An Examination of the Tax Foundation's Tax Day Report
At the close of income tax filing season, the Tax Foundation traditionally issues a report on the average tax rate for the nation. This year the Tax Foundation claims: "....the average American will have to work 128 days to pay off his or her total tax bill this year , only earning his or her "tax freedom" on the 129th day".1 According to the Tax Foundation, "Tax Freedom Day" is two days later than it was in 1996.
In assessing the Foundation's report, the following points should be considered.
The typical American works only until January 20th or 26 minutes of an eight-hour day to pay the federal personal income tax. Because the Tax Foundation is releasing its study to coincide with the April 15 income tax filing deadline, this might lead people to think federal income taxes are the main issue. But less than one-third of the taxes counted by the Tax Foundation are federal personal income taxes. Slightly more than a third are other federal taxes such as payroll and excise taxes and corporate taxes, and the remaining third are state and local taxes. Focusing just on federal personal income taxes, the Center on Budget and Policy Priorities finds that the typical American will pay for these taxes in less than three weeks of employment in 1997.2
The Foundation's use of averages is misleading. In describing typical earnings and taxes, the Tax Foundation should use medians, not averages. The Tax Foundation determines an average tax rate for American families simply by dividing all taxes paid by the total of everyone's income. It calls this the amount of tax that the "typical family" pays, even though the proportionately larger share of taxes that the wealthy pay inflates the average and makes the taxes paid by middle-class families appear higher than they really are. For example, if four middle-income families pay $3,000, $4,000, $5,000, and $6,000, respectively, in taxes, and one very wealthy family pays $82,000 in taxes, the average tax paid by these five families is $20,000 ($100,000 in total taxes divided by five families). But four of the five families have a tax bill equaling $6,000 or less.
The vast majority of analysts would define a median income family a family for whom half of all families have higher income and half have lower income to be the "typical family" and describe the taxes paid by a such a median-income family as the taxes that typical middle-class families owe.
Using averages rather than medians overstates the income of the typical American household by 36 percent. It overstates the proportion of income the household pays in federal personal income taxes by 83 percent. When all federal taxes are considered, using averages rather than medians overstates the typical tax rate by 21 percent.
A series of other methodological problems lead the Tax Foundation to further overstate the amount of taxes Americans pay. For example, the Foundation counts as taxes Medicare premiums that are paid voluntarily to buy supplemental insurance coverage. It also counts certain intragovernmental trust fund transfers as government tax receipts, even though these transfers do not involve collection of new taxes. Counting Medicare premiums and other non-tax receipts as though they are taxes exaggerates the size of taxes. Moreover, when more people age and enroll in Medicare, this approach makes it look as though the government has raised the typical family's taxes.
The Foundation's figures also omit an important component of income, even though they count the taxes paid on that income. The income number the Foundation uses to determine average taxes does not include capital gains income, which is the profit made on the sale of assets such as stocks, bonds, or real estate. But the Tax Foundation's measure of total taxes does include the capital gains taxes paid on such profits. When the Foundation divides all taxes by all income to derive an average tax rate, the omission of capital gains from the income in the denominator of their fraction leads to an overstatement of average tax rate.
Recent tax growth primarily affects upper-income taxpayers. Federal taxes did increase from 1992 to 1996 but this increase was heavily concentrated among upper-income people. Their taxes increased because of rising corporate profits and capital gains income, as well as tax reforms adopted in the 1993 budget agreement. (The 1993 budget agreement contained no significant tax increases for the typical family.)
Taxes are likely to be lower in 1997 and subsequent years than in 1996, not higher. In addition, the Foundation's claim that taxes will be at a record level in 1997 is their own projection and is inconsistent with the evidence. The Congressional Budget Office publishes projections of federal revenues as a share of the economy that are similar to the Tax Foundation's estimates of average tax rates. CBO projects that federal revenues as a share of the economy are likely to decline from 1996 to 1997, and then will continue to decline until 2002. Reliable projections of state taxes as a share of the economy are not available, but reductions in state taxes that have been recently enacted in state legislatures around the country, as well as reductions expected to be enacted in the near future, suggest that these taxes may also be declining.
