THE RELATIONSHIP BETWEEN FEDERAL AND STATE INDIVIDUAL INCOME TAX PROGRESSIVITY CHARLES E. SCOTT* & ROBERT K. TRIEST** Abstract - This study examines the extent to which states modified the progressivity of their individual income tax systems fol- lowing federal tax changes in the 1980s. Decreases in federal marginal tax rates decreased the value of the deduction for state income tax payments. This would cause an increase in effective state tax progressivity unless states modified their income tax systems to offset this effect. Using data from tax returns with adjusted gross incomes between $6,000 and $197,000, we find that there has been a decrease in statutory state income tax progressivity over this period. However, when state tax payments net of the value of the federal subsidy are analyzed, we find a sharp increase in state tax progres- sivity between 1984 and 1989. INTRODUCTION The U.S. federal and state income tax sys- tems are linked by the deductibility of state income tax payments on the federal return (for those who itemize deductions). The value of the state tax payment deduction l Loyola College, Baltimore, MD 2 12 lo-2699 **UniversEy of California-Davts, Daws, CA 95616-8578 95 on the federal return increases with in- come, since marginal tax rates and the probability of Itemizing increase with in- come. This leads to a reduction in the rate at which state tax payments, net of the value of the federal tax subsidy, increase with income. In this sense, the deductibility of state income tax payments on the fed- eral return results in a reduction in the ef- fective degree of state tax progressivity. Major changes have been made in the fed- eral income tax structure since the 1980 election. There were substantial cuts in federal marginal tax rates in both the Eco- nomic Recovery Tax Act of 1981 (ERTA) and in the Tax Reform Act of 1986 (TRA86). Major deductions have been elim- inated, personal exemptions and the stan- dard deduction have been increased, and the number of income tax brackets has de- creased from 16 to four.’ Both the reduc- tion in marginal tax rates and the de- creased incentive to itemize serve to decrease the reduction in effective state progressivity due to the federal deduction for state income tax payments. One would expect state legislatures to take this into account in setting the parameters of their income tax systems. There is con-
Transcript
THE RELATIONSHIP BETWEEN FEDERAL AND STATE INDIVIDUAL INCOME TAX PROGRESSIVITY CHARLES E. SCOTT* & ROBERT K. TRIEST**
Abstract - This study examines the extent to which states modified the progressivity of their individual income tax systems fol- lowing federal tax changes in the 1980s. Decreases in federal marginal tax rates decreased the value of the deduction for state income tax payments. This would cause an increase in effective state tax progressivity unless states modified their income tax systems to offset this effect. Using data from tax returns with adjusted gross incomes between $6,000 and $197,000, we find that there has been a decrease in statutory state income tax progressivity over this period. However, when state tax payments net of the value of the federal subsidy are analyzed, we find a sharp increase in state tax progres- sivity between 1984 and 1989.
INTRODUCTION
The U.S. federal and state income tax sys- tems are linked by the deductibility of state income tax payments on the federal return (for those who itemize deductions). The value of the state tax payment deduction
l Loyola College, Baltimore, MD 2 12 lo-2699
**UniversEy of California-Davts, Daws, CA 95616-8578
95
on the federal return increases with in- come, since marginal tax rates and the probability of Itemizing increase with in- come. This leads to a reduction in the rate at which state tax payments, net of the value of the federal tax subsidy, increase with income. In this sense, the deductibility of state income tax payments on the fed- eral return results in a reduction in the ef- fective degree of state tax progressivity.
Major changes have been made in the fed- eral income tax structure since the 1980 election. There were substantial cuts in federal marginal tax rates in both the Eco- nomic Recovery Tax Act of 1981 (ERTA) and in the Tax Reform Act of 1986 (TRA86). Major deductions have been elim- inated, personal exemptions and the stan- dard deduction have been increased, and the number of income tax brackets has de- creased from 16 to four.’ Both the reduc- tion in marginal tax rates and the de- creased incentive to itemize serve to decrease the reduction in effective state progressivity due to the federal deduction for state income tax payments.
One would expect state legislatures to take this into account in setting the parameters of their income tax systems. There is con-
slderable indirect evidence of this in the large number of states which have made changes in their income tax systems as the federal changes have taken place. The de- gree to which these states have been ac- counting for the net increase in the pro- gressivity of thieir income taxes can be investigated by exarnining the degree to which states modified their tax systems in such a ‘way as to counter the impact of the federal changes.
