Towards a More Consistent Distributional Analysis

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Abstract

Tax reform is likely to combine elements of income and consumption taxes. Special problems arise in developing consistent methods for allocating incremental options that transcend the boundaries between income and consumption taxes. This paper discusses issues in allocating consumption taxes and shows how the choice of allocation method affects conclusions for two prototypes. It then discusses how hybrid income-consumption taxes and corporate taxes ought to be allocated under different scenarios. A concluding section sums up.

Introduction

On November 1, 2005, the President’s Advisory Panel on Federal Tax Reform released a report recommending two options to overhaul the federal income tax. The first, called a Simplified Income Tax (SIT), would eliminate a host of deductions and credits, simplify others, and reduce income tax rates—all part of the classic recipe for improving the income tax. The second option, called the Growth and Investment Tax, would replace the current income tax with a so-called x-tax, which is a somewhat progressive kind of consumption tax. That plan, however, also includes a small add-on tax on capital income, as well as several credits and deductions in the SIT.

Part of the assessment of these options (and any tax reform proposal) will rest on how they affect the distribution of tax burdens. But there is not widespread agreement on how to measure these burdens. For example, an x-tax is essentially a value added tax (VAT) with the wage portion collected from workers rather than employers (and subject to progressive rates). Does the fact that workers pay part of the tax affect the distribution of burdens? Economic theory suggests that it should not matter, but standard distributional methodology allocates tax burdens based on statutory incidence—the wage tax would be allocated to the workers who earn the wages, while the consumption tax would be allocated to consumers in proportion to their spending—with very different implications for equity.

Tax reform is likely to combine elements of income and consumption taxes. Special problems arise in developing consistent methods for allocating incremental options that transcend the boundaries between income and consumption taxes. For example, specific consumption taxes such as excise taxes have been typically distributed to consumption, but corporate tax reductions such as investment tax credits and bonus depreciation (partial expensing) are often allocated to capital in general, following a general rule that assigns the corporate tax to capital income, even though these provisions move the income tax in the direction of a consumption tax.

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The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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