A final introductory point needs to be made. The Tax Foundation's report implies that people pay their taxes and then receive nothing back in return. The report ignores the fact that taxes flow back to Americans. Payroll taxes are a prime example; workers directly support their aged parents or grandparents by paying Social Security and Medicare taxes and will themselves receive these benefits when they retire. This example is especially notable since nearly three of every four American households that pay federal taxes pay more federal payroll tax which supports Social Security and Medicare than federal income tax.
Federal personal income taxes comprise less than one-third of all taxes
The Tax Foundation counts all federal, state, and local taxes in its calculations, and is careful to say so. But because the report is released on April 14 for April 15 newspapers, the income tax filing deadline, some readers may assume that federal income taxes are primarily at issue. In fact, less than one-third of all taxes paid by families and counted by the Tax Foundation are federal personal income taxes. Somewhat more than one-third are other federal taxes, and one-third are state and local taxes. Data from the Congressional Budget Office show that among households that pay federal taxes, 72 percent pay more in payroll taxes than in income taxes.3
The typical American will work just 26 minutes of the standard work day or until January 20th to pay federal personal income taxes. Combining personal and corporate income taxes, the typical American works until January 27th to pay all federal income taxes.
The Methodology used by the Tax Foundation significantly overstates tax levels
That Tax Foundation's methodology consistently and significantly overstates the tax levels faced by the typical American. The problems with their methodology include the following.
Using "Averages" versus using "Medians"
The Tax Foundation's claim that an average American works until May 9 to pay taxes is a colorful way of describing an average effective tax rate. The average effective tax rate the percentage of income paid in taxes nationwide is total taxes divided by total income.
In a tax system that is progressive that is, one in which higher income people pay a larger share of their income in taxes than middle- and lower-income people do an average effective tax rate gives disproportionate weight to the taxes paid by wealthy people. (See the text box for an example.) Since overall federal, state, and local taxes in the United States are progressive, this overstatement distorts the picture of taxes paid by typical Americans.4
A sounder approach is to use the median, the point at which half the population has higher household income and half lower. Use of the average tax rate rather than the median tax rate overstates the effective federal tax rate for a typical American by one-fifth. The average effective federal tax rate is 21.4 percent; the federal tax rate for the median household, however, is 17.7 percent.
The problems created by using the average effective tax rate rather than the median is further underscored when one considers capital gains and corporate profits taxes. The Tax Foundation's methodology wrongly suggests that a taxpayer with income of $30,000 has the same share of its income consumed by capital gains and corporate taxes as a taxpayer with income of $1 million. But the receipt of capital gains income profits derived from the sale of assets such as stocks, bonds, and real estate is disproportionately concentrated at the top of the income distribution. Households with incomes in excess of $100,000 receive approximately three-quarters of all capital gains income and, because they are subject to higher tax rates than lower-income taxpayers, pay considerably more than three-quarters of all capital gains taxes. Similarly, most economists believe that owners of corporations bear a disproportionate share of the federal tax on corporate profits. Such ownership also is concentrated among higher-income taxpayers. When the Tax Foundation computes an average tax rate, however, the distinctions among types of taxes and the types of taxpayers that pay them are lost.
The Average American versus The Typical American
Consider a hypothetical example: four families with $25,000 in income each pay $5,000 (or 20 percent of income) in local, state, and federal taxes, and one wealthy family with $500,000 in income pays $180,000 (or 36 percent of income) in taxes. The average income of those five families is $120,000 total income of $600,000 divided by five families. The average tax rate for these five families is 33 percent total income of $600,000 divided by total taxes of $200,000.
Yet four of these five families have incomes of $25,000 rather than $120,000. Those four families pay 20 percent of their income in taxes, not 33 percent. In what sense is a family income of $120,000 or a 33 percent tax rate typical?