States can respond to federal tax changes by changing the level of revenue raised, changing the shares of total revenue raised by the available tax instruments, and by changing the structule of the tax instru- ments used. Courant and Gramlich (1990) summarize earlier research on how state and loc,al governments respond to federal tax reform. They show that the decreased federal marginal rate*; and increased stan- dard deduction resulting from TRA86 could be expected to (1) decrease state and local spending, (2) increase nondeductible state and local taxes, (3) decrease deductible state and locall taxes, and (4) decrease s:ste and local sales taxes. Nondeductible taxes became less expensive relative to de- ductible taxes when .federal marginal tax rates and the likelihood of itemization fell. Sales taxes went from being deductible to nondeductible on fecleral returns. Overall, the net cost to state taxpayers of raising an additional dollar of state tax revenue in- creased, and state spending could be ex- pected to fall.
Analyzing data through 1988, Courant and Gramlich (1990) find little evtdence that these predictions were borne out. State and local spending rose rather than de- c ined and nondeductible (by pre-TRA86 rules) taxes fell. Deductible personal taxes and sales taxes first illcreased and then re- turned to roughly their previous levels.’ However, Metcalf (1993) presents empirical evidence that estate income tax revenue as a proportion of personal income does have a statistically silgnificant response to
changes in its tax price, although state sales tax revenue as a proportion of per- sonal income does not.
States may also have responded to the .federal tax changes by altering the struc- ture of their individual tax systems. Gold (1988) reports that a number of states modified their income tax systems follow- ing TRA86 Unless there was an increase in “inequality aversion,” states would be ex- pected to restructure their tax systems in order to prevent an increase in effective progressivity as a result of ERTA and TRA86. To the extent that the decreased federal marginal tax rates make intrastate redistribution more costly, states might elect to decrease effective progressivity fol- lowing ERlA and TRA86. Unless they in- crease the share of revenue being raised by taxes less progressive than the income tax to an extent sufficient to prevent an in- crease in clverall effective progressivity (which does not appear to be the case), we would expect states to decrease the statutory (tn terms of actual state income tax payments) progressivity of their income taxes.
The relationship between federal and state Individual Income tax progressivity during the 1980s is the subject of this study. Us- ing Internal Revenue Service Statistics of In- come data and the state income tax tables, the changes in both gross and net progres- sivity of states are analyzed for the years 1979, 1984, and 1989. We find that there has been a decrease in state income tax progressivity over this period when actual state tax payments are analyzed. However, when state tax payments net of the value of the federal subsidy are analyzed, we find a sharp increase iin state tax progres- sivity between 1984 and 1989. A possible lnterpretatton of this finding is that states have only partially adjusted their tax sys- tems in response to the TRA86.
The next section of this article contains discussion of the linkages between the faed-
I lNDlVlDUAL INCOME TAX PROGRESSIVITY
era1 and state personal income tax systems. Our empirical methodology is then de- scribed, followed by a section presenting estimates of the degree to which states adjusted the progressivity of their individual income tax systems following the federal changes. The article concludes with a brief summary and discussion of our results.
THE RELATIONSHIP BETWEEN THE FED-
ERAL AND STATE PERSONAL INCOME
TAX SYSTEMS
The state and federal personal income tax systems are linked both through the de- ductibility of state tax payments on federal returns (and in some states, deductibility of federal tax payments on state returns) and through most states basing their income tax systems on some aspect of the federal tax. Many states use the federal definition of adjusted gross income, while some base their taxes on federal taxable income or tax liability. The Advisory Commission on Intergovernmental Relations (1988) pro- vides an analysis of the links between fed- eral and state tax bases and documents the effect of TRA86 on state tax revenue. Our analysis instead focuses on the deduct- ibility of state tax payments.
We define effective state tax payments as the decrease in a tax filing unit’s dispos- able income due to the state personal in- come tax (taking the structure of the fed- eral income tax as given and ignoring behavioral effects). For nonitemizers, effec- tive tax payments are identical to actual state tax payments. For itemizers, however, effective state tax payments are less than actual state tax payments due to the de- ductibility of state taxes on the federal re- turn. To calculate effective state tax pay- ments, we first determine how much higher the filing unit’s federal taxes would have been if there were no deduction for state taxes. This amount is then subtracted from actual state tax payments.
