Tax Reform and Distributional Issues

Tax Reform and Distributional Issues

Order Code RL33285
Tax Reform and Distributional Issues
Updated September 7, 2007
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division

Tax Reform and Distributional Issues
Summary
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. 1025, and S. 1040, and S. 1081. S. 1111, 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.

Contents
Sources of Income: Wages and Capital Income . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Implications for the Distributional Effects of Tax Reform Proposals . . . . . . . . . . 9
List of Tables
Table 1. Major Sources of Income by Adjusted Gross Income Class, in
Percentages, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Table 2. Major Sources of Income by Income, Ordered by Population Share,
in Percentages, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Table 3. Self-Employment, Rent, and other Income by Income Class, as a
Percentage of Total Income, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Table 4. Labor Share of Individual Income, by Adjusted Gross Income Class . . 7
Table 5. Interest, Dividends, and Capital Gains by Adjusted Gross Income Class,
as a Percentage of Total Income, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Table 6. Labor Share of Individual Income, by Adjusted Gross Income
Class, Including Corporate Source Income, 2003 . . . . . . . . . . . . . . . . . . . . . 9

Tax Reform and Distributional Issues
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 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. Among other individual provisions, the 1986
law taxed capital gains at ordinary rates, restricted fully tax-favored individual
retirement accounts to those not covered by employer pension plans, and provided
significant restrictions on tax shelter operations. In 1997 capital gains rates were
reduced and the general availability of fully tax-favored IRAs restored, but with
income limits. Dollar limits on contributions to IRAs were increased in 2001 and
rates were lowered further on capital gains and on dividends in 2003. The 2001 and
2003 changes, absent new legislation, expire after 2010 and 2008 respectively.
There are proposals to maintain or extend the recently enacted tax cuts,
including the benefit for IRAs and dividends and capital gains. The President has
proposed greatly expanding preferences for individual savings accounts as well.
Some current proposals, including congressional proposals, propose a
fundamental change by moving to a consumption base.1 These consumption base
proposals include S. 1040 (Shelby) and S. 1081 (Specter), which propose a flat tax
(a tax on wages at the individual level and cash flow of businesses). H.R. 25 (Linder)
and S.1025 (Chambliss) propose a national retail sales tax. H.R. 1040 (Burgess)
would allow the option of a flat tax.
The President’s Advisory Panel on Federal Tax Reform presented two
proposals, one of which was a proposal similar to a flat tax in its base, but allowing
a graduated rate on wages (a type referred to as an x tax).2 The plan also included
an additional tax on financial income. The plan, however, allows greatly expanded
tax exempt savings plan limits without income limits and with much higher
1 See CRS Report RL33443, Flat Tax Proposals and Fundamental Tax Reform, by James
Bickley, for an overview of proposals.
2 The President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth:
Proposals to Fix America’s Tax System, November 2005.

