By KEVIN BRADY
As Congress moves toward tax reform this year, lawmakers on both sides of the aisle say they favor changes to the tax code that will keep the system as "progressive" as it is now. Congress uses tax-distribution tables to determine how different income groups are affected by tax proposals as a means of assessing progressivity. But a study recently conducted at my request by the congressional Joint Economic Committee staff, "How Tax Distribution Tables Mislead" found that the tables have serious limitations. The tables can be misused to make false claims about how proposed tax changes will affect taxpayers in the real world.
The JEC study examined tax-distribution tables produced by Congress's Joint Committee on Taxation and the Urban-Brookings Tax Policy Center. The tables use averages—rather than medians—to characterize changes in tax liabilities by income groups (or quintiles). But averages are wildly unrepresentative for this purpose. For example, the study found that the average tax liability for the second quintile (with adjusted gross incomes between $11,100 and $24,000) represents just 1.1% of the taxpayers in that quintile. The average reflects a mere 31.9% of taxpayers in the fourth income quintile ($42,600-$76,600).
The average adjusted gross income for all tax returns, according to the JEC study, was $59,800 while the median is only $32,200. The average tax liability was $8,000 while the median is $1,500. This dramatic difference suggests how much confidence one can place in these tables as a guide to policy makers.
The tables group taxpayers by income categories without regard to other relevant factors. In reality, income alone has little in common with tax liabilities—that is, how much a taxpayer owes the government—because of differences in the size and composition of households, the type of income, and the amount of deductions and exclusions.
For example, using data from the IRS's 2007 Statistics of Income Public Use File, the JEC study found that more than 4.3 million taxpayers in the third income quintile ($24,000-$42,600) pay more in federal income taxes than 9.6 million in the higher fourth income quintile. Similarly, nearly 6.2 million taxpayers in the fifth income quintile ($76,600 and above) pay less in federal income taxes than 3.9 million taxpayers in the lower fourth income quintile.
How could something like this happen? A one-income family of four with a mortgage making $100,000 may be able to shield more of its income from taxation than a young single earner without children making $50,000.
Tax-distribution tables cannot capture one of the most salient characteristics of the U.S. tax code—the decreasing share of taxes paid by the bottom 50% of taxpayers and the increasing share of taxes paid by the upper 1%. Between 1980 and 2010, the share paid by the top 1% nearly doubled to 37.4% from 19.1%, while the share paid by the bottom 50% fell by more than half to 2.4% from 7.1%.
Despite tax-rate cuts in 1981, 1986, 1997, 2001 and 2003, the U.S. tax system has become more progressive over the past three decades. The Organization for Economic Cooperation and Development rates the U.S. as second only to Ireland among OECD countries in terms of tax progressivity.
Tax-distribution tables are momentary snapshots that ignore income mobility. But taxpayers do not generally remain in the same income quintile over the years or decades. The nonpartisan Tax Foundation found in a study on income mobility in 2010 that nearly 60% of the households in the lowest quintile moved into a higher income group between 1999 and 2007, while almost 40% of households in the top quintile fell by at least one quintile. The ability of Americans to change their economic future renders traditional tax tables obsolete shortly after they are published.
The most important defect of tax-distribution tables is that they cannot help one to assess how proposed tax changes will affect economic growth.
Suppose Congress eliminated the double taxation of capital income by doing away with taxes on capital gains and dividends at the individual level. Current tax distribution tables would depict this change as a reduction in progressivity due to the large share of capital gains and dividends attributed to the top income quintile.
But doing away with taxes on capital gains and dividends at the individual level would significantly lower the after-tax cost of capital for new business investment in buildings, equipment and software. New business investment increases the demand for and productivity of labor, driving real wages higher.
For households in the bottom 50% of the income distribution, the benefits are significant but indirect—more jobs at higher real wages. Static tax-distribution tables ignore these benefits.
Until these flaws are corrected, Congress will have a skewed reading of the progressivity of proposed reforms to the tax code and their effects on America's taxpayers and economic growth.