This week, the CBO released its estimate of the distribution of household income and federal taxes. This report measures both average household income and average federal tax burden by income quintile in 2011.
There are many important parts to this report, but the main feature of this report is its estimation of the distribution of household income and federal taxes. The CBO finds:The median household in the United States earned $66,400 in pre-tax income plus government transfers. However, the distribution of income is skewed to the top. Households at every income level benefits from government transfers (Social Security, Medicare, etc.), but low income households rely on them the most. Conversely, low income individuals pay the lowest average effective federal tax rate (1.9 percent of household income). The top quintile paid the highest (23.4 percent). Although taxes are progressive at the federal level, certain taxes are more progressive than others. The corporate income tax is born by all households, not just the highest income households
The Distribution of Median Household Income is Skewed to the Top
The CBO’s measure of income is called “market income.” This measures not just wage income, but also business income and capital income (capital gains and dividends from investments). In addition, they add in the value of major government transfers: Social Security, Medicare, Medicaid, and other in-kind cash benefits.
In 2011, the Distribution of household income was skewed towards the top. The lowest quintile earned approximately $24,600. The middle quintile earned approximately $66,400. The top quintile earned an average $245,700. Across all households the average income was $93,900.
All Households Benefit from Government Transfers, but Low-Income Households rely on them the Most
Part of the CBO’s measure of income is transfers from the federal government. The CBO shows that all households benefit from government transfers, but low-income households rely on them the most. In the lowest quintile, government transfers make up 37 percent of total pre-tax income.
As you go up the income scale, the share of income from government transfers declines, but does not go away. This is due to the fact that Social Security and Medicare are universal programs with respect to income, unlike programs like the Temporary Assistance for Needy Families and Food Stamps.
Government transfers make up 35 percent of the income of second quintile households, and 25 percent of middle quintile households. Once you hit the top two quintiles, the reliance declines quickly to 14 percent of total income for fourth quintile households and 4 percent for top quintile households.
The Federal Tax System is Progressive
In contrast with the government transfers, which decrease as you go up the income scale, federal taxes increase in importance as you go up the income scale. As household income increases, average tax burden increases. The lowest income quintile paid a total effective income tax rate of 1.8 percent. The second quintile paid 7 percent. Middle income households paid 11.2 percent and the fourth quintile paid 15.2 percent. The top income quintile paid an effective tax rate of 23.4 percent, an effective tax rate two times higher than the middle quintile and 13 times higher than households in the lowest quintile.
The Distribution of Different Federal Taxes
Although the total tax burden is progressive, not all federal taxes are progressive. The distribution of these taxes varies by both the type of tax and the income level.
The federal individual income tax is highly progressive with respect to income ranging from negative 7.5 percent for households in the bottom quintile to 14.2 percent for households in the top quintile.
In contrast, excise taxes are slightly regressive, meaning that their burden goes down as household income goes up. The lowest quintile households pay the highest rate: 1.6 percent of income, while top quintile households pay the lowest: 0.4 percent.
Payroll taxes and corporate taxes are both rather flat. For the corporate income tax, the CBO assumes that the tax is born 75 percent by shareholders and 25 percent by laborers. What this means is that shareholders, which are disproportionately high-income households, bear most of the burden. This gives the corporate tax its slight progressive feature.
It is important to emphasize, however, that although the CBO states that corporate income taxes are born mostly by shareholders, there is by no means a consensus on this. Some estimates could place most of the corporate income tax on labors rather than their shareholders, which could drastically change the perceived progressivity of this tax.
Either way, everyone ends up bearing some of the corporate tax.
While there are some limitations to the CBO’s report—especially the exclusion of state and local taxes and some major public goods provided by governments—this report is important in understanding that the United States’ federal government has progressive tax and spending policies.
For more on the distribution of taxing and spending policy see here.
Household incomes have stagnated in recent years. From 1980 to 2000, when the economy was growing at a higher rate, real household income increased from $47,668 to $56,800, where it peaked. But since 2000, and after two recessions, median household income in the United States has declined. In 2013, median household income was $51,939, the lowest it has been since 1995.
For more charts like this, please see our new chart book, Business in America: Illustrated.
Milton Friedman once said that “nothing is more permanent than a temporary government program.” However, it turns out that nothing may be as permanent as a temporary tax increase, either. According to a new report from the Urban Institute, many of the temporary taxes created to fill state budget gaps during the 2008 recession have stuck around passed their expiration date.
The group found that between 2008 and 2011, 14 states and the District of Colombia enacted 25 temporary tax increases, 10 of which have been expended or been made permanent and three of which have been replaced with other increases. Of the remaining 12, nine have expired and three are still in their in original periods.
Increase sales tax from 5.6% to 6.6%
Increase personal income by 0.25 percent
Expired but replaced
Increases sales tax from 7.25% to 8.25%
Expired but replaced
Increased tobacco product tax
Add 10% corporate income tax surcharge
Extended and increased to 20%
Increase top rate ($60,000) from 5.95% to 6.95%
Permanent at 6.6%
Increase minimum tax
Calculate estate tax based on 2001 federal law
Increase sales tax from 5.75% to 6%
Increase lodging tax from 7.25% to 9.25%
Create new top rate plus exemption phase-out
Still in temporary period
Increase corporate rate from 4.8% to 7%, phasedown in 2015 to 5.25%
Still in temporary period, but possible extension
Increase individual tax from 3% to 5%, phasedown in 2015 to 3.75%, 3.25% after 2024
Still in temporary period, but possible extension
Increase sale tax from 5.7% to 6.3%
Permanent at 6.15%
Create top rate of 6.25% over $1 million
Additional tax on wages over $62,500
Increase sales tax from 6.5% to 6.85%
Increase taxes on over $400,000 and create top bracket for over $1 million
Tax on $500,000 plus at 8.97%, married filing jointly $300,000 plus at 7.85%. Limited deductions for $1 million plus earners.