Those who use the average tax rate instead of the median tax rate, such as the Tax Foundation, violate the standard approach that most analysts use and thereby exaggerate the proportion of income the typical family pays in taxes. In the example cited here, the median family the family that falls in the middle, with half of the families earning more income and half earning less pays 20 percent of its income in taxes, not 33 percent.
Counting Medicare premiums and other items as taxes
The Tax Foundation relies on Commerce Department data that include as government receipts two large items (among others) that are not tax revenues. The effect is to overstate the amount of taxes that are paid.
The Commerce data include as revenue the premiums that most elderly people choose to pay to purchase Medicare Part B (physician insurance) from the government. This is no more a tax than any other voluntary purchase, and neither CBO nor OMB treats the income from these premiums as tax revenue.
The Commerce data also includes as a government receipt the amounts transferred from the Treasury to the Civil Service and Military Retirement Trust Funds. This intra-governmental transfer is a bookkeeping device, not a tax. Neither CBO nor OMB treats it as a tax.
Counting capital gains taxes but not capital gains income
The data used by the Tax Foundation does not include the capital gains income received from the sale of assets. The Foundation does, however, count the taxes paid on these capital gains as part of its measure of overall taxes. The net effect is to overstate the share of income paid in taxes. An example shows why.
Take the example of a family whose income equals $200,000, which includes $20,000 in capital gains realization. Assume the family's total tax bill, including its capital gains taxes, come to $60,000.
If both capital gains income and taxes are considered, this family would be shown to pay 30 percent of its income in taxes ($60,000 divided by $200,000).
By contrast, under the Foundation's approach, which includes capital gains taxes but not capital gains incomes, its tax burden would be calculated as 33.3 percent ($60,000 divided by $180,000).
How Long Does it Take for the Typical Family to pay Taxes?
Returning to the Foundation's central finding that the average American will have to work until May 9 to pay all of its taxes, what would the number be if all of the above corrections were made?
The Center was able to estimate the size of some of the corrections for federal taxes. For example, if the Foundation had used the federal taxes paid by the median family instead of average taxes paid, this would reduce their estimate for federal taxes by one-fifth. The reduction for federal taxes would be larger if one could account for effects such as counting capital gains taxes but not capital gains realizations.
The Center was unable to estimate the corrections for state and local taxes due to the lack of reliable, current data. Actual data for state and local tax collections is available only through 1993. (See discussion below.)
Nevertheless, the net effect of the corrections is clear. The Tax Foundation's methodology serves to overstate the amount of taxes paid by the typical household.
Are Taxes on the Typical American at a Record Level, and Rising?
The Tax Foundation report claims that the combined level of taxes has risen to an all-time high in 1997. To assess this claim, it is necessary to examine tax trends through 1996 as well as expected trends from 1997 onwards.
Trends through 1996
Although the "average" share of income paid in federal taxes did rise from 1992 to 1996, it did not reach the highest level on record.5 Moreover, these average figures obscure which families are paying higher federal taxes. The increase in federal taxes from 1992 to 1996 was disproportionately concentrated among higher income families, for three reasons.
First, estimates suggest that capital gains income grew twice as fast as national income over this period, reflecting the sharp rise in stock prices. As noted, high-income households receive a disproportionately large share of capital gains income, and thus pay a larger share in capital gains taxes. The rise in capital gains income has meant an increase in taxes paid by these wealthier taxpayers. This has little effect, however, on the taxes of "typical Americans."
Second, corporate profits and hence corporate income tax collections also increased at an especially sharp rate from 1992 to 1996. Corporate tax receipts rose twice as fast as receipts of all federal taxes. Since the ownership of companies is concentrated among high-income households, the increase in corporate taxes was also felt more by high-income taxpayers than the typical taxpayer.
Third, some federal tax increases were part of the 1993 budget agreement that has substantially reduced the federal deficit. These increases, too, were very heavily concentrated among upper-income households. When the budget agreement was enacted, CBO estimated that 90 percent of the tax increases would fall on the wealthiest five percent of taxpayers. At the same time, the budget agreement lowered federal taxes on a large number of low- and moderate- income taxpayers because it included an expansion in the Earned Income Tax Credit.
