INCOME, TAXES, AND TAX PROGRESSIVITY: AN EXAMINATION OF RECENT TRENDS IN THE

INCOME, TAXES, AND TAX PROGRESSIVITY: AN EXAMINATION OF RECENT TRENDS IN THE

DISTRIBUTION OF INDIVIDUAL INCOME AND TAXES

Tom Petska and Mike Strudler, Statistics of Income Division, Internal Revenue Service

Internal Revenue Service, P. O. Box 2608, Washington, DC 20013-2608

KEY WORDS: Income distribution; individual income tax; tax progressivity

Statistics from individual income tax returns reveal

some dramatic changes in the past 18 years. The tax reforms of 1981 and 1986 significantly lowered individual

income tax rates and, in the latter, substantially broadened

the income tax base [1]. Tax law changes effective for

1991 and 1993 initiated rising individual income tax rates

and further modifications to the definition of taxable income. In addition, two recessions have transpired, and

the U.S. economy has become more service-oriented and

global in nature. With all of these changes, a question that

arises is what has happened to the distribution of individual

income and the shares of taxes paid by various incomesize classes?

This paper is an examination of recent trends in the

distribution of individual incomes based on a consistent

measure of taxable income. The paper has four sections.

The first section briefly summarizes background information on a measure of individual income derived as a “retrospective concept” from individual income tax returns.

The second section highlights some of the more substantial changes to the Internal Revenue (Tax) Code, particularly those affecting individual income tax liabilities. The

third section examines and analyzes aggregate time series

data on individual income and taxes based on income tax

return filings with the IRS. The last section summarizes

some of the results, presents conclusions, and describes

future research plans.

A Retrospective Definition of Income

In order to analyze changes in income and taxes over

a period of years, a consistent definition of income must

be used [2]. However, the most commonly used income

concept available from Federal income tax returns, adjusted

gross income (AGI), was designed to facilitate tax administration, and its definition has changed over time to reflect modifications to the Internal Revenue Code.

The new tax laws of the 1980’s and 1990’s, including

the Economic Recovery Tax Act of 1981 (ERTA), the Tax

Reform Act of 1986 (TRA), the Revenue Reconciliation Act

of 1990 (RRA), and the Omnibus Budget and Reconciliation Act of 1993 (OBRA) made significant changes to both

the tax rate schedules and the components of AGI. These

changes made it more difficult to use AGI for accurate

intertemporal comparisons of income. For this reason, an

income definition that would be applicable over

several years was developed to allow comparisons both

before and after the major tax legislation [3].

The “1979 Income Concept” was developed to address

this problem by providing a more uniform measure of income across tax years. This “retrospective income” concept was calculated by including the same income and

deduction items in each year’s income calculation and from

items available on Federal individual income tax returns.

Tax Years 1979 through 1986 were used as base years in

identifying the income and deduction items included in

this concept. As a result, the definition of the 1979 Income Concept is consistent throughout the base years and

was used for later years to compare income by including

only income components common to all years [3,4].

The calculation of the 1979 Income Concept is shown

in Figure A. Several items partially excluded from AGI

for the base years were fully included, the largest of which

was capital gains. The full amounts of all capital gains, as

well as all dividends and unemployment compensation,

were included in the income calculation. Total pensions,

annuities, IRA distributions, and rollovers were added,

including the nontaxable portions that were excluded from

AGI. Social Security benefits were omitted because they

were not reported on tax returns until 1984. Also, any

depreciation in excess of straight-line depreciation, which

was subtracted in computing AGI, was added back [4].

The 1979 Income Concept applied to 1996 includes

many income and deduction items that are components of

AGI and also includes nontaxable (i.e., tax-exempt) amounts

of income reported on individual income tax returns, as

well as disallowed passive loss deductions. Deductions

that are subtracted in the calculation of the 1979 Income

Concept include employee business expenses, alimony

paid, and moving expenses. These same items were subtracted in computing AGI until 1987, when unreimbursed

business expenses and moving expenses were changed

from adjustments to itemized deductions. (For 1996, moving expenses were once again an adjustment to income.)

