Effective Tax Rates

December 11, 2007

CBO released an update on effective tax rates today, which provides data for the 2005 calendar year.

  • In 2005, the overall effective tax rate (the ratio of federal taxes to household income) rose to 20.5 percent from 20.1 percent in 2004, reflecting a rise in the effective individual income tax rate and the effective corporate income tax rate.
  • The rise in the effective individual income tax rate resulted from several factors. Real bracket creep (which is the tendency for overall real income growth to shift income into higher marginal tax brackets) and a rise in income concentration (which, for any given total income, also shifts income toward higher marginal tax brackets) increased the effective rate. The effects of those factors more than offset a reduction in the effective income rate due to a shift in income toward capital gains (which faces lower tax rates than other forms of income).
  • The increase in the effective corporate income tax rate is consistent with the surprising rise in corporate tax receipts as a share of GDP between 2003 and 2006. In fiscal year 2004, such receipts amounted to 1.6 percent of GDP; in fiscal year 2005, they amounted to 2.3 percent of GDP. (The rise in corporate income tax revenue as a share of the economy explains a significant share of the improvement in the fiscal deficit since 2003, as CBO described in a letter to Senator Conrad earlier this year. More recently, corporate tax revenue has softened, as mentioned in a previous post.)
  • The share of total federal tax liabilities paid by the top 1 percent of the population rose from 25.4 percent in 2004 to 27.6 percent in 2005. That increase occurred despite a slight decline in the effective tax rate applied to income among the top 1 percent (from 31.4 percent to 31.2 percent) because the share of pretax income accruing to that part of the income distribution rose from 16.3 percent in 2004 to 18.1 percent in 2005.

Ed Harris of our Tax Analysis Division prepared these estimates. Ed has been at CBO since 2000, working on receipts forecasting, tax modeling, and individual income tax issues. Prior to joining CBO, he worked for the IRS. He holds a masters degree in public policy from Duke University and a bachelors degree from the State University of New York at Albany.

Questions and answers about the effective tax rate calculations

Some observers have raised questions about CBO's methodology in calculating these effective tax rates. Below I have therefore provided a set of questions and answers about the data and methodology.

Which taxes does CBO include in its analysis?

In its analysis, CBO estimates effective tax rates for the four largest sources of federal revenuesindividual income taxes, social insurance (payroll) taxes, corporate income taxes, and excise taxesas well as the total effective rate for the four taxes combined. Those taxes account for over 95 percent of total federal revenues. The analysis does not include federal estate and gift taxes, customs duties, and other miscellaneous receipts. Nor does it include state and local taxes.

What assumptions does CBO make about the incidence of those taxes?

CBOs analysis of effective tax rates assumes that households bear the economic cost of the taxes that they pay directly: individual income taxes (including taxes paid on dividends, interest, and capital gains) and employees share of payroll taxes. CBO also assumesas do most economiststhat the employers share of payroll taxes is passed on to employees in the form of lower wages than would otherwise be paid. Therefore, the amount of those taxes is included in employees income, and the taxes are counted as part of employees tax burden.

The analysis assumes that the economic costs of excise taxes fall on households according to their consumption of taxed goods (such as tobacco and alcohol). Excise taxes on intermediate goods, which are paid by businesses, are attributed to households in proportion to their overall consumption. CBOs analysis assumes that each household spends the same amount on taxed goods as a similar household with comparable income in the Consumer Expenditure Survey.

In its analysis of effective tax rates, CBO assumes that owners of capital bear the economic burden of corporate income taxes in proportion to their income from capital, measured as interest, dividends, rents, and adjusted capital gains. Adjusted capital gains are used in place of actual realizations to smooth out large year-to-year variations in the total amount of gains realized.

The ultimate incidence of income taxes levied on capital income, though, is uncertain. Although CBO's assumptions in this area are in line with those often adopted in this type of analysis by other economists, they are subject to some debate. In particular, if tax rates on different types of assets are not the same, households will shift resources to assets that are taxed at lower rates. This will have the effect of lowering the before-tax rate of return on those lightly taxed assets, shifting part of the economic cost of the tax to their owners. A similar uncertainty about the distribution of taxes on capital income applies to corporate income taxes. Only in the very short term are owners of corporate equity likely to bear most of the economic burden of the tax. Over the longer term, as capital markets adjust, the economic burden of the tax is spread across all types of capital. And over time, at least some of the economic burden could also be shifted to wage earners, although the degree of such shifting is uncertain.

What is the unit of analysis?

CBO uses households as the unit of analysis. A household includes all people living in a single housing unit. The presumption is that households make joint economic decisions, which may not be true in every case (a group house for example). Households may comprise more than one taxpaying unit, such as a married couple and their adult children living at home.

