Lcwmg/3: F R;:rE.Ifi=$o~~Ii§LLE 5‘ EONG \ R0 P E RTIIR E‘.?i5‘i‘»%’ 3 2999A 13$ 0 E. I N “ *£5RARy ‘ “S TAIVAPSAIA I 1 ‘ I A :I I (It? 17 '-A . ‘r, nguzm University 1 A - ...~_.‘ __'.. .,_-\ - THE IMPACT OF INFLATION AND SOCIAL SECURITY TAX INCREASES ON THE TAX LIABILITIES OF TYPICAL HOUSEHOLDS ‘ "Y — Gregg A. Esenwein Economic Ana1yst% Economics Division September 30, 1980 ° \\I\\\\fii‘1;i;u11i}{;\fi0'\i; 11l;\ji;\1‘j‘\Wii\\\\\|\\ The Congressional Research Service works exclusively for the Congress, conducting research, analyzing legislation, and providing information at the request of committees, Mem- bers, and their staffs. The Service makes such research available, without parti- san bias, in many forms including studies, reports, compila- tions, digests, and background briefings. Upon request, CRS assists committees in analyzing legislative proposals and issues, and in assessing the possible effects of these proposals and their alternatives. The Service’s senior specialists and subject analysts are also available for personal consultations in their respective fields of expertise. ABSTRACT The CRS Tax Computation Model was used to project the tax payments of typical households filing joint returns for the years 1979 through 1982. Issues examined are the impact of inflation and higher social security taxes on the tax liabilities of typical households. The objective is to provide an analysis of the probable change in the distribution of the tax burden over the next 3 years in the absence of a cut in personal taxes. LIBRARY OF WASHINGTON UNIVEHSITY J ? "3 A _ CRS-v CONTENTS ABSTRACT... . . . . . .......................................................... INTRODUCTION.............................................................. SUMMARY OF FINDINGS....................................................... BACKGROUND INFORMATION ON CURRENT INCOME TAX STRUCTURE AND METHODOLOGY.... AN ANALYSIS OF THE CHANGE IN EFFECTIVE TAX RATES: 1979 Lo 1982........... APPENDIX A: TAX LIABILITIES OF TYPICAL HOUSEHOLDS FILING JOINT RETURNS, O O O O O COC0000OOOOOOCOOOOOOOOOOOOOCOOCOCCOCOOOOCOOOOOOOOOC O O O O 00 APPENDIX B: EXPLANATION OF SMOOTHING METHODOLOGY......................... Production assistance was provided by Gary Hauk. iii 17 29 35 THE IMPACT OF INFLATION AND SOCIAL SECURITY TAX INCREASES ON THE TAX LIABILITIES OF TYPICAL HOUSEHOLDS INTRODUCTION The current economic situation has prompted a growing debate over the mer- its of enacting a cut in personal income taxes. The debate is similar in many respects to that which preceeded the passage of the last reduction in personal tax rates, the Revenue Act of 1978. One of the most commonly expressed justi- fications for cutting individual taxes has been that inflation, by pushing tax- payers into higher marginal tax brackets, is placing a disproportionately large tax burden on certain taxpayers. In addition to the distortions caused by inflation, successive increases in social security tax rates and higher tax bases to become effective over the next 3 years will also raise the tax liabil- ity of various households. It is argued that this combination of inflation and social security tax increases will produce a decline in the real purchasing power of a taxpayer's after-tax income over the next few years. Most of the specific tax-cut proposals under active discussion seek in some manner to minimize the impact of these two factors on average taxpayers. The focus and methods of approach, however, vary widely among the proposals. Some of the proposals address themselves primarily to offsetting the scheduled increases in social security taxes, while others try to lessen the impact of inflation through adjustments of the existing tax brackets. In order to assess the relative merits of these tax-cut proposals, it is first necessary to deter- mine the probable impact of both inflation and increases in social security taxes on individual taxpayers. CRS-2 Although inflation and social security tax increases will lower the real purchasing power of most households‘ after-tax income, the impact will by no means be evenly distributed over the entire income spectrum. Taxpayers in the lower and middle-income ranges probably will be more adversely affected by inflation and social security tax increases than will taxpayers in the upper income ranges. This phenomenon is primarily a function of three interrelated characteristics of the existing tax code. First, in the lower and middle-income ranges the tax brackets are more nar- row than in the upper income ranges. Therefore, as incomes are adjusted for in- flation, households in the lower to middle-income ranges are pushed into higher tax brackets, with corresponding increases in their marginal tax rates, at a faster rate than are households in the higher income ranges. Second, because the tax code limits the tax rate to 50 percent on taxable wage and salary income over $60,000 (for households filing joint returns), households that earn over $60,000 in taxable wage and salary income experience no increase in their marginal tax rates as a result of inflation-induced wage increases. However, households earning below $60,000 whose incomes are adjusted for inflation see each extra dollar of inflation-induced income taxed at progressively higher marginal rates. Third, because long-term capital gains receive preferential tax treatment, households which realize capital gains and whose incomes keep pace with infla- Ation face much smaller increases in their tax liabilities than do households earning only wage and salary income. Actual tax return data indicate that a majority of households in the upper income ranges derive a significant percent- age of their total income from capital gains; thus, if the returns from their capital investments keep pace with inflation, these households will not be as adversely affected by inflation as will lower income households which do not realize capital gains. CRS-3 In order to examine the validity of