Tax Reform and Distributional Issues

Publication Date: February 2006

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

Type:

Abstract:

Tax reform proposals may change the tax base as well as the rate structure. Both affect the distribution of the tax burden across individuals and across income classes. While relief for lower-income individuals can be achieved by exemptions and credits, the choice of tax base has consequences for the distribution of the tax burden between middle- and upper-income taxpayers, even for cases where rates are graduated.

The most significant tax reform in recent history, the Tax Reform Act of 1986, moved in the direction of expanding the individual income tax base, in part by reducing preferences for capital income. Many of these preferences have since been restored and, in some cases, expanded, moving further towards a wage base, and there are proposals for further expansion. Some current proposals, including congressional proposals, would move instead to a consumption base: H.R. 25, H.R. 1040, S. 25, S. 812, S. 1099, and S. 192. S. 1927, however, would move towards a broader income base. The President's Advisory Panel on Tax Reform presented two proposals, one moving toward a consumption tax base and the other reducing the coverage of capital income (and moving towards a wage base).

The consequences of choice of tax base for distribution depend on the source of income in different income classes. According to tax data, over 80% of income in the middle class came from wage income, while only a third to a half of income in the very high income levels was derived from wages. Some forms of income do not fit clearly into the wage or capital income categories. When adjustments are made to allocate these forms of income, such as pension income and proprietorship income, the concentration of labor income increases in the middle classes. When all income is assigned to either capital income or labor income, over 90% of income earned in the middle classes derives from labor, while half or less of income in the highest brackets derives from labor.

The more heavily that tax revision moves towards a wage base, which also occurs with consumption taxation in the long run, the more difficult it is to avoid shifting the tax from higher-income families to the middle class.

This report will not be updated.