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contribution limits, which would exclude much income from this tax. The panel
discussed, but did not recommend, a value-added tax (VAT).
There are also proposals that would retain an income base. S. 1111 (Wyden)
would broaden the income base, in part by reducing preferences for capital income.
The President’s advisory panel also has an income base reform plan, which they were
instructed to provide as at least one option. The proposal, however, reduces the
coverage of capital income by exempting dividends and capital gains, as well as
expanding tax-exempt savings plans. The advisory panel proposal, therefore, moves
towards a wage tax base, whereas S. 1111 moves towards a broader income tax base.
The consumption tax is equivalent to a tax on wages and a tax on old capital.
The flat tax approach collects the tax on old capital at the business level and the tax
on wages directly from individuals, while the retail sales tax collects all taxes at the
retail stage. (A VAT collects the tax at each stage of production.) Thus while
current owners of capital would pay the tax on consumption out of existing savings,
in the long run the consumption tax is essentially a tax on wages.
The economic standards for evaluating tax reform proposals usually include
effects on economic efficiency, administrative simplicity, and distribution. The first
and second are often stressed with respect to proposals for consumption or wage tax
bases, although the efficiency and simplicity benefits are not without dispute.3
Distributional issues are less easy to evaluate because there are subjective judgements
about what type of system is fair. However, an issue that can be addressed is the
consequences of tax base choice for the distribution of the tax burden. This report
examines the shares of income attributable to capital and labor income across the
income brackets and discusses the implications of choice of tax base on the
distribution of alternative tax systems.
Sources of Income: Wages and Capital Income
Income falls into two broad types, capital income and labor income. Table 1
uses data from the Internal Revenue Service Statistics of Income to examine the
sources of income by income brackets.4
This table reports the four major sources of income. The first three are wages,
financial capital income (interest, dividends and capital gains), and pensions and
distributions from individual retirement accounts (IRAs). The remainder of the
income (“other”) is derived largely from unincorporated business activities, including
3 See CRS Report RL32603, The Flat Tax, Value-Added Tax and National Retail Sales Tax:
An Overview of the Issues, by Jane G. Gravelle and Gregg A. Esenwein. For discussions of
the effects on saving see CRS Report RS22367, Federal Tax Reform and Its Potential
Effects on Savings, by Gregg Esenwein, along with the discussion of savings effects from
reducing capital income taxes (and the consequences for distribution) in CRS Report
RL32517, Distributional Effects of Taxes on Corporate Profits, Investment Income, and
Estates, by Jane G. Gravelle.
4 Found at [http://www.irs.ustreas.gov/taxstats/indtaxstats/article/0,,id=96981,00.html].

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proprietorships, partnerships, Subchapter S (small corporations taxed as
partnerships), rents, and royalties, estates and trusts, and minor items such as alimony
and state tax refunds.
Table 1. Major Sources of Income by Adjusted Gross Income
Class, in Percentages, 2003
Adjusted Gross
Interest,
Wage
Pensions and
Income Class
Dividends,
Other
Income
IRAs
($ thousands)
Capital Gains
Under $15
75%
5%
11%
8%
$15-$30
80
3
11
5
$30-$50
82
3
9
6
$50-$75
81
3
9
6
$75-$100
82
4
8
4
$100-$200
78
6
7
8
$200-$500
64
13
4
18
$500-$1000
52
20
2
23
Above $1000
32
39
1
24
Overall
75
9
7
9
Source: CRS calculations based on the Internal Revenue Service 2003 Individual Statistics of
Income. Excludes returns with negative adjusted gross income.
Note: Rows may not add to 100% because of rounding.
Table 2 arrays the same information by population share.
Both tables show that wage income accounts for the bulk of income in the
middle income classes, but that share declines substantially for higher income
classes. In the middle three fifths of the population, and for those earning under
$100,000, wage income accounts for close to 80%, or more, of total adjusted gross
income. For those in the top 1% of the population, wage income is less than half of
income, and for those with income of $1 million or more, wage income is only a third
of income.
The importance of interest, dividends, and capital gains is reversed. For those
with incomes under $100,000 and for the middle three fifths of the distribution, this
income accounts for less than 5% of total income. For those with income over $1
million, interest, dividends, and capital gains accounts for almost 40% of the total
and for the top 1%, almost 30%.

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Table 2. Major Sources of Income by Income, Ordered by
Population Share, in Percentages, 2003
Financial
Population
Pensions and
Wage Income
Capital
Other
Share
IRAs
Income
Bottom 20%
78%
6%
8%
8%
Second 20%
75
4
13
7