these justifications for a tax cut, this study assesses the impact of both inflation and social security tax increases on the tax payments of typical households. Specifically, attention is focused on determining which income classes experience the largest increases in their tax liabilities as a result of inflation and social security tax‘ increases, assuming the continuation of the present Federal individual income tax structure. In other words, the study provides answers to the following question: Assuming continuation of the present Federal tax structure, what will be the changes in tax liabilities and the distribution of the tax burden from 1979 (the last tax cut) to 1982, if taxpayers at all income levels keep pace with inflation? The period covered will include the years 1979 to 1982. The method of analysis focuses on the tax liabilities of hypothetical four- person households at income levels ranging from $5,000 to $500,000 filing joint returns. For the years after 1979, the income levels are adjusted for infla- tion to maintain incomes with constant purchasing power over time. The range and composition of incomes for the hypothetical households reflect the charac- teristics of aggregate statistics on income and taxes as reported on individual income tax returns, so that the results of this study can be generalized. The first section of the report provides a summary of the findings of the study; the second section provides background information on the current income tax structure and an explanation of the methodology used to calculate tax lia- bilities; and the third section provides a detailed analysis of the changes in tax liabilities between 1979 and 1982. CRS-5 SUMMARY OF FINDINGS '=lZHO"U _l"”iC)I.'D-'lZ!"'|023!"'I'U Seventeen of the eighteen household income levels studied experience increases in their tax liabilities between 1979 and 1982. Only the $500,000 household witnessed a decline in its tax liability. The remaining households experience, on average, a 3.53 percentage point increase in their effective tax rates over the 4-year period. Most of this increase, over 70 percent, is attributable to inflation. Changes in the social security tax rate and base have, on average, a much smaller impact on tax liabilities than does inflation. Figure A provides an overview of the percentage point change in the effective: tax rates of four household income groups between 1979 and 1982. FIGURE H HVERHGE PERCENTHGE POINT CHHNGE IN EFFECTIVE TRX RRTES JOINT RETURNS -- 1979 T0 1982 4 1 CHRNGE INDUCED BY INFLRTION ' “’ ” I CHRNGE INDUCED BY SOCIHL SECURITY __r-_-:'__,.,"""....'Z-« 2 - _.*':’~—-—..—r~.»-—T"""“f““":-5 ._~—;~.5"‘”‘"""J-:'~:-is ~<::Z3 533125 % ,.W_,_ 1 “ e EE:=== :::3EE :::::: EEEEEE EEEEEE EEEEEE EEEEEE EEEEEE‘ wi:::; :::::: ;::::S W122: :;.-~ B :2;-_—_._——« -/"‘ ';~'”r;-_—_--«*_:..:" e S—22.5 25-38 48-75 189+ INCOME CLHSSES (Thousands of 1979 Dollars) CRS-6 By far the largest increases in effective tax rates occur for households at the low end of the income spectrum (below $10,000). This increase was primarily the result of inflation, which tended to decrease the benefits of the earned income credit for low-income households. The middle-income households also experience substantial increases in their effective tax rates. The only group that experiences little or no increase in its effective tax rates is the upper income households ($200,000 and above). All households experience increases in their effective tax rates as the result of changes in the social security tax rate and base. For only one group of households, however, does the change in the social security tax rate and base produce more of an impact on effective tax rates than inflation. Due to the growth in the percentage of their income subject to social security taxes, households in the $25,000-to-$30,000 income range incur substantial increases in their tax liabilities between 1979 and 1982. The primary cause of increas- ing tax liabilities for all other households is inflation. CRS-7 BACKGROUND INFORMATION ON CURRENT INCOME TAX STRUCTURE AND METHODOLOGY All calculations in this report were derived through the use of the CRS Tax Computation Model, which calculates the income and payroll tax liabilities of various hypothetical households. In order to provide a representative por- trait of the tax liabilities of.a hypothetical household in a given income bracket the model makes several assumptions concerning the source of income and the amount of itemized deductions that, on average, occur in each income bracket. All assumptions are based on actual tax return data as published in the 1977 and 1978 Statistics of Income. lj First, only wage and salary income and long-term capital gains are consid- ered in the model. Other sources of income normally taken into account when determining tax liabilities (such as interest income, business income, farm income, etc.) are not considered individually in this study. Since these sources of income receive the same tax treatment as wage and salary income, for the sake of simplicity this study considers all income other than capital gains as wage and salary income. Additionally, in calculating payroll-tax liabili- ties, all wage and salary income is assumed to be earned by one household member. It should be noted that this study uses two different terms to describe income, one being total money income (TMI) and the other being adjusted gross income (AGI). For the purpose of this study, total money income is defined as being equal to the sum of total wage and salary income and total capital gains. Normally, the statutory definition of adjusted gross income is wage and salary income, interest income, business income, farm income, etc., plus the taxable I] Department of the Treasury. Internal Revenue Service. Statistics of Income Individual Income Tax Returns. CRS-8 portion of capital gains (under current law the taxable portion of capital gains is 40 percent) less any adjustments to income (e.g., moving expenses, employee business expenses, payments to an IRA, etc.). This study assumes, however, that there are no adjustments to income, and therefore adjusted gross income is defined as wage and salary income plus the taxable portion of capital gains. For households with no capital gains, adjusted gross income will equal total money income. The distinctions between the two definitions of income are important for several reasons. Tax return data contained in the Statistics of Income are comr piled on an adjusted gross income basis. Therefore, the assumptions contained in the model concerning both the composition of income and the amount of itemized deductions are based on adjusted gross income. For comparative pur- poses, however, total money income was used instead of adjusted gross income in the calculation of effective tax rates. 