How are households ranked?

 

For this purpose, CBO groups households into quintiles on the basis of their income and tabulates the income and taxes for each quintile. CBO adjusts for household size by dividing household income by the square root of household size, to take account of the differing needs of larger and smaller households. CBO then ranks households by their (adjusted) income and groups them in quintiles (fifths of the distribution). The quintiles contain equal numbers of people, but because households vary in size, quintiles generally contain unequal numbers of households. CBO then tabulates overall income and taxes for each quintile as well as for smaller groupings at the top of the distribution.

How does CBO measure household income?

The Current Population Survey (CPS) and the Statistics of Income (SOI) are the primary sources of data for CBOs estimates of population and household income. The SOI, produced by the Internal Revenue Service, reports much of the information that taxpayers provide on their individual income tax returns. It over-samples high-income returns, enhancing the richness of the data at the high end of the income distribution. The March supplement to the CPS contains survey data on both the demographic characteristics and income of a large sample of households.

CBO statistically matches each SOI record to a corresponding CPS record on the basis of demographic characteristics and income. Some types of income, such as most transfer payments and in-kind benefits, appear only in the CPS; values for those items are drawn directly from that survey. Because not all households have to file tax returns, some households do not appear in the SOI; the information for non-filing households comes from the CPS.

Why doesnt CBO just use the SOI or the CPS?

Both the SOI and the CPS lack important information needed for estimating and comparing effective tax rates over time. The SOI lacks information on non-filers, does not report all income from government cash transfer programs, has no information on the receipt of in-kind transfers and benefits, and uses tax returns rather than households as the reporting unit. The CPS lacks rich information on high-income tax households, does not report capital gains, under reports other income from capital, and lacks information on deductions and adjustments necessary to compute taxes.

How does CBO treat pension income?

In the analysis of effective tax rates, CBO measures pension income when families receive pension benefits. A comprehensive measure of income would include the value of pensions when benefits accrue rather than when received. For participants in defined-benefit plans, in which benefits are specified according to a formula based on years of service and salary at retirement, accrued pension income would include the increase in the future value of benefits (properly discounted by time until retirement and the probability of actually receiving those benefits) attributable to working an additional year. For participants in defined-contribution plans, current income would include pension contributions plus the yield on accumulated funds in the retirement account.

Counting benefits when they are received rather than when they accrue is consistent with current tax treatment. It matches the timing of tax payments with the timing of income receipt. If pension income were measured on an accrual basis, actual tax payments would exceed measured income for some elderly households.

How does CBO treat capital gains?

In the effective tax rate tables, CBO includes realized capital gains in household income. A comprehensive measure of income would instead include capital gains as increases in household wealth at the time gains accrue (as opposed to when they are realized). Including realized gains raises a number of issues. First, a large fraction of accrued gains are never realized and thus are missing from household income altogether. Second, many factors affect the timing of realization -- including changes in tax rates. Thus, measured household income in a particular year reflects a response to that years tax system.

Realized gains are used because of the difficulty in measuring accrued gains. Omitting capital gains entirely would understate income for many households, particularly upper-income households.

Does CBOs income measure misrepresent income growth because of a shift in the organizational form of corporations? 

Since the Tax Reform Act of 1986, the share of business income earned through pass -through entities (such as S corporations, limited-liability companies, and partnerships,) has risen and the share earned through C corporations has declined. Because the income of pass-through entities shows up on individual income tax returns, it has been suggested that some of the income growth at the high end of the income distribution observed in the CBO data is the result of this shift. This observation would be correct if CBOs income measure did not include income that passes from C corporations to households; most of that income, however, is captured in our measures. First, corporate dividends paid to households are reported on the SOI. Second, CBO distributes corporate tax payments to households and includes those taxes as part of household income. The only missing piece is therefore after-tax corporate retained earnings. In the long term, after-tax profits retained by corporations should be reflected in higher corporate stock values and eventually in capital gains realized by households on corporate stock, although these certainly will not match up in any particular year.

Does CBO adjust for year-to-year income volatility?

In its analysis of effective tax rates, CBO measures household income in a single year. Income averaged over a number of years would better represent a households true economic circumstances, but those data are not as timely and comprehensive as annual measures. In a particular year, household income may be lower than normal because of unemployment, poor investment returns, or a cyclical downturn in the economy. Capital gains realizations are particularly volatile, and may be exceptionally high for a particular household. CBOs analysis of long-term income shows somewhat less dispersion in the distribution of income and the distribution of effective tax rates.