In short, the increase in federal taxes between 1992 and 1996 has had significantly less of an effect on middle-class taxpayers. Upper-income taxpayers have paid more in taxes, but bear in mind that these taxpayers have also been the primary recipients of the gains in income.
Trends at the state and local level are more difficult to discern. Census data on state and local taxes the only reliable, comprehensive source of such data are current only through state fiscal year 1993. The Tax Foundation's estimates for later years, which show that the share of income going to state and local taxes has increased, suffer from the following problems.
For 1994 through 1996, the Foundation relies on state and local tax data from the National Income and Product Account. NIPA's data are projections based on the 1993 Census data and thus represent estimates rather than actual figures.
As explained in more detail below, the Tax Foundation then makes its own estimate of 1997 tax levels; the extent to which that estimate incorporates the effect of state tax reductions in recent years is unclear.
The data source for state and local taxes used by the Tax Foundation suffers from some of the problems described in relation to federal tax such as the counting of non-tax revenues such as intragovernmental transfers for pension contributions.
Taxes will likely fall in 1997 and in subsequent years
The Tax Foundation report indicates that taxes in 1997 are at an all-time high. This projection by the Tax Foundation is inconsistent with other sources of information.
The Congressional Budget Office projects that fiscal year 1997 will mark the first year of a several-year decline in federal taxes as a share of the economy, a measure very similar to the Tax Foundation's average tax rate measure. According to CBO, federal taxes as a share of national income equaled 19.4 percent in 1996 but are projected to fall to 19.2 percent in 1997. This decline will continue until 2002, when CBO projects federal taxes will equal 18.8 percent of national income. This percentage is projected to remain stable through 2007, the last year for which CBO has made a projection. These CBO projections do not assume any new changes in federal tax law.6
At the state level, taxes are also likely to fall in future years. In 1995 and 1996, some 16 states enacted significant reductions in state income taxes; these reductions have not yet all been fully implemented and so are not reflected in tax collection statistics. More of these reductions will take effect in 1997. In addition, several states have enacted tax cuts in 1997 legislative sessions and others are considering similar actions.
Food, Shelter and Housing
Another Tax Foundation claim is that Americans will pay more in total taxes than they will for food, clothing and housing combined.
This claim by the Foundation is further illustration of the problem with using aggregate figures. Even if the aggregate statement is accurate that taxes overall do exceed overall spending on food, clothing and housing it tells us little about the relationship between taxes and spending for families at different income levels. It is no doubt true that upper-income families pay more in taxes than they do for basic necessities. At the same time, it also true that low- and moderate-income families pay less in taxes than for basic necessities, in part because these necessities consume most of their income. The family income level at which taxes typically exceed spending on food, clothing and housing is unclear, and the Foundation's report does not help answer this question.
Americans are spending a smaller proportion of their incomes on food, clothing, and housing than they used to, but that is not because they are paying more in taxes.
Since 1970 the average effective federal tax rate has changed little.
In contrast, since 1970 the share of after-tax consumption expenditures devoted to food, shelter, and clothing has shrunk significantly. In 1970, some 44 percent of after-tax expenditures went for those three necessities. But by 1996, that figure had declined to less than 36 percent. The relative cost of food accounted for all of the decline.
Basically, since 1970 the share of income that families pay on average in taxes has risen only slightly. To a noticeably greater extent, the share of income that goes for food has shrunk. As a result, a larger share of Americans' income is now available for other purposes vacations, education, medical care, home computers, washer/dryers, and so on.
In short, the Tax Foundation has managed to take the trend toward relatively less costly food and has portrayed it in a way that misleadingly places emphasis on tax payments rather than on changing consumption patterns.
Where Do the Taxes Go?
The Tax Foundation does not mention that taxes paid to federal, state, and local governments are paid back to Americans. By defining "Tax Freedom Day" as the time a taxpayer "can begin working for himself," the Foundation implies that the typical American gets nothing in return. This implication is repeated by others who use Tax Foundation material. For example, the Washington Times' lead editorial on April 15, 1996 opened, "Another day, another two hours and 47 minutes shot working for the government."