In analyzing the progressivity of state in-
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come tax systems, one can argue that it is effective rather than actual state tax pay- ments which are relevant. State legislatures presumably consider the net rather than gross cost of taxes to their constituents when making tax policy decisions. A policy- maker aiming to make effective tax rates proportional to income would most likely favor adoption of a progressive graduated rate schedule due to the deductibility of state income taxes on the federal return.
A more complicated issue is how the en- dogeneity of state tax progressivity affects the overall progressivity of the combined federal and state tax systems. Suppose states act to maintain constant effective progressivity following federal tax reforms. Following a federal reform which lowers marginal tax rates, states would then re- duce the statutory progressivity of their tax systems in order to maintain constant ef- fective progressivity. This will result in up- per income taxpayers generally having smaller state income tax payment deduc- tions on their federal returns. The progres- sivity of the federal income tax will in- crease as a result of the state changes, although the overall level of combined fed- eral and state tax progressivity may move in either direction. Thus, ignoring the re- sponse of states to federal tax reforms could bias calculations regarding the ef- fects of such reforms on overall tax pro- gressivity.
We use two different measures to examine changes in tax progressivity. The first, in- troduced by Suits (1977), is based on a comparison of the distributions of before- tax income and tax payments3 The sec- ond, introduced by Reynolds and Smolen- sky (1977), is based on a comparison of the distributions of before-tax and after-tax income. Technical definitions of the two measures are provided in the appendix.
The Reynolds-Smolensky approach is part of a tradition dating back to Dalton (1936), which views the progressivity of a
tax as synomymous with the reduction in income inequality due to the tax. Their measure is defined as the Gin1 coefficient (a measure of income inequality) associated with the before-tax distribution of income rnlnus the Gini coefficient associated with the after-tax distribution of income.4 Thus, tax systems which reduce income inequal- ity generate a positive value, while systems which increase inequality generate a nega- tive value.
The Suits measure is based on the relation- ship between cumulative distribution of taxes paid and the cumulative distribution of income. It is positive for progressive taxes and negative for regressive taxes. The Suits measure is unaffected if the share of tax liability of every individual remains the same but total tax revenue changes (Kak- wani, 1984). In contrast, i.f we start with a progressive tax system and increase the to- tal revenue raised while keeping the tax ti- ability shares fixed, the Reynolds-Smolensky measure will increase. The reason for this is that after-tax income inequality de- creases as tax Irevenue inc:reases. Although the two measures may move in opposite directions for general tax changes, they will move in the same direction for tax reforms which do not affect the amount of reve- nue raised (Formby, et al., 1990).
The Suits and Reynolds-Srnolensky mea- sures capture different notions of progres- sivity. The Suits measure can take on a large value for a tax which has little effect on the distribution of after-tax income but for which the average tax rate increases steeply with income. The Reynolds.-Smolen- sky measure will always be small for a tax system which has little effect on after-tax income inequality but may take on a large value for a tax systerr which raises a large arnount of revenue and thus has the po- tential of having a large effect on the af- ter-tax income distribution, even if the av- erage tax rate irises with income relatively slowly. Both colncepts of progressivity are
useful in analyzing actual taxes, trated bY our empirical results.
as illus-
EMPIRICAL METHODOLOGY
The primary data source for the empirical analysis is the 1984 St’atistics of Income (SOI) individual income tax file. This dataset contains information from over 70,000 in- dividual tar, returns. Since we are Inter- ested in the effect of federal tax changes on state progressivity over the 1979--1989 period, we imputed feideral and state tax payments to each record for 1979, 1984, and 1989. Due to the complexity of the imputation procedure, we analyzed only returns from married couples filing jointly and single taxpayers. VVe also omitted re- turns from taxpayers living in Washington, D.C., U.S. territories, and outside the United States. Observations with adjusted gross income (according to the 1989 defi- nition) less than $6,000 were omitted from the analysis, since only a nonrandom por- tion of those with low incomes file returns. Observations with adjusted gross income (AGI) greater than $197,000 were also omitted, since state of residence was not consistently reported for these observa- tions.’ Truncating the sample in this way will affect the particular values taken on by the progressivity measures but should have relatively little impact on changes in the measures over time. After the sample se- lection restrictions are imposed, 41,469 ob- servations remain. The 40 states with in- come taxes account for 33,632 of the observations; the number of observations per state ranges from ‘79 (Vermont) to 5,455 (California).