Third 20%
82
3
9
6

Fourth 20%
82
3
9
6
Top 20%
69
12
5
14
Top 10%
64
15
4
19
Top 5%
57
20
3
20
Top 2%
50
25
2
21
Top 1%
44
29
1
26
Source: CRS calculations based on the Internal Revenue Service 2003 Individual Statistics of
Income. Excludes returns with negative adjusted gross income.
Note: Rows may not add to 100% because of rounding.
The relative concentration of wage income as a source of income in the middle
brackets and reliance on capital income at the higher levels is increased if we
consider pensions and IRAs to be forms of deferred wage income. The tax treatment
of these items allows the deduction (or exclusion) of contributions, with tax due on
benefits. This treatment effectively exempts income from capital from tax and thus
is a capital income preference, not a wage income preference.5 We would obtain the
same economic result if contributions were not deductible but earnings were not
taxed (as is the case for Roth IRAs). If that method of providing a benefit were used,
wage income would be larger because contributions would not be excluded from
income (and pensions would not be included).
Depending on the growth rate versus the rate of return of these provisions, the
pension and IRA income may overstate or understate the value of wage income. In
a steady state, with the real rate of return 5% and the growth rate 3%, typical of the
past economy, and assuming an average lag of 15 years between contribution and
benefit, wage inclusions would be about 75% of benefits.6 Assigning most of the
pension and IRA benefits to wage income would move the share of wage income to
5 For a mathematical demonstration, see CRS Report RL30255, Individual Retirement
Accounts: Issues and Proposed Expansion, by Thomas L. Hungerford and Jane G. Gravelle.
6 The formula for constant growth is e(g-r)t, where e is a natural constant, approximately
2.718, g is the growth rate, r is the real rate of return (i.e., nominal return minus inflation
rate), and t is the time period.

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close to 90% for middle income groups while having little effect on higher-income
individuals.
Most of the remainder of the income is from self-employment, and some income
that is largely capital income (rents, royalties, and estate and trust income). Self-
employment income is a combination of the return to labor and the return to capital,
and, particularly in the lower and middle classes, much of it is labor income.
Unincorporated businesses are divided into proprietorship (or earnings from a
business or profession) and the combination of partnership and Subchapter S income.
Table 3 shows the distribution of this unincorporated business activity by
income class. (Note that the sums do not strictly match because of loss deduction
restrictions.) Proprietorship income dominates at the lower income levels, while
partnership and Subchapter S income is more important at higher levels.
A typical rule of thumb in the economy is that capital income accounts for
around 25% of total income. But this share can vary across types of businesses, and
in particular, proprietorships tend to be smaller and the owners’ labor income likely
to be larger relative to capital income. Allocating labor income for unincorporated
businesses is hampered by lack of data on capital assets for proprietorships.
Accordingly, we used data on depreciation deductions, based on the assumption that
the real rate of return is about 5%. Then using estimates of the distribution of asset
types and the average depreciation rates of equipment and structures,7 we estimated
the depreciation rate; this rate actually turned out to be almost identical. This
suggests that depreciation deductions as a percentage of net income from trade or
business is a good proxy for the share of capital income. These data, taken
respectively from the Statistics of Income data for proprietorship returns (2003),
partnership returns (2003), and Subchapter S returns (2002), indicate that capital
income is about 18% for proprietors and 53% for partnerships and Subchapter S
firms.
7 The distribution of assets was taken from Jane G. Gravelle, The Economic Effects of
Taxing Capital Income, Cambridge, MIT Press, 1994, p. 300.

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Table 3. Self-Employment, Rent, and other Income by Income
Class, as a Percentage of Total Income, 2003
Partnership
Rents,
Adjusted Gross
Proprietor-
and
Royalties,
Income Class
Total
ship
Subchapter
Estate and
($ thousands)
S* Income
Trust
Under $15
10.7%
-0.3%
1.1%
11.5%
$15-$30
4.1
0.1
0.7
4.9
$30-$50
2.8
0.4
0.6
3.8
$50-$75
2.6
0.8
0.7
4.1
$75-$100
2.9
0.9
0.7
4.6
$100-$200
4.3
3.1
1.2
8.6
$200-$500
6.4
11.4
2.2
20.0
$500-$1000
4.3
19.4
2.9
26.6
Above $1000
1.5
22.6
2.4
26.7
Overall
4.7
4.1
0.2
8.0
Source: CRS calculations based on the Internal Revenue Service 2003 Individual Statistics of
Income. Excludes returns with negative adjusted gross income.
* The allocation rule for assigning income to labor and capital is based on 2002 data, but the aggregate
amounts of Subchapter S income are from 2003.
Using these data, we then summarize the labor income share in Table 4, which
involves reducing the denominator by 25% of pension and IRA income, and counting
as labor income wages, 75% of pensions and IRA distributions, 82% of
proprietorship income, and 47% of income of partnerships and sole proprietorships.
We also report in that table the overall share of returns that fall into each income
class.