It is worth remembering that payroll taxes pay for the Social Security checks and health insurance coverage under Medicare for our parents and grandparents. Local, state, and federal taxes pay for schools, roads, parks, police officers, firefighters, and air traffic controllers. Federal taxes pay for the defense of our freedom, and more prosaically for clean food, air, and water. They insure bank deposits up to $100,000, preventing the sort of depositors' panic that helped turn the 1929 stock market crash into the Great Depression. They also cover programs that provide some support if, for example, a person suffers a permanently disabling accident or other misfortunes of life: unemployment insurance, disability benefits, Medicaid, federal assistance following natural disasters, and so on. While many Americans may never need these programs themselves, many have family members who will need them at some point. These programs provide partial insurance against physical or financial disaster, and exist because the private sector does not offer that insurance. To some degree, taxes are much like the premiums paid for fire or automobile insurance; the insurance can be worth buying even if an individual does not need to collect on it.
Finally, the increase in federal taxes collected from 1993 to 1996 (which, as noted, was heavily concentrated among higher-income people) served an important purpose. This revenue helped contribute to a decline in the federal deficit, a positive development for virtually all Americans that is reflected in low interest rates, low inflation, and sustained economic growth.
Appendix: Notes on Data and Methodology
The Center made an independent calculation of the date to which the typical American would have to work to pay federal income taxes. For both the Center's calculation and the Tax Foundation's calculation, this involved determining the tax rate paid by the "typical" American (defined differently by the Center and the Tax Foundation) and then converting that tax rate into a number of days in the year or number of hours in a day. For example, if the tax rate of a typical taxpayer were 10 percent, then taxes would be fully paid 37 days into the year (365 days times 10 percent) or 48 minutes into the day (480 minutes in an eight hour day times 10 percent).
The Center's analysis of federal tax rates paid by the typical American involved several steps. The first step was to calculate the nation's effective federal tax rate. To find that rate, one divides the total taxes collected by the federal government by the total income earned in the nation. The measurement of total income used is Net National Product, the same measure used by the Tax Foundation. As mentioned in the text, this measure does not incorporate capital gains realizations, and thus leads to some degree of overstatement of the effective tax rate.
Historical data on total federal taxes come from the Budget of the United States Government. To calculate total federal taxes, it is necessary to subtract Federal Reserve deposits and fines neither of which are taxes from total federal revenues. Unlike the data used by the Tax Foundation, the accounting methods used in the Budget do not include Medicare premiums or government contributions to employee retirement funds in total revenue. The most recent data available is for federal fiscal year 1996. To obtain estimates for 1997, NNP and federal taxes were assumed to grow at the same rates by which the Congressional Budget Office estimates GDP and total federal revenues will grow between fiscal year 1996 and 1997.
Discussion of tax rates for median income families uses the most recent set of tables from CBO showing household income and federal taxes by income quintile. The measurement of total income used in this analysis was distributed to quintiles in the proportions shown in the CBO tables. Since CBO does not calculate medians, figures given as medians in this analysis are actually averages for the middle quintile as defined by CBO. Averages for the middle quintile are likely to overstate the median by a slight margin.
1. Tax Foundation News Release, April 14, 1997.
2. This estimate does not include the effects of corporate income taxes. Combining personal and corporate income taxes, the typical American works until January 27th to pay all federal income taxes.
3. The CBO data include both the employer and employee share of the payroll tax, as do the Tax Foundation data.
4. State taxes are typically regressive consuming a larger share of the income of lower and middle-class families than of high-income families so the Tax Foundation methodology understates the state taxes paid by the typical family. The degree of the understatement, however, is less than the degree of the overstatement in federal tax payments. The progressivity within the larger amount of federal taxes collected more than offsets the regressivity of the state system.
5. Federal taxes as a share of income were higher both in 1981 and in 1969.
6. Congressional Budget Office, "Preliminary Analysis of the President's Budgetary Proposals for Fiscal Year 1998", March 3, 1997.