2/ Since adjusted gross income includes only 40 percent of capital gains, comparing effective tax rates based on adjusted gross income can be somewhat misleading. For example, a $27,500 household with no capital gains has an effective tax rate based on AGI of 17.66 percent, while a $75,000 household with capital gains has an effective tax rate based on AGI of 27.6 percent. When total money income is used to calculate the effective tax rates, the $27,500 household's rate remains the same, 17.66 percent (since AGI equals TMI), but the $75,000 household's rate decreases to 26.2 percent. The use of total money income in the calculation of effective tax rates provides a better perspective of the actual tax burden of a household than does adjusted gross income. The 1979 total money incomes and adjusted gross incomes used in this study are given in Table 1. 2] Effective tax rates are defined as total taxes paid as a percentage of total money income. TABLE 1. CRS-9 1979 Household Income Levels Total Money Income Wage and Salary Income Capital Gains Adjusted Gross Income $ 5,000 $ 5,000 $ 0 $ 5,000 7,500 7,500 0 7,500 10,000 10,000 0 10,000~ 12,500 12,500 0 12,500 15,000 15,000 0 15,000 17,500 17,500 0 17,500 20,000 20,000 0 20,000 22,500 22,500 0 22,500 25,000 25,000 0 25,000 27,500 27,500 0 27,500 30,000 30,000 0 30,000 40,000 38,494 1,506 39,097 50,000 47,462 2,538 48,477 75,000 68,943 6,057 71,366 100,000 88,940 11,060 93,364 200,000 171,703 28,297 183,022 350,000 276,500 73,500 305,899 $500,000 $358,934 $141,066 $415,360 Second, for the purpose of examining the tax treatment of capital gains, the model assumes that all households with an adjusted gross income over a specified level realize capital gains. In the case of joint returns, all house- holds with adjusted gross incomes over $30,000 were designated as realizing cap- ital gains. Table 2 provides a breakdown of the mix between wage and salary income and capital gains for households with adjusted gross income over $30,000 filing joint returns. 6 6 TABLE 2. Composition of Income Capital Gains as a Percentage of Wage and Salary Income as a Percentage of Adjusted Gross Income Level Greater Than or Equal To Less Than Total Money Income Total Money Income $ 30,000 $ 50,000 96.13% 3.87% 50,000 100,000 91.47 8.53 100,000 200,000 86.85 13.15 200,000 $500,000 76.26 ' 23.74 $500,000 67.05 32.95 Source: Department of the Treasury. Internal Revenue Service. CRS-10 These percentages reflect the portion of total income that, on average, is derived from capital gains in each of these adjusted gross income brackets u(based on 1977 tax return data). The importance of including capital gains when examining tax liabilities of typical households is demonstrated in Figure 1. This graph presents the effective tax rates of households with income in the $40,000-to-$500,000 range. If the examination of tax liabilities were limited to only wage and salary income, the conclusions reached as to the tax liabilities in the upper income brackets would be misleading. As shown in Figure 1, the effective tax rates on wage and salary income are substantially higher than the effective tax rates on income which includes capital gains. For example, the effective tax rate of a hypothetical four-person household with $150,000 of wage and salary income would be 34.89 percent. When, however, that $150,000 income comprises both wage and salary income as well as capital gains in the percentages reflected by actual tax return data, the effective tax rate drops to 32.15 percent. 3/ The third major assumption is that households with adjusted gross incomes of over $20,000 filing joint returns itemize their deductions. This assumption is prompted by the fact that over one-half of actual tax returns filed in this adjusted gross income range and above itemize. The percentages used in the model to determine the amount of itemized deductions were derived by calculating the average amount of itemized deductions for each AGI level over $20,000. This information is based on actual data on income tax returns as contained in the 1978 Statistics of Income. The table on page 12 presents a summary breakdown of 3/ At a $150,000 income level, 87.09 percent or $130,649 would be wage and salary income, while 12.9 percent or $19,351 would be long-term capital gains. -1 18 << *4 -4 (3 F1 *1 "1 F1 I) >< ; U1 F1 -4 Z) 3 CRS-11 FIGURE - 1 EFFECTIVE THX RHTES -— JOINT RETURNS NHGE HND SRLRRY INCOME ONLY VS. 9 MIX OF NRGE/SHLHRY INCOME HND'CRPITHL GHINS 38 38 34 32 38 291 26‘ 24 22 28* 18 48 / NHGE/SRLRRY INCOME ONLY I C NHGE/SHLRRY & CRP. GHINS "—““”m”"E”“° § ElfifliflEljlflflflfliififll[BEIRflRELfl!lllJlllll,_,1,qL_flill]ill“I 188 288 388 488 S88 INCOME%LEVELS ;(Thousands of 1979 dollars) CRS-12 the percentages used in the calculation of itemized deductions for households with AGI over $20,000. TABLE 3. Average Amount of Itemized Deductions As a Percentage of Adjusted Gross Income Adjusted Gross Income Level Greater Than or Equal To Less Than Percentages of AGI $ 20,000 $ 25,000 23.8% 25,000 30,000 21.6 30,000 ' 50,000 20.1 50,000 100,000 18.9 100,000 200,000 17.9 200,000 $500,000 20.6 $500,000 . ' ‘ 23.1 Source: Department of the Treasury. Internal Revenue Service Again, the importance of this assumption can best be demonstrated graphi- cally. Figure 2 shows the effective tax rates for households with income between $10,000 and $100,000 filing joint returns. For example, if a household with an AGI of $22,500 did not itemize its deductions, its effective tax rate would be 18.86 percent. If this same household did itemize its deductions, and if the amount of itemized deductions equaled the average amount of itemized deductions normally taken at the $22,500 AGI level, then its effective tax rate would decrease to 16.78 percent. Itemizing deductions substantially reduces a household's tax liability. When calculating the amount of capital gains and the size_of itemized deductions, the model employs a simple smoothing technique to eliminate discrete jumps in the effective tax rates at tax bracket end points. The exact percent- ages contained in both Table 2 and Table 3 are considered to occur only at the midpoint of the income levels given as the upper and lower bounds of the AGI bracket. For example, in Table 2, 8.53 percent of income is capital gains, and 91.47 percent of income is wage and salary for only those households receiving -1 F1 <2 #4 -4 (3 F1 "1 *1 F1 D )< U) F1 -1 I) 23 CRS-13 FIGURE - 2 EFFECTIVE THX RHTES -- JOINT RETURNS STRNDRRD DEDUCTION VS. ITEMIZED DEDUCTIONS CURRENT INCOME TRX LRN C 38 38“- 34 1- 324- aa #- 29*- 26“- 24“- aa L» 231 18* L L 153- ML L 12* 18* 3.LuumLuhuuuflIHHumHuwnnhwannflnuunnflHMaHHhHsnndumuuui4 18 STHNDHRD DEDUCTION ITEMIZEU DEDUCTION ixnjjrjvuu-nuns:-as-nag:-n¢:—oo 28 30 40 58 68 ?B 88 90 188 INCOME LEVELS (Thousands of 1979 doilars) CRS-14 a total income of $75,000. For any household with a total income not equal to the midpoint of the income brackets contained in Tables 2 and 3, the composition of its income and the amount of its itemized deductions within the model is a function of the household's relative position between income-bracket end- points. 3/ 1 Fourth, income levels for years after 1980 were determined by inflating the original (1979) income levels by the expected increases in the implicit .price deflator for expenditures on personal consumption as projected by the latest (summer 1980) Data Resources Inc. long-term forecast. The following table summarizes the projected inflation rates for the years 1980 to 1982. IABLE 4. Inflation Rates 1980 1981 1982 10.8% 10.4% 9.5% Income levels were adjusted for the projected rates of inflation in order to examine the tax payments of incomes with constant before-tax purchasing power over time. It should be noted that this is done as an analytical device and not as a forecast. In reality, during periods of inflation some households experience real gains in income, while others sustain real losses. Additionally, it should be noted that this study does not distinguish between a nominal capital gain and a real capital gain. Current tax law requires that a tax be paid on the difference between the selling price and the original cost of a capital asset. Since taxes are assessed solely on the basis 3/ For a more detailed explanation of the smoothing technique, see Appendix 2. CRS-15, of the nominal gain, the result is to increase the effective tax rate on the real or inflation-adjusted gain. This study assumes that after 1979 the nomi- nal gain from an asset keeps pace with inflation, so that the inflation-adjusted gain is equal to the nominal gain realized in 1979. However, since no adjust- ment was made to the nominal gain realized in 1979, the taxes assessed on cap- ital gains in this study are all based on the nominal value of the gain. In order to assess the impact of increases in the payroll tax on the tax liabilities of hypothetical households, the payroll tax base and rate were increased each year beginning in 1980. The payroll tax rates are fixed by law through 1983. iThe taxable base for 1979, 1980, and 1981 is also fixed by law. The taxable base for 1982, which will depend on the average wage increase dur- ing 1981, is estimated from the 1980 Annual Report, Board of Trustees, Social Security Programs. The payroll tax rates and bases used in this study are pre- sented in Table 5. TABLE 5. Payroll Tax Rates and Bases, 1980-83 Year Payroll Tax Rate Taxable Base 1979 6.13% $22,500 1980 6.13 25,900 1981 ‘ 6.65 29,700 1982 6.70 32,700 In this study, average effective tax rates (taxes paid as a percentage of total money income) are the primary focus of the analysis instead of taxes expressed in dollar amounts. Effective tax rates were used for two reasons. First, effective tax rates are more appropriate for comparing tax burdens over time. During periods of inflation, comparing annual tax payments expressed in dollar amounts can be inconclusive and misleading because of the different price levels in each year. Taxes divided by total money income offers a CRS-16 standard for comparison in this study because it represents the tax rate on an income with constant purchasing power over time. Second, the use of effective tax rates allows a comparison of the impact of taxes paid at different income levels. i Three simulations were run using the Tax Computation Model with each simu- lation covering the years 1979 through 1982. The first simulation included the assumptions concerning inflation and social security tax increases. The second included the inflation assumptions but held the social security tax rate and base constant at its 1979 level. The third simulation excluded inflation but allowed the increases in social security taxes to take effect as planned. By comparing the results of these three simulations, it was possible to reach con- clusions on the extent to which both inflation and social security taxes influ- enced the tax liabilities of the typical households. CRS-17 AN ANALYSIS OF THE CHANGE IN EFFECTIVE TAX RATES: 1979 to 1982 Of the 18 hypothetical household income levels