The TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Foundation has highlighted in past blog posts how both Congressional Budget Office and Treasury data show that the current U.S. tax and transfer system is very progressive. In a new paper, Laurence Kotlikoff of Boston University and his coauthors apply their economic model to assess the impacts of taxes and transfers on fiscal progressivity and inequality. They find less inequality in household spending than in wage income and wealth, and attribute to this to the “fiscal system’s high degree of progressivity.”
The authors developed a model to measure the consumption and savings behavior of households within an age group and income quintile. The model incorporates all state and federal tax and transfer policies into its analysis, and then estimates net average and marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s for each household and age cohort.
We have previously discussed how income data may overstate inequality. The findings of this paper underscore this point. The authors find substantially less inequality in spending power between low income and high income households. For example, whereas the top 1% of 40-49 year-olds account for 18.9% of the wealth in this cohort, they account for only 9.2% of the net spending. The bottom quintile in this cohort, while only capturing 2.1% of the wealth, still captures 6.9% of the net spending.
The bulk of the spending power of the bottom quintile is supported by government transfers, which subsequently reduces the effective tax rates on these households. In fact, most households in the bottom quintiles face substantially negative average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. s because they receive more transfers from the government than they pay in taxes.
Consider again the cohort from the previous paragraph. The top 1% of that cohort face a net average tax rate of 45%, whereas the bottom quintile receives a net subsidy of 34.2%. The differences in tax rates are even starker for those households in the older cohorts.
The top 1% in the age 70-79 cohort, for instance, face an average tax rate of 26.8%, but households in the bottom quintile face negative average tax rates of almost 700%! This reflects the fact that the majority of government spending is directed toward older households, primarily through Medicare and Social Security.
However, due to the complex system of phase outs of certain tax credits and government transfers, poor households may face marginal tax rates as high as some middle and upper-income households. Kotlikoff and his coauthors find that the bottom quintile in the age 30-39 cohort face a negative average tax rate but a median marginal rate of 45%, nearly as high as the marginal rate for the top quintile. They further observe some unusual variation in marginal tax rates for households with similar resources. For middle-income households in the age 50-59 cohort, they estimated a median marginal net tax rate of 44.2%.
But in this quintile, the minimum marginal tax rate for a household was -5.3% and the maximum marginal tax was a staggering 262.3%. As the authors note, such variation stands in contrast to most economists’ recommendation of imposing similar tax burdens on those with similar resources.
Proponents of tax reform across the political spectrum must acknowledge this simple fact: The primary beneficiaries of our tax code are poor households, and the rich bear a disproportionate share of the tax burden. Tailoring reform proposals to acknowledge this reality will continue to challenge policymakers.
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