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Table 4. Labor Share of Individual Income, by Adjusted Gross
Income Class
Adjusted Gross Income
Share of Tax Returns
Labor Share of Income
Class ($ thousands)
(%)
(%)
Under $15
28.1%
94%
$15-$30
23.0
94
$30-$50
19.0
94
$50-$75
13.5
93
$75-$100
7.4
93
$100-$200
6.9
90
$200-$500
1.6
78
$500-$1000
0.3
66
Above $1000
0.1
45
Overall
100.0
87
Source: CRS calculations, see text.
As this table indicates, for individuals earning under $100,000, the labor share
of income, in general, is in excess of 90%. For very high income levels the share
drops, and is only 45% for those earning more than a million. Overall, the labor
share of income is 87%.
These calculations do not take account of the fact that some income is subject
to tax at the corporate level, which means that labor income is smaller than that
reported in Table 4. There are two types of income reported on tax returns that
reflect corporate income, dividends and capital gains.8 As shown in Table 5, which
reports the distribution of financial income by type of income, capital gains are much
more concentrated in higher income levels than are dividends. For example,
although capital gains in the aggregate is 3.6 times dividends, in the $1 million
income class, gains is 7.6 times dividends. That greater concentration is likely due
to two effects, the first being that some capital gains are earned on assets other than
corporate stock, and the second that higher-income individuals are more likely to
hold riskier stocks and stocks that tend to pay out less income in dividends.
8 Pension and IRA distribution also reflect corporate source income, but do not separate
interest income from dividends and capital gains, or easily permit a separation of principal
from return.

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Table 5. Interest, Dividends, and Capital Gains by Adjusted
Gross Income Class, as a Percentage of Total Income, 2003
Adjusted Gross
Total
Income Class
Interest
Dividends
Capital Gains
Financial
($ thousands)
Income
Under $15
4.7%
0.9%
-0.5%
5.2%
$15-$30
2.6
0.6
0.2
3.4
$30-$50
1.8
0.5
0.3
2.6
$50-$75
1.8
0.6
0.6
3.0
$75-$100
1.7
0.8
1.1
3.5
$100-$200
2.0
1.2
2.7
5.9
$200-$500
2.9
2.1
8.2
13.2
$500-$1000
3.5
3.0
13.4
19.9
Above $1000
5.0
4.0
30.3
39.4
Overall
2.5
1.3
4.7
8.6
Source: CRS calculations based on the Internal Revenue Service 2003 Individual Statistics of
Income. Excludes returns with negative adjusted gross income.
Table 6 reports labor income shares by income class using the dividend
distribution and the capital gains distribution to allocate corporate source income,
with the true share likely somewhere in between. Accounting for corporate source
income decreases the share of labor income, but does so notably for the higher
income classes, and this is particularly the case when the capital gains allocation is
used.

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Table 6. Labor Share of Individual Income, by Adjusted Gross
Income Class, Including Corporate Source Income, 2003
Labor Share
Labor Share
Adjusted Gross Income
of Income,
of Income,
Share of Returns
Class ($ thousands)
Dividend
Capital Gains
Allocation
Allocation
Under $15
28.1%
90%
94%
$15-$30
23.0
92
94
$30-$50
19.0
92
94
$50-$75
13.5
91
92
$75-$100
7.4
90
92
$100-$200
6.9
85
87
$200-$500
1.6
72
71
$500-$1000
0.3
59
58
Above $1000
0.1
39
34
Overall
100.0
83
87
Source: CRS calculations, see text.
The calculation accounting for corporate income indicates that the middle class
receives over 90% of their income from labor income. Overall, labor income
accounts for less than 85%. However, for those with incomes over $1 million, labor
income is only about a third of income, and for the $500,000 to $1 million class,
about 60%.
Implications for the Distributional Effects of Tax
Reform Proposals
There are important implications in the choice of tax base in tax reform
proposals for the distribution of the tax burden across income classes. For example,
under a tax base that is confined to wage income, only a significant increase in the
progressivity of the rate structure would prevent the burden in a revenue neutral
change from being shifted away from high-income individuals. While low-income
individuals can be protected through tax relief provisions, absent a change in the rate
structure, the middle class would pay higher taxes. Keeping roughly the same
relative progressivity of the current rate structure, moving towards a wage base would
shift the burden from high- to middle-income taxpayers, whereas moving towards an
income base (that includes a more comprehensive measure of capital income) would
shift the burden from middle- to high-income taxpayers.