studied, 17 experienced increases in their tax liabilities between 1979 and 1982 resulting from infla- tion and the social security tax changes. Table 6 and Figure 3 present the effective tax rates for the hypothetical households in 1979 and 1982. TABLE 6. Effective Tax Rates for 18 Household Income Levels, 1979 and 1982 Total Money Income 1979 Effective 1982 Effective Percentage (1979 Dollars) Tax Rates Tax Rates Point Change $ 5,000 -3.87% 0.54% 4.41 7,500 2.15 10.50 8.35 10,000 9.87 13.81 3.94 12,500 12.47 16.14 3.68 15,000 14.41 18.00 3.59 17,500 16.07 17.76 1.69 20,000 17.46 19.02 1.57 22,500 16.78 20.40 3.62 25,000 17.22 20.82 3.60 27,500 17.66 21.23 3.57 30,000 18.26 21.65 3.39 40,000 19.58 24.45 4.86 50,000 21.81 26.72 4.90 75,000 26.24 30.49 4.25 100,000 28.92 32.24 3.31 200,000 33.50 34.77 1.27 350,000 33.69 33.77 0.07 $500,000 32.43% 32.42% -0.01 As can be seen in Table 6 and Figure 3, the largest increases in effective tax rates, increases of well over 3 percentage points, occurred for households in the low-income (below $17,500) and mid- to upper-income ($22,500 to $100,000) brackets. The $17,500 and $20,000 households experienced more moderate increases in their effective tax rates of 1.69 and 1.57 percentage points, respectively. Of all households studied, households in the highest income brackets (above $100,000) witnessed the least change in their effective tax rates--on average less than 1 percentage point. Although both inflation and 40 35 30 25 20 15 18 CRS-18 FIGURE 3 EFFECTIVE TRX RRTES 1879 HND 1982 JOINT RETURNS 1982 \19?9 10 20 30 40 50 200 358 INCOME LEVELS (Thousands of 1979 Dollars) SOB CRS-19 social security tax increases affected all households‘ tax liabilities, the impact varied among the income classes. Through comparison of the three simulations (simulation one, which included both the inflation and social security assumptions, simulation two, which included only the inflation assumptions, and simulation three, which included only the social security assumptions), one can determine the extent to which each factor influenced the total change in each household's effective tax rate. Table 7 and Figure 4 show the impact of social security increases and inflation on effective tax rates. Two major conclusions can be reached from analyzing the results of the three simulations. First, inflation had a much more pronounced impact on the lower and the upper income groups than did social security tax increases. Second, for households in the middle-income brackets the increase in social security taxes was primarily responsible for increasing their tax liabilities. Inflation had a much smaller impact on these households. 2/ As can be seen in Table 7, the increases in the effective tax rates of households in the lower income range ($5,000 to $22,500) and households in the §/ Isolating the separate effects of changes in social security taxes and inflation presents a conceptual problem, since the two effects are not independ- ent. The relationship of these two factors requires that certain judgmental decisions be made when assessing the share of the total change in effective tax rates explained by each factor. One solution to this problem was achieved by assuming that for those households whose incomes were less than the social security base in both 1979 and 1982, the total impact of changes in social security taxes would be the difference between the social security tax rate in 1979 and 1982. For households above the $22,500 income level, the impact of social security taxes was isolated by calculating the difference between the effective tax rate for social security in simulation one (both inflation and projected changes in social security tax base and rate) and simulation two (inflation with social security tax rate and base held constant at the 1979 level). This procedure allocates somewhat more of the total change in effec- tive tax rate to the social security and somewhat less to inflation than an allocation based strictly on the change in the effective tax rates for social security that assumes changes in both inflation and social security taxes. The difference is small and in no way detracts from the conclusion of the study. CRS-20 TABLE 7. Changes in Effective Tax Rates: 1979-82 Change in Change in Percentage Percentage Total Change Points Points Income Level in Percentage Attributable Attributable to (1979 Dollars) Points to Inflation Social Security $ 5,000 4.41 3.84 0.57 7,500 8.35 7.78 0.57 10,000 3.94 3.37 0.57 12,500 3.68 3.11 0.57 15,000 3.59 3.02 0.57 17,500 1.69 1.12 0.57 20,000 1.57 1.00 0.57 22,500 3.62 3.05 0.57 25,000 3.60 1.22 2.40 27,500 3.57 1.37 2.20 30,000 3.39 1.37 2.02 40,000 4.86 3.35 1.51 50,000 4.90 3.69 1.21 75,000 4.25 3.44 0.81 100,000 . 3.31 I 2.71 0.61 200,000 1.27 0.97 0.30 350,000 0.07 -0.10 0.17 $500,000 -0.01 -0.13 0.12 upper income range ($40,000 to $200,000) were primarily the result of inflation. Increases in social security taxes contributed a relatively modest amount to the overall change in effective tax rates for these two groups, accounting for less than 50 percent of the total change in both the upper and lower income ranges. The modest increase in effective tax rates attributable to social security taxes in these income ranges can be explained in the following manner. First, the lower income households ($5,000 to $22,500) remain below the upper limit on the taxable base for social security in both 1979 and 1982. Therefore the max- imum amount that changes in social security taxes can increase the total effec- tive tax rate of the lower income households is 0.57 p¢rcentage point (the dif- ference between the social security tax rate in 1979, 6.13 percent, and the social security tax rate in 1982, 6.7 percent). Second, households in the upper CRS-21 FIGURE 4 PERCENTHGE POINT CHHNGE IN EFFECTIVE TRX RHTES 1979 TO 1982 []Chango Induced By Inflation — 'Chnngo Induced By Social Socurlty - VF“ r r'*~__ F --I 10 15 28 25 36 SB 180 588 INCOME