Distributional Analysis of Tax Policy: Theory and Practice

Joseph RosenbergUrban-Brookings Tax Policy Center

February 20, 2014

Distributional Analysis of Tax Policy

Measuring the impact of tax laws and tax policy changes on individuals.

- Motivation?

- Concerns?

Distributional analysis at the federal level is routinely produced by:

Congressional Budget Office (CBO),

Joint Committee on Taxation (JCT),

U.S. Treasury’s Department of Tax Analysis (OTA),

Urban-Brookings Tax Policy Center (TPC)

Distributional Analysis: Overview

• Unit of analysis Tax unit; Family; Household

• Time periodSingle year; Multiyear; Lifetime

• Ranking individualsIncome; Consumption

Definition of income

Adjustments for size of unit

• Measuring tax burdenTaxes paid; Burden

• Incidence assumptionsHow should we assign tax burdens back to individuals

Distributional Analysis: Comparison

JCT OTA CBO TPC

Unit of Analysis

Tax unit Family Household Tax unit

Time Period Single year Single year (fully phased-in law)

Single year Single year*

Income Measure

Expanded Income

Cash Income

Before-tax Income

Expanded Cash Income

Size adjusted No Yes No Both

Taxes Included

Income Payroll

Corporate* Excise

Income Payroll

CorporateExcise

Estate & Gift

IncomePayroll

Corporate Excise

IncomePayroll

Corporate

Estate & Gift

Measure of burden

Taxes paid Burden Burden Burden

Common Incidence Assumptions

• Individual Income Tax: Borne by individual taxpayer

• Payroll Tax: Employer & employee portions borne by employee

• Estate Tax: Borne by decedent

• Corporate Income Tax: It’s complicated

CBO & JCT*: 75% Capital, 25% Labor

OTA: 63% Shareholders, 18% Capital, 18% Labor

TPC: 60% Shareholders, 20% Capital, 20% Labor

• Consumption/Excise Tax: It’s really complicated

e.g., Toder, Nunns, Rosenberg (2011)

JCT Distribution Table, 2012

TPC Distribution Table, 2013

Lowest Quintile 43,453 26.8 13,607 328 13,279 2.4 4.7 5.5 0.6Second Quintile 36,220 22.4 33,863 2,454 31,409 7.3 9.7 10.9 4.0Middle Quintile 31,791 19.6 59,141 7,309 51,832 12.4 14.8 15.8 10.3Fourth Quintile 25,914 16.0 99,185 15,630 83,555 15.8 20.3 20.8 18.0

Top Quintile 22,833 14.1 280,129 65,893 214,236 23.5 50.5 47.0 66.9All 161,868 100.0 78,255 13,905 64,350 17.8 100.0 100.0 100.0

Addendum80-90 11,458 7.1 151,406 27,375 124,031 18.1 13.7 13.6 13.990-95 5,652 3.5 210,456 41,802 168,654 19.9 9.4 9.2 10.595-99 4,566 2.8 336,973 75,952 261,020 22.5 12.2 11.4 15.4

Top 1 Percent 1,157 0.7 1,670,664 525,231 1,145,433 31.4 15.3 12.7 27.0Top 0.1 Percent 118 0.1 7,744,239 2,616,751 5,127,488 33.8 7.2 5.8 13.8

Source: Urban-Brookings Tax Policy Center Microsimulation Model (version 0613-1).

Baseline Distribution of Income and Federal Taxesby Expanded Cash Income Percentile, 2013 ¹

Expanded Cash Income

Percentile2,3

Tax Units4 Average Income

(Dollars)

Average Federal Tax

Burden (Dollars)

Average After-Tax

Income5

(Dollars)

Average Federal

Tax Rate6

Share of Pre-Tax Income

Share of Post-Tax Income

Share of Federal

TaxesNumber

(thousands)Percent of Total

Percent of Total

Percent of Total

Percent of Total

Number of AMT Taxpayers (mill ions). Baseline: 3.9

TPC Distribution Table, 2013

Lowest Quintile 43,453 -4.8 6.5 0.7 * 2.4Second Quintile 36,220 -1.3 7.6 0.9 * 7.2Middle Quintile 31,791 3.1 8.2 1.1 * 12.4Fourth Quintile 25,914 5.8 8.6 1.4 * 15.8

Top Quintile 22,833 14.3 6.3 2.7 0.2 23.5All 161,868 8.5 7.2 1.9 0.1 17.8

Addendum80-90 11,458 7.5 9.0 1.6 * 18.190-95 5,652 9.4 8.3 2.1 * 19.995-99 4,566 13.5 6.4 2.5 0.2 22.5

Top 1 Percent 1,157 24.1 2.6 4.2 0.5 31.4Top 0.1 Percent 118 26.4 1.7 5.1 0.7 33.8

Source : Urban-Brookings Tax Policy Center Microsimulation Model (version 0613-1).* Less than 0.05.