The amounts reported for moving expenses (for 1987-1993)

and employee business expenses by taxpayers who itemized deductions were also subtracted in the calculation of

the 1979 Income Concept. Taxpayers who did not itemize

deductions, however, could not claim either of these two

expenses because they were not allowed as adjustments

after 1986 (until 1994, when moving expenses were once

Figure A.--Components of the 1979 Income Concept for

Tax Year 1996

1979 Total Income Concept =

Salaries and wages1

Plus (+):

Interest1

Dividends1

Taxable refunds1

Alimony received1

Capital gains minus allowable losses reported on

Schedule Dl

Capital gains and losses not reported on Schedule D1

Other gains and losses (Form 4797)1

Business net income or loss1

Farm net income or loss1

Rent net income or loss1

Royalty net income or loss1

Partnership net income or loss1

S Corporation net income or loss1

Farm rental net income or loss1

Estate or trust net income or loss1

Unemployment compensation1

Depreciation in excess of straight-line depreciation 2

Total pension income3

Other net income or loss1

Net operating loss1

Minus (-):

Disallowed passive losses (Form 8582)4

Moving expenses1

Alimony paid1

Unreimbursed business expenses4

1

2

3

4

Included in adjusted gross income (AGI) for Tax

Year 1996.

Adjustment to add back excess depreciation (accelerated over straight-line depreciation) deducted

in the course of a trade or business and included

in net income (loss) amounts.

Includes taxable and tax-exempt pension and retirement distributions, including IRA distributions.

Not included in AGI for Tax Year 1996.

again allowed as an adjustment). For this reason, the deduction for these two expenses beginning in 1987 is not

completely comparable to that for previous years [4].

Comparison between AGI and retrospective income. -As stated, the Tax Reform Act of 1986 (TRA) made ex-

tensive changes to the calculation of AGI beginning with

1987, and these changes made necessary a revision of the

calculation of the 1979 Income Concept, in order to make

tax years beginning with 1987 comparable to the base

years, 1979 through 1986. TRA limited the deduction of

passive losses and eliminated unreimbursed employee

business expenses and moving expenses as adjustments

in figuring AGI beginning with Tax Year 1987. Since passive losses had been fully deductible for both income measures prior to 1987, the disallowed passive losses had to

be deducted in the 1979 Income Concept calculation for

tax years after 1986 [4].

Before TRA became effective, a comparison of income

measured by AGI with that measured by the 1979 Income

Concept showed significant differences at income levels

of $200,000 or more. But, with the elimination of preferential treatment of various income items by TRA, such as

the exclusion of a portion of capital gains, much of the

difference disappeared. Under tax law prior to 1987, the

capital gains exclusion accounted for the largest difference between the two income measures at the higher income levels. For 1996, the 1979 retrospective income

amount was 8.3 percent higher than income calculated using AGI. This difference was primarily attributed to the

inclusion of more than $130.6 billion in nontaxable pensions and annuities (including IRA distributions) in retrospective income.

Some limitations of the data.--The Statistics of Income

(SOI) Division of IRS produces annual studies of individual income and taxes by sampling and compiling data

from Forms 1040, U. S. Individual Income Tax Return.

Returns are selected as part of random, stratified crosssectional samples. For this study, returns are then tabulated into size classes of retrospective income, and the

percentile thresholds are estimated by interpolation [5].

While the 1979 retrospective income concept is a consistent measure for interyear income comparisons, its application in this study still has shortcomings. First, since

the data set is based on successive cross-sectional samples,

it is not a panel. In the underlying microdata, individuals

can move in and out of annual studies, as well as move

across size classes. For example, a person with a large

windfall gain could appear in the top 5-percent class in

one year, but then fall to a lower size class or even out of

the samples in other years.

It should also be noted that cash and in-kind public

assistance, as well as Earned Income Tax Credit refunds,

are all excluded from the income measure. Further, while

Federal individual income taxes are included in the database, Social Security (FICA) taxes, corporation income

taxes, and excise taxes are not. Therefore, the database is

a good measure of what it includes but does have some

limitations in content or scope.

Marginal and Average Tax Rates

Marginal tax rates for a specific individual income tax

return depend on the types and amounts of income reported

and assumptions concerning the order in which the income

is taxed. This determination is complicated by the presence of the alternative minimum tax, various tax credits,

limitations on itemized deductions, and phaseout of exemptions, all of which are not specifically addressed in

this study. However, despite these limitations, it is still of

interest to compare the highest individual marginal tax rate

and the highest marginal tax rate for capital gains to the

empirically-determined average effective tax rate, all of

which are shown in Figure B [6].