The distribution of real adjusted gross in- come was (assumed to be constant over the period analyzed. This is clearly incor- rect, although this assumption allows us to separate changes in progressivity due to shifts in the distribution of income from changes due to tax reforms. For 1979 and 1989, the GNP deflator was used to con- vert the 1984 income and deduction fig-
Combined state and federal 0.19 0.17 0.17 Federal 0.20 0.18 0.19 State-actual payments 0.16 0.13 0.12 State-effective payments 0.05 0.03 0.06 Federal-including high
Combined state and federal 3.33 2.85 2.72 Federal 2.83 2.42 2.27 State-actual payments 0.41 0.36 0.35 State-effective payments 0.15 0.12 0.18 Federal-including high
income returns 0.24 0.20 0.20 income returns 3.44 2.70 2.45
ures to current dollars; regional variation in inflation rates was not accounted for. The federal and state tax tables were then used to impute federal and state tax payments. A more detailed description of our meth- odology is provided in the Appendix.
EMPIRICAL RESULTS
Table 1 displays results of calculation of the Suits progressivity measure for (1) com- bined state and federal income taxes, (2) the federal individual income tax, (3) actual state tax payments, and (4) effective state tax payments for 1979, 1984, and 1989. In order to gauge the effect of omitting high income returns from the sample, we also report the value of the Suits index for the federal income tax based on an ex- panded sample which includes the high in- come returns (as well as nonstate returns and returns from the District of Columbia); these calculations are reported in the “fed- eral-including high income returns” row.
for state tax payments. Since the federal deduction for state income tax payments is deducted from both federal tax liability and effective state tax liability, considering the effective state tax payments row in con- junction with the federal income tax row in some sense leads to “double counting” of the federal deduction for state tax pay- ments. It would be possible, for example, for both federal tax progressivity and effec- tive state tax progressivity to increase over a period of time but for the progressivity of the combined federal and state tax sys- tem to decrease over this same period. The “combined state and federal” row is based on actual (rather than effective) state and federal tax payments and is not subject to the double counting problem.
The “actual state tax payments” row shows the effect on state tax progressivity of state rate and base changes but does not reflect the changing value of the fed- eral offset. The “effective state tax pay- ments” row incorporates the combined ef- fects of rate and base changes and changes in the value of the deduction for state tax payments on the federal return. In interpreting the figures in this row, one must remember that a filing unit’s effective state tax payments are calculated by sub- tracting from state tax liability the decrease in federal tax liability due to the deduction
Table 2 is similar to Table 1 but contains calculations for the Reynolds-Smolensky measure rather than the Suits index. Some of the information displayed in Tables 1 and 2 is presented in a less abstract form in Table A.1 in the Appendix, where aver- age state and federal income tax rates by pretax income decile are reported.
When returns with AGI over $197,000 are omitted from the sample, the Suits mea- sure indicates that federal individual in- come tax progressivity decreased from 1979 to 1984 (reflecting the impact of the Economic Recovery Tax Act of 1981) and then increased slightly between 1984 and 1989 (reflecting the impact of the Tax Re- form Act of 1986). When returns with AGI over $197,000 are included in the calcula- tions, the Suits index shows a much larger
99
drop in progressivity between 1979 and 1984 and no {change in progressivity be- tween 1984 and 1989. In interpreting the results for federal tax progressivity, one should keep in mind that our calculations do not incorporate the Social Security pay- roll tax which increased substantially during the 1980s.
The Suits measure for actual state income tax payments decreases by roughl’y the same magnitude as the measure for fed- eral tax payments from 1979 to 1984. However, unlike the federal case, progres- sivity of state tax payments decreases slightly between 1984 and 1989. Effective state tax payments became less progressive between 1979 and 1984, but their pro- gressivity increased sharply between 1984 and 1989. Note that,, over time, the mea- sures of statutory and effective state pro- gressivity converge due to the decreasing value of the federal subsidy.
The Reynolds-Smolensky measure produces a pattern for federal income tax progressiv- ity that differs somewhat from that gener- ated by the Suits measure. Like the Suits measure, the Reynolds-Smolensky measure indicates a decline in federal tax progressiv- ity from 1979 to 1984. However, accord- ing to the Reynolds-Smolensky measure, the federal inc:ome tax was less progressive in 1989 than it was In 1984 while the Suits measure indicates that it was more progressive. The decrease in federal pro- gressivity is especially strong when the sample includes the returns with AGI over $197,000. The reason for the difference in the patterns produced by the Suits and Reynolds-Smolensky rneasures becomes clear when one recalls the different aspects of progressivity that the two measures are capturing. The decrease in the Reynolds- Smolensky measure from 1984 to 1989 re- flects a decrease in the reduction in in- come inequality due to the federal income tax. The Suits measure increases (in the subsample omitting the high income re- turns) olver the same period, since the
share of taxes paid by upper income tax- payers’ increased. These two observations are consistent wrth each other as long as total federal tax payments declined during this period. In fact, our simulated total (within our subsample omitting the high Income returns) real federal tax payments are approximately 9 percent lower for 1989 than they are for 1984 and approxi- mately 15 percent lower than in 19’79.
