competitive industries with upward-sloping supply curves imply that prices increase by less than the tax and that a portion of excise taxes is borne by businesses.
The burden of sales taxes is generally assumed to fall directly on consumers who buy the taxed goods and services. Again, this is a simplifying assumption – in reality some portion of sales taxes filters to corporate owners, other capital owners, and workers. Personal income taxes paid by households are directly attributed to those households paying the tax. Estate tax burdens fall on the heirs paying the tax. Finally, property tax burdens are generally assumed to fall on property owners although the burden can be passed on renters (some analysts attribute property taxes more broadly to owners of capital).
So, for several types of tax mechanisms (personal income, sales, excise, and estate taxes), data on direct tax payments is analogous to tax incidence. However, for other taxes (payroll, corporate, and to a lesser extent property taxes) the direct data on tax payments will differ from the ultimate burden of the tax.
Using Effective Tax Rate Data to Determine Tax Progressivity
|Table 1: Distribution of Federal Income Taxes, 2000|
|More than $1,000,000||0.3||3,415,975||946,946||27.7|
A tax is progressive if the percentage of income a person pays for the tax increases as income increases. Thus, we can determine whether a tax is progressive or regressive by looking at a table showing the effective tax rates for a particular tax for people in different income categories. If effective tax rates increase (decrease) with increasing income, then the tax is progressive (regressive). Table 1 shows the percentage of income people in each adjusted gross income (AGI) category paid in federal income taxes in 2000, the most recent data available. We see that effective tax rates for the federal income tax tend to increase with increasing income. For taxpayers making less than $50,000 per year, the effective federal income tax rate averages less than 10% of income. For those making more than $200,000 per year, the federal income tax averages more than 20% of income. The federal income tax is clearly progressive because those with higher incomes pay a larger share of their income for the tax. For a regressive tax, effective tax rates tend to decrease as income increases. If effective tax rates are constant at different income levels, then a tax is proportional.
Looking at effective tax rates by income categories can normally determine whether a tax is progressive or regressive. However, there may be some cases where effective tax rates do not follow a consistent pattern across income levels. For example, suppose that effective taxes first increase but then decrease as we move up the income spectrum. Another limitation with data on effective tax rates is that this approach does not tell us the degree of progressivity or regressivity. We might not be able to determine whether one tax is more progressive than another or whether a particular tax becomes more or less progressive over time.
Researchers have come up with several tax indices that measure the progressivity of a tax as a single number, considering the incidence of the tax across all income levels. These indices allow direct comparisons across different tax types and across time.
Effective Tax Rates in the United States
|Table 2: Effective Tax Rates, 2001|
|Effective Tax Rates|
Data on the distribution of taxes in the U.S. are available from several government and non-governmental sources. The government sources that publish data on tax distribution include the Internal Revenue Service (IRS), the Joint Committee on Taxation (JCT), the Congressional Budget Office (CBO), and, until recently, the Office of Tax Analysis within the U.S. Treasury. The IRS data are the most detailed but focus on federal income and estate taxes. The IRS publishes data on corporate taxes but does not conduct tax incidence analysis. The JCT does conduct tax incidence analyses but only on the federal income tax, payroll taxes, and federal excise taxes. The CBO adds the incidence of federal corporate taxes to their analyses but still omits the federal estate tax and all state and local taxes.
The only source for tax incidence data for all taxes in the U.S., including state and local taxes, is Citizens for Tax Justice (CTJ), a non-profit organization. CTJ uses data from government sources but has developed its own models of tax incidence. Comparison of tax progressivity data from CTJ with data from the federal sources listed above indicates that the CTJ results are generally similar to the government’s and not biased in either direction.
Table 2 presents the tax distribution data for all tax types from CTJ for 2001. These data include the effect of the 2001 Bush tax cut but not the most recent cuts. As in Table 1, we see that the federal income tax is progressive. Those in the lowest income group actually receive, on average, a rebate on their federal income taxes due to the availability of various tax credits. Effective tax rates for the federal income tax rise with each income category.
