Measuring the Distribution of Tax Changes
TPC's distribution tables provide quantitative information on the way in which tax proposals affect different groups of individuals. Ideally, we would like our tables to measure the impact that a tax proposal has on the distribution of economic well-being across households (what economists refer to as "utility" or welfare), but that is an abstract concept that cannot be directly measured.
In practice, there is no perfect measure of the distributional impact of a tax change. At TPC, we proceed on the notion that a household's economic well-being, or welfare, is closely linked to its after-tax income. Current after-tax income is a measure of the new resources available to a household this year to devote to either consumption or saving. Thus, we believe that the most informative distributional measure may be the percentage change in after-tax income. A tax cut that gives everyone the same percentage increase in after-tax income leaves the relative distribution of after-tax income unchanged. A tax cut that increases after-tax income proportionately more for lower- than for higher-income taxpayers will make the tax system more progressive (or less regressive). One that increases after-tax income more for higher-income taxpayers than for lower-income taxpayers will make the tax system less progressive (or more regressive). Note that since the income tax is one of the most progressive taxes in the federal system, an across-the-board income tax cut that increases every tax filer’s after-tax income by the same percentage would tend to make the overall tax system less progressive, because it would collect proportionally less revenue from one of the most progressive sources.
We also report several other measures in our distribution tables including the share of the tax cut received, and the size of the tax cut in both absolute dollars and as a percentage of initial tax liability. Each of these measures are useful for certain purposes, but can be misleading. The share of the tax cut received can be misleading because the income tax is highly progressive. High-income taxpayers may garner a large share of an income tax cut, but the tax system could still end up more progressive if their share of the tax cut is much smaller than their share of overall tax liabilities.
The tax cut in dollars can be similarly misleading because high-income households have substantially more income than others and pay more tax. Thus, even a progressive tax cut (that is, one that gives a bigger percentage increase in after-tax income to lower-income households than to higher-income households) is often larger in dollar terms for higher-income households than for lower-income households.
The percentage change in tax liability can also be extremely misleading if it is used to assess the impact of a tax proposal on the change in the relative well-being of households with different incomes. Because low-income taxpayers tend to pay less tax than high-income taxpayers, a small tax cut for a low-income household can be an enormous reduction in their percentage tax liability, even though it does not raise its after-tax income significantly. Consider a household that earns $20,000 and pays $1 in taxes and another that earns $2 million and pays taxes of $500,000. Suppose that legislation is enacted that provides a $1 tax cut for the low-income household and a $100,000 tax cut for the high-income household. The percentage change in tax liability is 100 percent for the low-income household but only 20 percent for the high-income household. In terms of its effect on current household resources, such a tax cut increases the after-tax income of the poor household by only 0.005 percent while increasing after-tax income of the wealthy household by 5 percent. Relying on the percentage change in tax liability makes the tax cut appear to be tilted toward the low-income household even though the legislation provides the high-income household with a percentage increase in after-tax income that is 1,000 times larger than the low-income households, whose change in taxes is miniscule.
TPC's distribution tables also show the impact of a tax proposal on effective tax rates (ETR). In general, an ETR expresses tax liability as a share of income. Thus, a household with income of $100,000 that pays $15,000 in federal taxes would have an effective tax rate of 15 percent. Clearly, ETRs are highly sensitive to the definition of income used in the denominator and to which taxes are included in the numerator. Including more taxes in the analysis would tend to drive the ETR up, whereas using a broader definition of income would tend to drive it down.
In its distributional analysis, TPC includes the following federal taxes in its calculation of effective tax rates: individual and corporate income taxes; payroll taxes for Social Security and Medicare; excise taxes; and the estate tax.
Beginning in July 2013, TPC calculates effective tax rates using a broad measure of income called Expanded Cash Income (ECI). We define ECI to be adjusted gross income (AGI) plus: above-the-line adjustments (e.g., IRA deductions, student loan interest, self-employed health insurance deduction, etc.), employer paid health insurance and other nontaxable fringe benefits, employee and employer contributions to tax deferred retirement savings plans, tax-exempt interest, nontaxable Social Security benefits, nontaxable pension and retirement income, accruals within defined benefit pension plans, inside buildup within defined contribution retirement accounts, cash and cash-like (e.g., SNAP) transfer income, employer’s share of payroll taxes, and imputed corporate income tax liability. Between 2004 and July 2013, TPC used a more narrow definition of income called Cash Income to calculate effective tax rates. Cash income equals ECI minus: employer paid health insurance and other nontaxable fringe benefits, accruals within defined benefit pension plans, inside buildup within defined contribution retirement accounts, and SNAP benefits. Finally, before 2004, TPC used AGI as our income measure and we generally included only the individual income tax in our ETR calculations. Because of the different income measures and the differences in the taxes that we have included over time, users should take care when comparing effective tax rates between tables using the ECI and older tables that used the narrower income definitions. TPC has, however, posted its historical series on effective tax rates going back to 2004 and projected forward to 2024 using the new income measure.