Progressivity and Potential Income: Measuring the Effect of Changing Work Patterns on Income Tax Progressivity

Abstract:     
The income tax taxes the proceeds from market work, but not the proceeds from time otherwise allocated - whether enjoyed as self-provided goods and services or leisure time per se. A two-earner couple that out-sources household and child care services, for instance, pays for these services with after tax earnings, while a single-earner couple that self-provides such services pays no tax on their provision. This article uses data from the Panel Study of Income Dynamics to measure the distributive impact of the implicit exclusion for non-market activity. Viewing the exclusion as a kind of tax benefit, it asks: how is such tax benefit distributed across the income spectrum? The article finds that variation across income levels in the labor-income realization ratio - the portion of potential labor income that is realized as actual labor income - has played a decisive role in shaping the real progressivity of the Federal income tax. On paper, the Federal income tax became more progressive during the 1990s. When average tax rates are measured in terms of potential rather than actual income, however, the income tax shows a decline in progressivity during that decade. The discrepancy arises from a change in work patterns. At the start of the decade, tax units with higher income were realizing a greater proportion of their potential earnings than were tax units with lower income. By the end of the decade, the realization ratio was greater at the lower end of the potential income spectrum. This reversal in labor income realization patterns was substantial enough to overpower the increase in statutory progressivity.

Keywords: Income taxation, progressivity, endowment taxation, work patterns, potential income, tax incidence, redistribution

JEL Classifications: C42, D1, D3, D63, H, H2, H22, H23, H24

Accepted Paper Series