Statutory state tax progressivity declines by a smaller proportion using the Reynolds- Smolensky measure than using the Suits measure. Again, the explanation seems to be a change in the level of tax revenue Our simulated total state tax revenue is ap- proximately 10 percent higher for 1989 than it is for 1979. The higher level of state tax revenue leads to potentially greater inequality reduction due 1.0 the tax.
The Suits rneasure shows a much higher level of state relative to federal tax pro- gressivity than does the Reynolds-Smolen- sky measure. The low value of the Reyn- olds-Smolensky measure for state income taxes reflects the fact that they raise con- siderably less revenue per capita than does the federal income tax. The Suits measure indicates that taxpayers with relatrvely high Incomes pay a smaller share of total reve- nue under the state systems than under the federal .6 However, even if the Suits measure was the same for the federal and state systems, the Reynolds-Smolensky measure would be lower for the state taxes than for the federal due to the lower level of revenue terns.
raised by the state sys-
By using the 1984 dstribution of pretax in- come in our progressivity calculations, we are able to isolate changes in progressivity
I INDIVIDUAL INCOME TAX PROGRESSIVITY
TABLE 3 AGGREGATE TAX PROGRESSIVITY-
SUITS MEASURE (RETURNS WITH CAPITAL GAINS EXCLUDED)
1979 1984 1989
Combined state and federal 0.19 0.16 0.16 Federal 0.20 0.17 0.17 State-actual payments 0.16 0.12 0.11 State-effective payments 0.07 0.04 0.06
in the late 1960s and continued through the 1980s (Burtless, 1990). Nominal inter- est rates were at very high levels early in the 1980s and then declined as the rate of inflation fell. This may have led to atypical changes in the level of interest income and interest payment deductions during the de- cade. Similarly, the large increase in equity prices led to an increase in accrued capital gains and probably an increase in their re- alizations. To the extent that these changes in the composition and size distribution of income were independent of tax changes, it is appropriate to control for them in measuring changes in progressivity.
However, at least some of the changes in the pretax income distribution are likely to have been induced by changes in the tax code. Capital gains realizations are often singled out as being particularly responsive to changes in the rate at which they are taxed and were subject to greater changes in their effective tax rate than were other forms of income during the 1980s. Capital gains are also potentially quite important in the progressivity calculations, since the re- moval of the preferential treatment of cap- ital gains in the 1986 Act tended to cause a disproportionate increase in the taxable income of upper income taxpayers.
The results of a fairly crude attempt at gauging the sensitivity of our progressivity estimates to the treatment of capital gains are reported in Tables 3 and 4. These are identical to Tables 1 and 2 but with tax re- turns which report capital gains realizations excluded from the calculations. The pro- gressivity estimates for 1979 vary remarka-
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TABLE 4 AGGREGATE TAX PROGRESSIVITY-
REYNOLDS-SMOLENSKY MEASURE (x 100) (RETURNS WITH CAPITAL GAINS EXCLUDED)
1979 1984 1989
Combined state and federal 3.10 2.59 2.28 Federal 2.63 2.19 1.88 State-actual payments 0.39 0.34 0.32 State-effective payments 0.17 0.12 0.17
bly little depending on whether or not re- turns with capital gains are included in the analysis.
Not surprisingly, inferences regarding the effect of the TRA86 on progressivity vary somewhat depending on whether the cal- culations include the returns with capital gains. For the subsample omitting the high income returns, the Suits measure for the federal income tax measure does not change from 1984 to 1989 when returns with capital gains are excluded (Table 3); when these returns are included (Table l), it increases. The Reynolds-Smolensky mea- sure decreases by a greater amount be- tween 1984 and 1989 when returns with gains are excluded than when those re- turns are included. Considering all of the evidence provided in Tables l-4, one would conclude that the TRA86 had little effect on the Suits index for the federal in- dividual income tax but that the Act re- sulted in a substantial drop in the value of the Reynolds-Smolensky progressivity mea- sure.