Effective Federal Tax Rates - All Tax Units

By Expanded Cash Income Income Percentile, 2013

Baseline: Current Law

Expanded Cash

Income Percentile1

As a Percentage of Expanded Cash Income

Individual

Income Tax2

Tax Units (Thousands) Payroll Tax3 Corporate

Income TaxEstate Tax

All Federal

Tax4

TPC: Distributional Impact of ATRA

CBO, 1979-2010

Measuring Income for Distributional Analysis

• Ranking taxpayers Standard distributional tables rank taxpayers based on annual income as a proxy for their economic status and ability to pay taxes.

• Measuring tax burdensThe overall burden of the tax system (excluding indirect economic costs) can be summarized in the effective tax rate (ETR), the amount of taxes paid measured as a percentage of income.

• Evaluating the effects of tax policy changesChanges in taxes are often shown as a percentage of pre-tax income or as a percentage change in after-tax income.

Measuring Income for Distributional Analysis (cont.)

Haig-Simons Income:

Consumption + Change in Net Wealth

Practical Difficulties:

Administrative (e.g., accrued capital gains)

Timing (e.g., retirement income)

Imputed Rent!

Relative to narrow income measures (e.g., AGI), broad income measures provide a more accurate ranking of taxpayers and better estimates of the burden of the tax system and tax policy changes.

Conceptual Issues in Measuring Income

• Transfer Payments– Cash transfers

– In-kind transfers

• Timing of Retirement Income– Defined benefit

– Defined contribution• Front-loaded

• Back-loaded

• Corporate Income Tax• Data Quality

– Administrative vs. Imputed Data

Comparison of Different Income Measures

Distribution of Sources of ECI

Distributional Analysis in Practice: Example

“Who Benefits from Tax-Exempt Bonds?: An Application of the Theory of Tax Incidence”(with Harvey Galper, Kim Rueben, and Eric Toder)

Motivation: Often claimed…•“Tax-exemption only benefits holders of tax-exempt bonds”

•“80% of the benefit accrues to state & local governments in the form of lower financing costs”

Tax Incidence: General Principles

General Principles:•Economic burdens may differ from statutory burdens

•Tax burdens ultimately borne by individuals

•Individuals are affected according to how they earn the income (“sources-side”) and how they spend their income (“uses-side”)

Sources-side: Taxes reduce after-tax incomes depending on the size and composition of an individual’s income

Uses-side: Taxes affect relative prices and can reallocate resources across goods and/or sectors of the economy

Incidence of Muni Tax Exemption: Theory

Current Method: Allocate benefit in proportion to reported tax-exempt interest

Sources-side: Creates implicit taxes and subsidies in pre-tax incomes, spread across…

•all interest income

•all capital income

•capital and labor income

Uses-side: Net transfer to S&L governments from other sectors

•lower S&L taxes (to whom?), or

•higher S&L spending (for what?)

Capital Market Effects of Tax Exemption

• In theory, the yield spread between tax-exempt debt and similar taxable debt should proxy for the value of tax exemption.

• Literature on BABs finds a range of yield spreads, but generally centered around 25%

Important Stylized Fact: Tax-exempt interest reported across a wide range of incomes and marginal tax brackets, casting doubt on pure clientele or “marginal investor” model of capital market equilibrium. We refer to the empirical yield spread as the “implied equilibrating tax rate.”

Model Simulations: Methodology

Sources-side:•Using implied yield spread, we calculate an “adjusted” measure of pre-tax income by grossing up tax-exempt interest and then adjusting down relevant income sources in order to hold aggregate pre-tax income constant.

Uses-side: Zero-sum reallocation among…•Positive reallocation to state & local governments

– Case 1: Lower taxes distributed in proportion to MAGI– Case 2: Higher spending distributed per capita

•Negative reallocation to other sectors– Distributed in proportion to private consumption by income

group3

Simulations: Main Findings

Overall, majority of the benefit from exemption accrues to top 5%. However:•Relative to conventional methodology, “sources-side” effects spread the benefit more broadly across income distribution

– Benefits spread to holders of taxable securities

– But benefit still goes disproportionately to top 5 percent

•Uses-side effects can be large for the bottom quintile – They either benefit more from increased S&L provided goods

& services or less from S&L tax cuts, than the harm to them from higher relative prices on consumption goods

Simulations: Results

Advances in Distributional Analysis

Where to go from here:•Better data sources

•Incorporating state/local taxes– Distribution of federal taxes by state

– Distribution of state income taxes

•Integrating taxes and transfer/spending programs (e.g., CBO, 2013)