Replaced with another temporary tax
Create corporate tax surcharge and expand credits
Added 3% surcharge to top earners
Increase sales tax from 6.75% to 7.75%
Increased corporate rate for business over $250,000
Increased taxes $250,000-$500,000 to 10.8% and 11% above $500,000
Added 50 cent surcharge per bottle of distilled liquor
While most increases were one percent or less, some states aggressively increased rates. Illinois experienced one of the most significant temporary tax increases, raising its flat tax from 3 percent to 5 percent on individual income and 4.8 percent to 7 percent on corporate income. These programs are still under their original temporary periods. However, as the first rollback quickly approaches, discussions are already underway to make them permanent. Hawaii will likely face the same debate.
The fact that half of temporary taxes become permanent should be no surprise. In most situations, the tax increases have been extended at least once, if not more. This effectively creates a new tax baseline in the minds of many taxpayers and lawmakers, making it more difficult to argue for a “tax cut” that actually restores the original rates, as promised.
Even those that have expired didn’t do so without a fight. Maryland considered making its tax increase on top earners permanent in order to create a special teacher pension fund. Arizona’s increase on sales taxes was another that drew debate over permanence when a special interest group lobbied for a permanent increase, though voters rejected the initiative.
Rather than temporary increases, lawmakers should look to broad tax bases and eliminating special carve-outs, keeping rates lower for all tax payers.
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The economy is growing modestly again, in spite of several increases in taxes on saving and investment since 2012. This has led some people to believe that taxing investment does not matter. In fact, the recession knocked the economy back to a lower-than-optimal starting point, and the subsequent tax increases are making it impossible to recapture lost ground. The level of GDP should be much higher at this stage of the recovery. Looking only at the positive movement in GDP while failing to see its depressed level misses key elements of the economics of taxation.
The economics of taxation can be illustrated by the Milton Bradley board game, Chutes and Ladders. The game is played on a board of ten rows of ten squares each. Players march along a row, then back along the next row up, and so on to the hundredth square at the top. Players move forward by spinning a needle that points to a 1, 2, 3, 4, or 5 square advance. The average spin is three moves forward each turn.
Here’s the catch. There are chutes and ladders printed on the board that connect squares on different levels. If a player lands at the foot of a ladder, he moves his piece to the top of the ladder, a boost of two to five rows on his march. If he lands at the top of a chute, he slides down two to five rows. After each rise or fall, he resumes plodding upward about three squares a turn, but from a higher or lower starting point. From then on, he will be above his pre-ladder or below his pre-chute level going forward, unless he hits an offsetting chute or ladder to put him back on his old trajectory.
Think of the economy as marching along a path like the players in the Chutes and Ladders game, but with a board of infinite height. The amount of capital and employment has adapted to the current tax and regulatory regime, and the average rate of growth is in line with increases in population and technological progress, with more capital added each year to match the growth in the labor force.
The enactment of tax reductions or regulatory changes that make it possible to profitably employ more capital is like landing on a ladder. These policies induce a burst of capital formation and super-normal economic growth until the additional capital is built up. The added amount of capital per worker raises productivity and wages. Output jumps. Then the economy returns to a normal growth rate, but from a higher level. It will always be ahead of where it would have been without the added capital, as long as the better tax treatment of capital is still in place. (A smaller but similar surge can occur if a tax cut on addition labor income boosts hours worked per worker or raises the labor force participation rate. Once the higher levels are reached, growth resumes in line with the change in the working age population.)
Enacting adverse policies that force a reduction in the amount of capital that people are willing to maintain is like hitting a chute. The economy slows, or even contracts for a period, as the amount of capital that can no longer be profitably employed is shed. Productivity and wages fall. Then growth resumes at its regular pace (in line with the normal growth of population and technology), but from a lower level. Resumption of growth after a bad policy shift does not mean that the policy was harmless, only that the amount of damage was finite. The economy will remain below the level it would have reached without the tax increase on capital income as long as the policy remains in place. (A smaller but similar effect occurs from a rise in the tax on labor; there is a drop in the labor supply, then a resumption of normal increase, but from a lower base.)
There is one major difference between the game of chutes and ladders and the practice of public policy. In the game, the chutes and ladders are predetermined at fixed locations on the board, and landing on one is determined by random chance. In the case of public policy, the chutes and ladders represent changes in tax and regulatory policy; they are created by the Congress, and are determined by politics.
Congress can create growth ladders that raise investment, incomes, and employment by enacting pro-growth tax changes. It can also create anti-growth chutes that reduce investment, employment, and income by imposing higher taxes on saving, investment, and employment. If the game of politics were more focused on growing the economy than on growing the government, we’d encounter more ladders and fewer chutes.