Statutory state tax progressivity decreased slightly between 1984 and 1989 according to both measures regardless of whether re- turns with capital gains are excluded or in- cluded in the calculations. Similarly, both the Suits and Reynolds-Smolensky mea- sures show an increase in effective state tax progressivrty between 1984 and 1989 both with and without capital gains in- cluded in the calculations. These findings do not appear to be at all sensitive to whether returns with capital gains are in- cluded in the calculations.
Table 5 shows the statutory and effective Suits progressivity measures broken down by states. As with the national measures, one must bear in mind that the calcula- tions are basecl only on returns with AGI between $6,000 and $197,000. Results are only shown for states with at least 1,000 observations due to possible unreliability of the progressivity calculations for states with small numbers of observations. Table 6 is similar but presents results for the Reyn- olds-Smolensky measure. These tables are based on calculations using all tax returns for each state, including those with capita gilins.
There is considerable variation in the pro- gressivity of state income tax systems. Some states whrch have income tax sys- tems which are progressive in statutory terms are actually regressive in effective terms.
We expected to find a decrease in the vari- ance of statutory progressivity across states over timle as states adjusted their tax sys- tems in iresponse to the federal changes. This occurs to some degree, although not to the extent we expected. The standard deviation of the Suits measure of statutory progressrvity over the nine states shown decreases from 0.09 in 1979 to 0.07 in 1989; the standard deviation of the Reyn- olds-Smolensky measure decreases from 0.0041 in 1979 to 0.0030 in 1989. One
reason for the relatively low degree of con- vergence is that, as noted above, states have not fully adjusted their tax systems in response to the federal changes.
Our results are generally consistent with the findings of Feenberg and Rosen (1985), who study the change in the structure of state tax systems between 1977 and 1983. Although Feenberg and Rosen do not cal- culate summary measures of tax progressiv- ity, they do construct an annual series of elasticities of state incolme tax liability with respect to income for each state. On aver- age (over states), this elasticity declines be- tween 1977 and 1983. This is consistent with our finding of dec:reased state income tax progrersivity between 1979 and 1984.
Since performing the research described in this paper, we have become aware of two related studies which measure changes in state income tax progressivity following passage of the TRA86. Berliant and Strauss (1993) analyze changes in the progressivity of state and federal income tax systems between 1985 and 1987. They conclude that state Income tax systems generally be- came less progressive between these 2 years. It is difficult to compare their results with ours, since they do not hold the dis- tribution of pretax income constant in measuring the changes in tax progressivity. There are also differences between the progressivity measures we employ and
TABLE 5 STATE TAX PROGRESSIVITY-SUITS MEASURE
STATE (Observations) - -- California (5455) Illinois (1997) Massachusetts (1 167) Michigan (1519) New Jersey (1687) New York (3250) Ohio (1716) Pennsylvania (1981) Virginia (1052)
Mean (unweighted) 0.41 0.10 0.38 0.09 0.34 0.14 Standard deviation 0.41 0.25 0.38 0.25 0.30 0.24
those used by Berliant and Strauss. How- ever, their finding of decreased state tax progressivity between 1985 and 1987 seems roughly consistent with our catcula- tions showing a decrease in statutory state income tax progressivity (measured in terms of actual rather than effective pay- ments) between 1984 and 1989.
Metcalf (1992) measures changes in state income tax progressivity between 1984 and 1989 using data from the Consumer Expenditure Survey. He presents calcula- tions of the Suits index of state income tax progressivity which are conceptually similar to our Suits index estimates of effective state tax progressivity, although his calcula- tions do not hold the pretax distribution of income fixed. Metcalf finds that effective state income tax progressivity decreased between 1984 and 1989, while we find that it increased. One possible reason for this difference is that Metcalf is using sur- vey data in which sample members report the value of their state tax payments. This is likely to lead to a large degree of mea- surement error in state income tax liability. While this would not necessarily bias Met- calf’s calculations in the direction of find- ing decreased effective tax progressivity, it would introduce a large amount of “noise” into the calculations. The noise problem would be exacerbated by the much smaller number of observations in
103
the Consumer Expenditure Survey (Metcalf uses roughly 1,600 per year) compared to the Statistics of Income data (we use over 41,000 observations). Still, the difference in findings is very disturbing and deserves fur- ther attention.