LEVELS (Thousands of 1979 dollars) CRS-22 income brackets were insulated from the impact of social security tax increases by the relatively large size of their incomes. Although there were increases in both the tax rate and tax base for social security, the total increase in social security tax liability for the households in the $40,000-and-up income classes was small in comparison to the size of their incomes. Inflation, on the other hand, had a much more pronounced effect on the tax liabilities of the households in both the upper and lower income levels. For example, the largest increase in tax liabilities occurred for the $7,500 house- hold, which experienced an 8.35 percentage point increase in its effective tax rate between 1979 and 1982. Of this 8.35 percentage point increase, 7.78 per- centage points (or over 93 percent of the total increase) were the result of inflation. ,The reason for this large change was that by 1982 inflation had increased the householdls income to the point where it was no longer eligible for the earned-income credit. In 1979, because of the earned-income credit, the $7,500 household received an income-tax rebate of $299. This $299 rebate helped to offset the $460 social security tax liability and resulted in a net total tax payment of only $161, which equates to a 2.15 percent effective tax rate. By 1982, however, inflation had pushed this household's income up to $10,046 in current dollars, which disqualified the household from claiming the earned-income tax credit (the upper income limit for earned-income credit is $10,000). Hence the income-tax payment for this household was $381 in 1982, which represented a 7.78 percentage point increase in its effective tax rate. Combined with an increase in its social security tax liability, which added 0.57 percentage points to its total effective tax rate, the $7,500 household had a total tax liability of $1,054 in 1982 and an effective tax rate of 10.50 percent. The $5,000 household also experienced an increase in its tax liabil- ity for basically the same reasons as the $7,500 household. Inflation increased CRS-23 the $5,000 household's income to $6,697 by 1982, which resulted in decreased benefits from the earned-income tax credit. This partial loss of benefits increased the $5,000 household's effective tax rate by 3.84 percentage points. An additional 0.57 percentage point increase in the effective tax rate for social security resulted in a total change of 4.41 percentage points in the $5,000 household's effective tax rate between 1979 and 1982. For the remaining households in the lower income brackets (below $15,000), inflation played the major role in increasing tax liabilities. As mentioned previously, this is a result of the progressivity of the tax brackets in the lower income levels. At these income levels each extra dollar of inflation- induced income is taxed at progressively higher marginal rates. For example, the $12,500 household's marginal tax rate in 1979 is 18 percent, but by 1982 its marginal tax rate has risen to 21 percent. On average, households in the $l0,00-to-$15,000 income range experienced increases of 3.16 percentage points in their effective tax rates as a result of inflation. Households in the $17,500-to-$20,000 income classes were affected by infla- tion and social security tax increases in the same manner as were households in the lower income classes; that is, social security increases added less to the total change in effective tax rates than did inflation. However, with the exception of households in the upper income ranges (above $100,000), households in the $17,500-to-$20,000 income range experienced a smaller change in effective tax rates (1.69 and 1.56 percentage points, respectively) than did any other group. This relatively small change is a function of the assumptions contained in the model and requires further elaboration. As described in the section on methodology, the model makes certain assump~ tions concerning the size and type of deductions a household claims when it files a tax return. Actual data indicate that over half of the households CRS-24 filing joint returns begin to itemize their deductions when their adjusted gross income passes $20,000. The model assumes that at an AGI of $20,000, a house- hold will begin to itemize its deductions with the amount of itemized deduc- tions equal to 17 percent of AGI. The 17 percent increases to 23 percent of AGI as a household approaches an AGI of $22,500. In 1979, both the $17,500 and the $20,000 household take the standard deduction. In subsequent years, how- ever, both households begin to itemize their deductions as inflation increases their AGI above the lower AGI bound ($20,000) of the assumption. By itemizing their deductions, both the $17,500 and the $20,000 household are able to lower their taxable income and therefore offset a large percentage of the inflation- induced increase in their effective tax rates. If the two households had not itemized their deductions, the effective tax rate for the $17,500 household would have increased by 2.01 percentage points, and the effective tax rate for the $20,000 household by 2.43 percentage points. It should be noted that not all households moving into higher income brackets owing to inflation-induced increases in.their income will necessarily respond by adopting the statistical characteristics of households already in that income bracket. In fact, in the long run it is probable that the factors influencing a household's budgetary decisions are a function of real income rather than a function of nominal income. For the purpose of this analysis, however, it is assumed that enough of the households moving into a new income bracket will display the characteristics of households already in that income bracket that valid conclusions can be reached as to the effect this movement would have on a household's effective tax rate. Households in the upper income ranges ($40,000 to $200,000) represent