Of the three series, the average tax is clearly the lowest

and the most stable over the time period. The average tax

rate, which was computed from the retrospective income

and tax liabilities, varies between 12.5 percent and 15.1

percent over this 18-year period. The variation between

years is small despite the frequent and substantial changes

to the marginal tax rates, which are at considerably higher

levels and show substantially more change.

From an historical perspective, what is most striking

about the top individual marginal tax rate is that it was as

high as 70 percent for the highest income levels (such as

married filing joint returns with taxable income over

$215,400) for 1979 through 1981. These historically high

marginal tax rates declined substantially with the passage

of the Economic Recovery Tax Act (ERTA) in 1981, effective for Tax Year 1982, which lowered the top marginal rate

to 50 percent, where it remained through 1986. The passage of the Tax Reform Act of 1986 (TRA), the most comprehensive revision of the Internal Revenue Code since

1954, broadened the individual tax base by curtailing or

rescinding many provisions that had previously eroded

the base, while lowering the top marginal tax rate to 28

percent (once fully phased in for 1988).

The new rate structure remained in effect through Tax

Year 1990, but, beginning for Tax Year 1991, the top individual rate began to climb. For 1991, the top marginal tax

rate climbed to 31 percent, and it again increased, this time

to 39.6 percent, under the Omnibus Budget and Reconciliation Act (OBRA) beginning for 1993. The highest marginal rate for capital gains income is also shown in the

figure, since it is a key determinant of the overall effective

rate, particularly for high-income individuals who often

have substantial capital gains. Despite the high marginal

tax rates, particularly in the pre-TRA period, capital gains

have generally been taxed at significantly lower levels. In

the pre-TRA period, this was mainly attributable to the fact

that 60 percent of long-term gains could be excluded. So,

even with top marginal rates of 70 percent in the early

1980’s, the 60-percent exclusion effectively created a maximum tax rate of 28 percent (40 percent of 70 percent) [7].

When the top individual marginal tax rate was lowered to

50 percent, effective for 1982, the top capital gains rate

declined correspondingly to 20 percent (40 percent of 50

percent).

Time Series Data on Income and Taxes

This section of the paper examines the income percentile data for 1979 through 1996 with attention to the

income and tax shares by percentile and average tax rates.

The database for this study ranks individual taxpayers from

highest to lowest, by size of retrospective income annually, for the period 1979 to 1996 and groups them into income-size classes. The income-size classes were converted

Figure B.--Average and Marginal Tax Rates, 1979-1996

Tax rate (%)

80

70

60

50

Average Tax Rate

40

Top Marginal Tax Rate

30

Top Capital Gains Rate

20

10

0

1979

1981

1983

1985

1987

Years

1989

1991

1993

1995

Figure B.--Average and Marginal Tax Rates, 1979-1996

Tax rate (%)

80

70

60

50

Average Tax Rate

40

Top Marginal Tax Rate

30

Top Capital Gains Rate

20

10

0

1979

1981

1983

1985

1987

Years

1989

1991

1993

1995

to percentiles and were collapsed to: the top 1 percent; the

next 1 to 10 percent; the next 10 to 50 percent; and the

bottom 50 percent of the overall income distribution. In

addition to the numbers of individual tax returns and the

amount of retrospective income in each size class, the database includes taxes paid. Using these data, the income

and tax shares and the average taxes have all been computed for each income-size class for all years.

With this database, we sought to answer the following

questions--have changes to the tax laws or, more specifically, the tax rates, affected the distribution of individual

incomes (i.e., income shares), the shares of taxes paid by

income-size classes, and the average tax burdens or effective rates of taxation?

Income shares.--The data on income shares by incomesize class are shown in Figure C. The share of income

accounted for by the top 1 percent of the income distribution has climbed steadily from a low of 9.6 percent for

1979 to a high of 16.5 percent for 1996. While this increase is quite steady, there were some significantly large

jumps, particularly for 1986, due to a surge in capital gains

realizations after the passage, but before the implementation, of TRA. The top 1-percent share also increased for

1995 and 1996. Notable declines in the top 1-percent share

occurred in the recession years of 1981 and 1990-1991.

