Measuring Tax Fairness The Problems with Tax Distribution Tables

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Measuring Tax FairnessThe Problems with Tax
Distribution Tables

• Presentation to the Presidents Advisory Panel on
  
• Federal Tax Reform
• New Orleans
• March 23, 2005
• William W. Beach
• Director, Center for Data Analysis
• The Heritage Foundation
• Washington, D.C.

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What is tax fairness?

• In many respects, tax fairness is similar to the
  concept of fairness in other aspects of U.S. law.
• Equal treatment
• Transparency
• Continuity of rules and practices
• Fairness in the tax realm certainly means that
  everyone pays their fair share. That could mean
  that taxes are proportional to consumption, to
  income, or to some other factor that measures our
  use of government.
• Fairness also implies forward equity, since tax
  policy today frequently shapes the future.

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Why consider forward equity

• Economists frequently talk about horizontal
  equity (that equals will be treated equally) and
  vertical equity (that, for example, tax burden
  rises with income).
• Lawmakers, however, need to recognize that most
  of their decisions will affect relatively distant
  future acts rather than todays activities or
  todays income or tax distribution.
• That being so, lawmakers should consider whether
  policy change facilitates individual economic,
  social, and personal choices that set in motion a
  sequence of activities that lead to goals a
  person sets for him or herself.
• For example, do tax policy changes made today
  raise barriers to women re-entering the workforce
  years from now after raising a family, or to
  immigrants starting micro-businesses, or to
  retirees pursuing part-time work?
• Do policy changes make it more or less difficult
  for young people to achieve their goals?

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How would you measure fairness?

• One of the goals of distribution analysis is to
  show how policy change affects the economic
  well-being of taxpayers and non-taxpayers. The
  problem, however, is deciding how to measure the
  relationship between tax policy and economic
  well-being.
• Unfortunately, we cannot measure all of the
  things that affect a taxpayers well-being.
  Thus, we settle on proxies for those data we
  cannot obtain or activities we cannot measure.
• The most common way of measuring fairness is to
  analyze changes in income.
• However, what is income?
• What is spent on all goods and services
  including leisure?
• Net worth?
• Cash and non-cash compensation?
• Even if we settle on a concept, how good are the
  data?

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The neat classification of taxpayers by income
breaks down when we look at their tax liability
in each quintile.
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Why does the neat classification of taxpayers by
income so easily break down?

• The previous chart shows that taxpayers who are
  grouped into quintiles by income have vastly
  different tax liabilities.
• Millions of taxpayers in the third quintile pay
  more in taxes than those in the fourth quintile
  there are millions in the fourth that pay more
  than those in the fifth.
• These differences stem from many factors that are
  not revealed by simple income distribution
  family businesses, differences in family size,
  investments, access to itemized deductions, and
  so forth.

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What about distributing tax policy effects by
consumption?

• Avoids many of the definitional problems
  surrounding income, even though short-run and
  long-run consumption (housing, education) muddy
  the data waters.
• Over the course of an individuals life,
  consumption tends to follow income change
  incomes are low in youth, rise to a peak in
  middle age, and fall again in retirement.
  Generally, consumption follows a similar pattern.
  
• However, hard to study an income tax by looking
  at consumption.
• Significant data problems, especially with the
  Consumer Expenditure Survey.

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How much can we learn about the complexity and
equity of our tax system from marginal tax rates
?

• If a primary fairness goal is steadily higher tax
  rates as income rises, then looking at marginal
  tax rates after a policy change may be a good
  metric for fairness.
• However, targeting tax policy at specific groups
  in order to achieve fairness often frustrates the
  analysis of whether the overall tax system is
  more just.
• As Kevin Hassett of AEI shows in the following
  dramatic graphic, current marginal tax rates on
  the income of a family of four shows distinctly
  unequal treatment as their income rises.
• Further information can be found at
  http//www.aei.org/publications/pubID.22160/pub_de
  tail.asp

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• Marginal Tax Rates for 2004
• (Drawing by Marina Sagona based on graph from
  Kevin Hassett, American Enterprise Institute)

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Is this just? The marginal tax rates of a
family of four as income rises.(Graph courtesy
of Dr. Kevin Hassett of the American Enterprise
Institute)
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Snapshot Analysis

• When economists create a cross-section of
  taxpayers, they have grouped these people by
  income and, usually, family type at a moment in
  time. It truly is a snapshot of our tax system.
• This snapshot analysis is done differently at
  Congresss Joint Committee on Taxation and the
  Treasury Departments Office of Tax Analysis, the
  two agencies most responsible for tax policy
  analysis.
• These two agencies use snapshot analysis of the
  policy change implementation using projected
  historical data.

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Snapshot Analysis(continued)

• The groupings are based on historical data that
  have been changed to reflect the increase in
  income and taxpayers that forecasting models
  predict. But, these groupings commonly are not
  affected in all of the ways that tax policy
  changes can impact the economy.
• The next three graphs show how JCT and OTA
  distribute tax changes across income. JCT uses
  an income concept most taxpayers would recognize.
  OTA used to employ an income concept that only
  an economist would appreciate. It has recently
  used an income concept more like that of the JCT.

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The JCT distributes taxes against a measure based
on Adjusted Gross Income (an expanded version of
AGI) Analysis of the Bush 2001 tax cut proposal
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The OTA, however, used to adjust the JCT income
concept to include imputed income from things
not commonly taxed.
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The new OTA distribution method uses an income
concept closer to the Joint Committees Analysis
of the Bush 2001 tax cut proposal
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But, do these approaches tell us what we really
want to know about tax policy change?

• Answering fairness questions by looking at
  snapshot changes in tax liability does not tell
  us what happens to individual taxpayers living in
  a society reshaped by tax policy change.
• What we really want to know is how certain types
  of tax policy changes affect long-term social and
  economic outcomes.
• To answer those types of questions, we need
  longitudinal tax analysis. An example of
  excellent longitudinal work is the Congressional
  Budget Offices Effective Tax Rate Comparing
  Annual and Multiyear Measures (January, 2005).
• In the following graph, the number in bold along
  the diagonal represents the percentage of
  taxpayers who were at that tax rate in 1987 and
  remained there ten years later. The chart shows
  significant income mobility.

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Follow taxpayers not classifications over time
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The Center for Data Analysis is taking
longitudinal analysis one step further

• The CDA uses a rich database of taxpayers,
  taxpaying families, and households to analyze tax
  policy change.
• We employ standard projection techniques to
  create a ten-year panel of taxpayers.
• However, we also shape each years cross-section
  a dynamic simulation of how tax policy affects
  those economic factors that shape income, job
  creation, and other key indicators.

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Summary

• Fairness questions are natural and inevitable
  features of tax policy debate.
• Tax and economic data as well as definitions of
  income poorly serve those seeking answers.
• Snapshot analysis probably produces more
  confusion and bad information than clarity.
• Following taxpayers over time should provide more
  insight on fairness than other analytical
  approaches. It is important to
• Include more than one year of income in our
  analysis
• Continue to move beyond snapshot analysis
• And, wherever possible, incorporate the impact of
  tax policy on the economy and, thus, on the pool
  of income and economic decisions that compose the
  base from which taxes are drawn.
• Note Many of the slides used in this
  presentation were taken from Jason Fichtners
  excellent essay, A Comparison of Tax
  Distribution Tables How Missing or Incomplete
  Information Distorts Perspectives, The Heritage
  Foundation Center for Data Analysis Report
  CDA04-13, November 9, 2004.