another group whose increases in effective tax rates were caused primarily by inflation. On average, inflation added 2.8 percentage points to the effective CRS-25 tax rates of households in this income range, while increases in social security taxes added, on average, less than one percentage point. The impact of infla- tion, however, was not evenly distributed along the higher end of the income spectrum. Inflation displayed a diminishing influence as income levels increased. At the $50,000 income level, inflation added 3.69 percentage points to a household's effective tax rate betweeen 1979 and 1982. Over the same period, inflation increased a $200,000 household's effective tax rate by less than one percentage point. At the $350,000 and $500,000 income level, inflation actu- ally reduced a household's tax liability. In fact, it can be shown that infla- tion will decrease the effective tax rates of households whose adjusted gross income is above $350,000. The decline in the impact of inflation for the high-income households is the result of several factors. First, as incomes increase, the percentage of income derived from capital gains also increases. Since only 40 percent of the income derived from capital gains is subject to tax, 60 percent of any inflation-induced increase in capital gains is fully exempt from taxation. Second, as a household's AGI increases above the $200,000 mark, so does the amount of itemized deductions. An increase in the amount of itemized deductions helps decrease a household's tax liability.. Finally, households in the upper income brackets have reached the 50 percent maximum tax rate on wage and salary income, and therefore each extra dollar of inflation-induced wage and salary income is taxed at the same marginal rate (50 percent), rather than at progres- sively higher marginal rate, as is the case in the lower income brackets. These factors taken together help to hold constant or reduce the effective tax rates of households in the upper income ranges. Households in the middle-income range ($25,000 to $30,000) absorbed the brunt of the increases in social security taxes. Increases in the social CRS-26 security tax rate and base added, on average, over two percentage points to the effective tax rates of households in this income range. The increase in the social security tax base was the major factor affecting the tax liabilities of the middle-income households. As the social security tax base increased, households in the middle-income range witnessed a steady growth in the percentage of their total income subject to social security deductions. Table 8 presents the percentage of wage and salary income subject to social security tax in 1979 and 1982 for all households. As can be seen in Table 8, the $25,000, $27,500, and $30,000 households experienced a larger increase in the percentage of wage and salary income subject TABLE 8. Percentage of Wage and Salary Income Subject to Social Security Taxes, 1979 and 1982 1979 ‘ 1982 Percentage Percentage of Wage of Wage and Salary and Salary’ Income . Income Percentage Total Wage and Covered by Total Wage and Covered by Point Money Salary Social Money Salary Social Increase, Income Income Security Income Income Security 1979-82 $ 5,000 $ 5,000 100% $ 6,697 $ 6,697 100% 0 7,500 7,500 100 10,046 10,046 100 0 10,000 , 10,000 100 13,394 13,394 100 0 12,500 ~ 12,500 100 16,743 16,743 100 0 15,000 15,000 100 20,092 20,092 100 0 17,500 17,500 100 23,440 23,440 100 0 20,000 20,000 100 26,789 26,789 100 0 22,500 22,500 100 30,137 30,137 100 0 25,000 25,000 90 33,486 32,511 100 10 27,500 27,500 81.8 36,835 35,601 91.9 10.1 ‘30,000 30,000 75 40,183 38,661 84.6 9.6 40,000 38,494 58.4 53,578 51,560 63.4 5 50,000 47,462 47.4 66,972 63,527 51.4 4 75,000 68,943 32.6 100,458 92,345 35.4 2.8 100,000 88,940 25.2 133,944 119,130 27.4 2.2 200,000 171,703 . 13.1 267,888 229,986 14.2 1.1 350,000 276,500 8.1 468,804 370,355 8.8 0.7 $500,000 $358,934 6.3% $669,720 $480,770 6.8% 0.5 CRS-27 to social security taxes than did any other household. Households under the $25,000 level experienced no change in the percentage of wage and salary income covered by social security, while households above the $30,000 level experi- enced only a moderate increase in their coverage. Inflation, on the other hand, had only a modest impact on the $25,000-to- $30,000 households, increasing effective tax rates on average about 1.3 percent- age points over the 4-year period. By 1982, the adjusted gross income of all three middle-income households had risen above the $30,000 level, the AGI level at which households begin to realize capital gains. The $25,000 household realized capital gains beginning in 1981, while both the $27,500 and $30,000 households realize capital gains beginning in 1980. Since capital gains receive preferential tax treatment, increasing the percentage of income derived from this source helped the middle-income households to limit the impact of inflation on their tax liabilities. The data on the actual tax payments of the 18 hypothetical household income level for the years 1979, 1980, 1981, and 1982 are contained in the attached appendices. In conclusion, it appears that for the majority of households inflation is likely to exert the dominant influence on effective tax rates in future years. The effects of inflation will be most evident in the $5,000-to-$22,500 and the $40,000-to-$100,000 income ranges. Social security tax increases, on the other hand, will have a relatively minor impact on the effective tax rates of most households. Households earning $100,000 or above will be least’ affected by changes in social security taxes, followed closely by households with $22,500 of income or less. Only the $25,000-to-$30,000 income households will experience substantial increases in their tax liabilities as a result of changes in the social security tax rate and base. CRS-2 9 APPENDIX A: I — : I I TAX LIABILITIES or TYPICAL HOUSEHOLDS FILING JOINTHRETURNS, 