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Proposals to reduce taxes on capital income through, for example, reducing or
eliminating taxes on dividends, capital gains, and interest income (as in the case in
one of the tax options by the President’s advisory commission) would likely shift the
burden, other things equal, away from high-income individuals to the middle class.
The commission report shows a distributionally neutral system,9 but it is likely that
is a temporary artifact of the shift into back-loaded savings accounts (which raise
revenue on owners of assets in the short run but lower it dramatically in the long
run).10 Proposals such as S. 1111, which expand the base towards an income base,
would shift the burden away from the middle class and towards high-income
individuals.
As noted earlier, a consumption tax base is, in the long run, roughly a tax on
wages. (For those individuals who leave significant bequests, some part of wage
income is also exempted.) Consumption taxes are more likely to shift the burden in
the long run away from high-income individuals, not only because high-income
individuals over their lifetime tend to consume less of their earnings but also because
some forms of consumption taxes necessarily have a flat rate (e.g., national sales tax
and the flat tax).
The President’s advisory panel had a partially graduated consumption tax (x tax)
with a supplementary lower-rate tax on passive financial income, and reported
distributional neutrality for that proposal as well.11 That outcome, however, is due
to two reasons. The first is the effect of savings accounts that also contributed to
higher rates on owners of capital in the short run, while allowing increased sheltering
of passive financial income in the long run. A second reason is the method of
distributing a tax. A consumption tax is a tax on wage income and a lump sum tax
on old capital that is effectively collected over time as the assets are consumed. For
very-high-income individuals who indefinitely pass on assets in estates, that
consumption may never occur. If one distributed the tax on the basis of
consumption, the tax would decline as income rises despite the rate structure. The
tax was, however, distributed as if it were an income tax and thus the cash flow tax
at the firm level (which is really a lump sum tax on old capital that may or may not
be translated into an effective tax on consumption) is treated as if it is a tax on
income.
To illustrate the importance of these approaches, consider a recent study that
compared the distributional effects of an x tax with a 15% and 30% rate and a
demogrant (rebate to lower-income individuals to offset the tax) under both
9 The President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth:
Proposals to Fix America’s Tax System, November 2005, p. 136. This discrepancy also
means that the proposed tax reform is not fully revenue neutral in the long run.
10 See CRS Report RL32228, Proposed Savings Accounts: Economic and Budgetary Effects,
by Jane G. Gravelle and Maxim Shvedov for an explanation of this budget effect.
11 The President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth:
Proposals to Fix America’s Tax System, op cit., p. 175.

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approaches.12 This plan is similar in many respects to the panel’s proposal. If
distributed according to consumption, the middle quintile has a tax rate of 23.3%, the
top quintile a tax rate of 12.1% and the top 1% a tax rate of 6.1%. If distributed
according to income, the tax rate is 11.4% for the middle quintile, 22.5% for the top
quintile and 22.0% for the top 1%.
Distributing a consumption-based tax in the short run is tricky, and there is no
perfect answer because the cash flow tax is a tax that causes asset values (or their
purchasing power) to fall but does not burden new saving which can be purchased
at a discount. However, in the long run the consumption tax base tends to be similar
to a wage tax base, except that it also favors higher-income people, even in the long
run, because they are less likely to consume all of their lifetime income
12 See Leonard Burman, Jane Gravelle, and Jeff Rohaly, “Towards a More Consistent
Distributional Analysis,” Proceedings of the 2005 Conference, National Tax Association,
Washington. D.C. 2006.