This pattern of an increasing share of total income is

mirrored in the 1-to-10 percent class, but to a lesser extent. For this group, the income share increased from 23.5

percent to 26.0 percent in this period. The lower incomesize classes, 10-to-50 percent and the bottom 50 percent,

both show declines in shares of total incomes over the 18-

year period. However, the 10-to-50 percent group still accounted for the largest share of income in all years.

Tax shares.--Data on tax shares by income-size groups are

shown in Figure D. The share of taxes accounted for by

the top 1-percent group also climbed steadily in this period, from initially at 19.8 percent for 1979, then declining to

a low of 17.4 percent for 1981, but then rising to a high of

31.7 percent for 1996. As for incomes, there were some

unusually large increases, particularly for 1986, but also

for 1993, the first year of the 39.6-percent marginal tax rate.

As for incomes, the tax share of the top 1-percent group

declined in recession years.

The 1-to-10 percent size class exhibited relatively little

change in the overall share of taxes paid, increasing from

30.1 percent to 30.3 percent in the 18-year period. The 10to-50 percent class and the bottom 50-percent class both

had declining shares of total taxes paid. The 10-to-50 percent class accounted for the largest share in taxes paid, but

had a decline from 43.0 percent to 33.6 percent of the total

in the 1979 to 1996 period. The bottom 50-percent class

had a decline in share of taxes paid from 7.0 percent to 4.4

percent in this period.

Effective tax rates.--Average tax rates by income-size class

are presented in Figure E. In looking at these data, what is

most striking is the progressivity of the tax system--average tax burdens increase with income-size classes in all

years, since none of the lines intersects. Clearly, the overall progressivity of the individual tax system is reaffirmed.

Average tax rates declined between 1979 and 1996 for

all income-size classes; however, the trends are not as

Figure C.--Income Shares by Income Percentiles by Year, 1979-1996

Income share (%)

55

50

45

40

35

Top 1%

30

1 to 10%

25

10 to 50%

Bottom 50%

20

15

10

5

0

1979

1981

1983

1985

1987

Years

1989

1991

1993

1995

Figure D.--Tax Shares by Income Percentiles by Year, 1979-1996

Tax share (%)

50

45

40

35

30

Top 1%

25

1 to 10%

20

10 to 50%

Bottom 50%

15

10

5

0

1979

1981

1983

1985

1987

1989

1991

1993

1995

Years

steady as those for the income and tax shares. For example, all size classes show declines in average taxes in the

pre-TRA years, but all show increases in the 1994-96 period. The top 1-percent group clearly shows the effects of

the 1986 capital gains realizations, in anticipation of the

ending of the long-term gains exclusion, which began in

1987. This brought about a substantial increase in realizations that swelled the income amounts in the highest income groups. This effect caused a significant increase in

income, taxes, and the income threshold of the top 1-percent group for 1986.

As a result of the OBRA-initiated 39.6-percent top marginal tax rate, both the average tax rate and the income tax

shares of the 1-percent group increased sharply beginning

for 1993. This was an expected result, but average tax

increases were also evident in smaller income-size classes as

well.

Conclusions and Future Research

Some conclusions can be drawn from examination of

these data. First, the income and tax shares of the top 1percent group increased substantially in this period. The

income share of the top 1-percent rose considerably from

9.6 percent to 16.5 percent of total income, while the share

of taxes paid by this group also increased significantly,

rising from 19.8 percent to 31.7 percent, an increase

Figure E.--Effective Tax Rate for Income Percentile Classes by Year, 1979-1996

Effective tax rate (%)

35

30

25

Top 1%

20

1 to 10%

10 to 50%

15

Bottom 50%

10

5

0

1979

1981

1983

1985

1987

Years

1989

1991

1993

1995

of nearly 60 percent. The income share of the 1-to-10 percent group increased modestly, from 23.5 percent to 26.0

percent of the total, but their share of taxes only increased

from 30.1 percent to 30.3 percent.

The lower income groups had very different patterns of

change over this period. The 10-to-50 percent group, while

accounting for the largest shares of both income and taxes,

had its income share decline from 50.0 percent to 43.5 percent and its tax share decline from 43.0 percent to 33.6

percent. The income share of the bottom 50 percent declined from 18.1 percent to 14.0 percent, and its tax share

declined from 7.0 percent to 4.4 percent.