1979 TO 1982 CRS-30 TABLE 1A. Joint Return, 1979, Current Income Tax Law Tax Payments Effective Tax Rates Total Money Income Income Payroll Total Income Payroll Total (Current Dollars) Taxes Taxes Taxes Tax Tax Tax $ 5,000 $ -500 307 $ -194 -10.00% 6.13% -3.87% 7,500 -299 460 161 -3.98 6.13 2.15 10,000 374 613 987 3.74 6.13 9.87 2 12,500 792 766 1,558 6.34 6.13 12.47 15,000 1,242 920 2,162 8.28 6.13 14.41 17,500 1,740 1,073 2,813 9.94 6.13 16.07 20,000 2,265 1,226 3,491 11.33 6.13 17.46 22,500 2,396 1,379 3,775 10.65 6.13 16.78 25,000 2,925 1,379 4,304 11.70 5.52 17.22 27,500 3,476 1,379 4,855 12.64 5.02 17.66 30,000 4,098 1,379 5,477 13.66 4.60 18.26 40,000 6,454 1,379 7,834 16.14 3.45 19.58 50,000 9,527 1,379 10,906 19.05 2.76 21.81 75,000 18,299 1,379 19,678 24.40 1.84 26.24 100,000 27,545 1,379 28,925 27.55 1.38 28.92 200,000 65,620 1,379 66,999 32.81 0.69 33.50 350,000 116,542 1,379 117,921 33.30 0.39 33.69 500,000 160,773 1,379 ’162,152 32.15 0.28 32.43 TABLE CRS-31 2A. Joint Return, 1980, Current Income Tax Law Total Money Income (Current Dollars) $ 5,540 8,310 11,080 13,850 16,620 19,390 22,160 24,930 27,700 30,470 33,240 44,320 55,400 83,100 110,800 221,600 387,800 554,000 $ Income Taxes -500 -84 547 1,035 1,555 2,137 2,383 2,910 3,525 4,100 4,733 7,746 11,380 21,544 31,761 73,814 ‘ 129,327 177,508 Tax Payments $ Payroll Taxes 340 509 679 849 1,019 1,189 1,358 1,528 1,588 1,588 1,588 1,588 1,588 1,588 1,588 1,588 1,588 1,588 $ Total Taxes »-160 426 1,226 1,884 2,574 3,326 3,741 4,438 5,113 5,688 6,321 9,334. 12,967 23,132 33,349 75,402 130,915 179,096 Effective Tax Rates Income Tax -9.03% -1.01 4.94 7.47 9.36 11.02 10.75 11.67 12.73 13.46 14.24 17.48 20.54 25.93 28.67 33.31 33.35 32.04 Payro11 Tax 6.13% 6.13 6.13 6.13 6.13 6.13 6.13 6.13 5.73 5.21 4.78 3.58 2.87 1.91 1.43 0.72 0.41 0.29 Total Tax -2_ 5 11. 13. 15. 17 16. 17 18. 18. 19. 21. 23. 27 30. 34. 33. 32 90% .12 07 60 49 .15 88 .80 46 67 02 06 41 .84 10 03 76 .33 \. CRS-32 TABLE 3A. Joint Return, 1981, Current Income Tax Law Tax Payments Effective Tax Rates Total Money Income Income Payroll Total Income Payroll Total (Current Dollars) Taxes Taxes Taxes Tax Tax Tax $ 6,116 $ -485 $ 407 $ 6 -79 -7.94% 6.65% -1.29% 9,174 145 610 755 1.58 6.65 8.23 12,232 744 9813 1,557 6.08 6.65 12.73 15,290 1,294 1,017 2,311 8.46 6.65 15.11 18,348 1,918 1,220 3,138 10.45 "6.65 17.10 21,407 2,349 1,424 3,772 10.97 6.65 17.62 24,465 2,810 1,627 4,437 11.49 6.65 18.14 27,523 3,482 1,830 5,312 12.65 6.65 19.30 30,581 4,124 1,975 6,099 13.49 6.46 19.94 33,639 4,833 1,975 6,808 14.37. 5.87 20.24 36,697 5,596 1,975 7,571 15.25 5.38 20.63 48,929 9,292 1,975 11,267 18.99 4.04 23.03 61,162 13,434 1,975 15,409 21.96 3.23 25.19 91,742 24,969 1,9754 26,944 27.22 2.15 29.37 122,323 36,451 1,975 38,426 29.80 1.61 31.41 244,646 82,530 1,975 84,505 33.73 0.81 34.54 428,131 142,765 1,975. 144,740 33.35 0.46 33.81 611,616 195,335 1,975. 31.94 0.32 32.26 197,310 CRS-33 TABLE 4A. Joint Return, 1982, Current Income Tax Law Tax Payments Effective Tax Rates Total Money Income Income Payroll Total Income Payroll Total (Current Dollars) Taxes Taxes Taxes Tax Tax Tax $ 6,697 $ -413 $ 449 $ 36 -6.16% 6.70% 0.54% 10,046 381 673 1,054 3.80 6.70 10.50 13,394 953 897 1,850 7.11 6.70 13.81 16,743 1,581 1,122 2,703 9.44 6.70 16.14 20,092 2,271 1,346 3,617 11.30 6.70 18.00 23,440 2,593 1,570 4,164 11.06 6.70 17.76 26,789 3,302 1,795 5,096 12.32 6.70 19.02 30,137 4,129 2,019 6,148 13.70 6.70 20.40 33,486 4,795 2,178 6,973 14.32 6.51 20.82 36,835 5,630 2,191 7,821 15.29 5.95 21.23 40,183 6,507 2,191 8,698 16.19 5.45 21.65 53,578 10,907. 2,191 13,098 20.36 4.09 24.45 66,972 15,701 2,191 17,892 23.44 3.27 26.72 100,458 28,437 2,191 30,628 28.31 2.18 30.49 133,944 40,991 2,191 43,182 30.60 1.64 32.24 267,888 90,945 2,191 93,135 33.95 0.82 34.77 468,804 156,102 2,191 158,293 33.30 0.47 33.77 669,720 214,902 2,191 217,093 32.09 0.33 32.42 CRS-35 APPENDIX B: EXPLANATION OF SMOOTHING METHODOLOGY In order to minimize the discrete fluctuations in effective tax rates dur- ing the transition from one AGI bracket to another, a simple smoothing algo- _ rithm was developed. An example illustrating the steps involved in determining the mix of capital gains and wage/salary income for a household with an AGI of $375,000 will help to explain the smoothing technique used in this study. First, the relative position of the household within its AGI bracket is calculated. This is done by calculating the percentage difference between the lower bound of the AGI bracket in which the household is located and the actual level of the household's AGI. For example, the position of a household with an AGI of $375,000 (an AGI level which falls within the $200,000-to-$500,000 AGI range) would be calculated as follows: Position of a Household AGI - Lower bound of AGI bracket household in = AGI bracket Upper bound of AGI bracket - Lower bound of AGI bracket ($375,000 - $200,000) 0.583 = ($500,000 - $200,000) This figure (0.583) is then multiplied by the difference in the percentage of total money income derived from capital gains at the lower bound of the AGI bracket and the percentage of total money income derived from capital gains at the upper bound of the AGI bracket. Thus: Z of TMI that is Z of TMI that is capital gains at - capital gains at 0.583 * upper bound of lower bound of AGI bracket AGI bracket 0.583% * ( 0.3945 - 0.156) 0.138 CRS-36 Finally, this percentage point amount is added to the percentage of TMI that is derived from capital gains at the lower bound of the AGI bracket. In the case of a household with an AGI of $375,000, the lower bound of the AGI bracket is $200,000. At an AGI of $200,000, 15.7 percent of total money income is capital gains income. Therefore, for a household with an AGI of $375,000, capital gains as a percentage of total money income would equal 29.5 percent (13.8% + 15.7%). The same procedure is used when calculating the amount of itemized deduc- tions at a given income level.