Federal social insurance taxes are slightly progressive at lower income levels but then become very regressive at the highest income levels. This is a case, as mentioned above, where looking at effective tax rates is insufficient to determine whether a tax is progressive or regressive. Other analysis of the federal social insurance tax reveals that overall this is a regressive tax.
Table 2 also shows that federal corporate taxes are progressive while federal excise taxes are regressive. The federal estate tax is extremely progressive, with the vast majority of taxpayers paying no federal estate taxes. State and local taxes, which include sales, income, corporate, and property taxes, are regressive. When all taxes are considered, the U.S. system is progressive. Those in the middle of the income spectrum pay, on average, about 29% of their income in taxes. Those at the top 1% pay about 42% of their income in taxes while those in the bottom group pay about 19% of their income.
Tax Progressivity over Time
Consistent data are generally not available to determine how the entire U.S. tax burden has shifted over time. Most analyses are limited to one, or a few, tax types. Further, interest groups can interpret the data to support a particular agenda.
Analysis over time indicates that the U.S. tax system is about as progressive now as it was in the 1970s. The progressivity of federal taxes declined during the early 1980s, rose sharply in 1987 (the year after the passage of the Tax Reform Act of 1986), rose in the early 1990s (during the Bush and Clinton tax increases), and remained stable in the late 1990s. The Bush tax cuts since 2000 have decreased the progressivity of federal taxes and, under current law, this trend will continue for several years.
An ongoing trend is that federal tax rates on investment income are falling relative to tax rates on labor. The Bush tax cuts have lowered federal taxes on labor income 9% while taxes on investment income have fallen by 22%. In 2004, the average effective federal tax rate on labor income (including income and social insurance taxes) was 23.4% while the average rate on investment income was only 9.6%. Investment income, unlike labor income, is highly concentrated in wealthy households. The top 1% of all taxpayers receive about 12% of labor income but 43% of investment income.
State and local tax systems are becoming more regressive in response to current budget crises in most U.S. states. States looking to close current budget deficits through revenue increases are generally raising regressive taxes, such as excise and sales taxes, rather than raising progressive taxes like income taxes. No data are available on the potential overall impact of changes to state tax systems.
With the federal tax system becoming less progressive and state and local taxes becoming more regressive, the progressivity of taxes in the U.S. has declined in the past few years. This trend is likely to continue, especially if the Bush tax cuts are made permanent. All the Bush tax cuts are set to expire in 2010. Making these cuts permanent would provide approximately $100 per year in lower taxes to those in the middle income quintile. Meanwhile those in the top 1% would gain approximately $40,000 per year.
Taxes and Social Welfare
As a final note, realize that tax policy cannot be studied in isolation from broader policy issues. Ceteris paribus, everyone would prefer lower taxes. Yet lower government revenues do not automatically imply an increase in social welfare. If this were the case, then clearly the optimal tax rate would be zero. But public revenues are used to finance programs and policies that provide numerous benefits, such as education, national defense, roadways, and environmental quality.
Lowering government revenues imply a reduction in public services or an increase in the public debt:
Popular discussions about the advisability of recent tax cuts have frequently ignored a simple truism: someone, somewhere, at some time will have to pay for them. The payment may be in the form of increases in other taxes, reductions in government programs, or some combination of the two; the payment may occur now or later; it may be transparent or hidden. But iron laws of arithmetic and fiscal solvency tell us that the payment has to occur. (Gale, et al., 2004, p. 1)
While tax incidence analysis can provide at least an approximate measure of how changes in tax policy affect different groups, it is only a partial analysis. A complete welfare analysis would incorporate how a tax change leads to changes in public services and debt levels. Unfortunately, all the implications of a tax policy change cannot be reliably measured in dollars or isolated apart from broader policy issues. Whether the government responds to lower revenues by reducing spending on education or national defense, for example, has different impacts on different groups. Tax policy is inextricably linked to policy decisions regarding public expenditures. In other words, how and from whom the government gets its money is closely related to what the government spends its money on and who benefits. As usual, economic issues are ultimately political issues.
- Global Development And Environment Institute, Tufts University