Overall, average tax rates increased with income for all

years. Clearly, the average effective tax rate grew with

increases in the size of income. This is conclusive evidence of the effectiveness of tax progressivity. Between

1979 and 1996, average tax rates declined for each incomesize group; however, all income-size groups show increases

for 1994 and later years.

In summary, the upper tail of the income distribution

has increased its share of total income at the expense of the

lower percentiles. However, this rise in inequality in pretax income has been somewhat offset by the increases in

taxes paid by the top groups, particularly the top 1-percent

group in the post-OBRA period.

This study is the first of several planned to use the retrospective income-size distribution database to further

examine distributional effects. Plans are also to extend this

analysis and compare these results to those of other researchers.

Footnotes

[1] Internal Revenue Service, Explanation of the Tax Reform Act of 1986 for Individuals, Publication 920 and

the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986.

[2] See, for example, the following for discussions on

measuring economic income: Haig, Robert Murray,

“The Concept of Income — Economic and Legal Aspects,” The Federal Income Tax, Columbia University Press, 1921; Simons, Henry C., Personal Income

Taxation: The Definition of Income as a Problem of

Fiscal Policy, Chicago University Press, 1938; and

Nelson, Susan, “Family Economic Income and Other

Income Concepts Used in Analyzing Tax Reform,”

Compendium of Tax Research, 1986, Office of Tax

Analysis, U.S. Department of the Treasury, 1987.

[3] Hostetter, Susan, “Measuring Income for Developing

and Reviewing Individual Tax Law Changes: Exploration of Alternative Concepts,” 1987 Proceedings of

the American Statistical Association, Section on Survey Research Methods.

[4] See, for example, Cruciano, Therese, “Individual Income Tax Rates and Tax Shares, 1995,” Statistics of

Income (SOI) Bulletin, Spring 1998, Volume 17, Number 4; and Internal Revenue Service, Statistics of Income--Individual Income Tax Returns (selected years).

[5] Oh, H. Lock, “Osculatory Interpolations with a Monotonicity Constraint,” 1977 Proceedings of the American Statistical Association, Section on Statistical

Computing.

[6] For this paper, marginal tax rate is the top rate paid on

taxable income and is based on income tax before credits. Taxes, taxes paid, tax liabilities, tax shares, and

average or effective tax rates are based on income tax,

defined as income tax after credits plus alternative minimum tax less nonrefundable earned income credit.

[7] This does not take into account the fact that excluded

income was subject to the alternative minimum tax.

General References

Advisory Commission on Intergovernmental Relations,

Significant Features of Fiscal Federalism, Volume I, Budget Processes and Tax Systems, (selected years).

Feenberg, Daniel R. and Poterba, James M., “Income Inequality and the Incomes of High-Income Taxpayers: Evidence From Tax Returns,” Tax Policy and the Economy,

Volume 7, Cambridge: MIT Press, 1993.

Karoly, Lynn M., “Trends in Income Inequality; the Impact

of, and Implications for, Tax Policy” and Cutler, David M.,

“Comments,” in Tax Progressivity and Income Inequality,

Cambridge University Press, 1994.

Kasten, Richard; Sammartino, Frank; and Toder, Eric,

“Trends in Federal Tax Progressivity, 1980-93,” in Tax

Progressivity and Income Inequality, Cambridge University Press, 1994.

Nelson, Susan and Petska, Tom, “Partnerships, Passive

Losses, and Tax Reform,” 1989 Proceedings of the American Statistical Association, Section on Survey Research

Methods, 1990.

Nunns, James R., “Tabulations from the Treasury Tax Reform Data Base,” Compendium of Tax Research, 1986,

Office of Tax Analysis, U.S. Department of the Treasury,

1987.

Pechman, Joseph A., Federal Tax Policy, The Brookings

Institution, 1987.

Pechman, Joseph A. and Okner, Benjamin A., Who Bears

the Tax Burden? The Brookings Institution, 1974.

Slemrod, Joel and Bakija, Jon, Taxing Ourselves: A Citizen’s

Guide to the Great Debate Over Tax Reform, The MIT

Press, 1996.