The Case Against Income Averaging
67 Pages Posted: 30 Jan 2006 Last revised: 10 Nov 2010
Date Written: November 9, 2010
[Note: Earlier versions of this article appeared on SSRN under the titles 'Should We Adopt William Vickrey's Cumulative Averaging Income Tax System? Progressivity and Simplicity in Tax Reform,' and 'Should We Tax Average Income? Vickrey, Equity, and Tax Design.' They have been superseded by this version.]
Should tax liability be based on annual income or on the average of a taxpayer's income earned over the space of several years (or even a lifetime)? This article assesses proposals to replace the current method of computing taxes with a system that would allow taxpayers to smooth out their income tax liabilities by offsetting high-income years with low-income years. While the usual discussion of this issue revolves around supposed horizontal inequities, I show that it is not clear that the current system generates horizontal inequities at all; and even if it does, I suggest as a normative issue that these horizontal inequities alone are not sufficiently important to justify a change in the method of computing tax liability.
Looked at from a vertical equity perspective, however, I note that income averaging targeted toward lower income earners can be a helpful way to provide relief to workers who have uneven earnings patterns. I thus endorse a very limited averaging plan that would apply to the working poor and near-poor, allowing them to reduce their federal tax liability and to avoid losing EITC benefits due to temporary swings in income.
Keywords: income averaging, cumulative averaging, averaging, Vickrey, horizontal equity, vertical equity, winner-take-all
JEL Classification: H00, H20, H24
Suggested Citation: Suggested Citation