Conclusions
We find that states did adjust the statutory progressivity of their income tax systems following the federal tax changes in the 198Os, but that they did not do so to the point where effective tax progressivity was unaffected by the federal changes. There are a number of possible explanations for the incomplete nature of the adjustment. First, we should note that state tax pro- gressivity is likely to be influenced by a va- riety of factors, such as the pretax distribu- tion of income and the strength of political interest groups, which we are not control- ling for. Some of the increase in effective state tax progressivity may be a deliberate reaction to the increase in the inequality of pretax income which occurred during this period. Further research is needed to deter- mine the effect of such changes.
Even if all factors other than the federal tax structure which affect progressivity had not changed, we might still not expect to see a complete adjustment on the part of the states. State legislators may not fully recognize the impact of federal reforms on
the effective progressrvity of their tax sys- tems. Alternatively, the politicians may be constrained by an electorate which does not fully understand the relationship. An- other possibility is that the adjustment pro- cess is still underway. If this is true, then states will continue to reduce their statu- tory progressivity in the near future.
Our analysis illustrates the need for jointly analyzing the state and federal tax systems when analyzing the effect of federal tax reform on progressivity. Since statutory and effective state tax progressivity moved in opposite directlions during the 198Os, a reasonable conclusion is that the federal tax reform was at least partly responsible for the reduction in state statutory tax pro- gressivity.
Our analysis has considered only personal ini:ome taxes. However, as discussed ear- lier, in addition to inducing changes in the statutory progressivity of state income tax systems, federal tax changes rnay also in- duce changes iin the relative use of differ- ent tax instruments by state governments. One must consider the possibility of this in examining the effect of federal tax reforms on the overall level of state tax progressiv- ity.
!3oth the Suits and Reynolds-Smolensky prl3gresslvity measures were very useful in analyzing changes in tax progressivity. This suggests that discussion of the correct way to measure progressivity may be mls- guided. Indices which equate progressivity with reductions In after-tax income in- equality, such as the Reynolds-Smolensky measure, convey very different information than that contained In indices based on how the relative tax burden varies with in- come, such as the Suits measure. The two approaches to progressivity measurement complement each other and are both nec- essary for describing distributional aspects of tax systems.
EN0NOTES
We wish TV thank Steve Shefinn, participants at the NBER 1991 Summer lnstltute and a 1990 Western Fconomlc As-
soclatlon Corference session, three anonymous referees,
and the edltor for helpful comments on earlier versions of
this paper
’ AddItIonal br‘jckets are lmpllcltly created by the phaseout
of personal Ie<emptlons and certain Itemized deductlons for
taxpayers with high adlusted gross Income
’ The changes *re actually restduals from regressions (using
data from 1960- 1986) of spending and the various cate-
gories of taxes on a constant, grants and previously unallo-
cated balances, Income less federal wlthdrawals, and a
gross price deflator
’ A closely related measure was developed Independently by
Khetan and P,ddar (1976) Kakwanl (1977) also Intro-
duced a measure based on a IcomparIson of the before-tax
and tax payment dlstrlbutlons Kiefer (1984) surveys pro
gressivity measures
4 Reynolds and Smolensky actually define their measure as
the after-tax Gent minus the before-tax GInI 1 heir measure
IS negative for tax systems which reduce Ineqilallty and
posltlve for those which Increase tt Other measures based
on a comparison of the before-tax and after-lax Glni coef-
flclents includll Musgrave and Thin’s “effective progres-
sm” and the measure used by Pechman and Okner
(1974)
’ The state of rc>sldence was noi reported If 1984 AGI was
greater than 4~200,000 Some returns with ACII between
$107.000 and $200,000 accordtng to the 1989 definition
had AGI ovel $200,000 accorcling to the 1984 definition
and had to be dropped
6 Table A 1 In the Appendix Indicates that this IS true In
general, however, the Suits measure IS sensltlve to tax
shares across the enttre Income dlstrlbutlon
REFERENCES
Advisory Commission on Intergovernmental Relations.
S/gn/fmnt Features of f/sea/ Federahsm Washington, D.C
Gove1 nment Pnntlng Office, various years
--. “The Ta< Reform Act of 1986-Its Effect on Both
Federal and Stat11 Income Tax Llabllitles ” Staff Information
Report H-8, 1988
Berliant, Marcus C. and Robert P. Strauss. “State and
Federa Tax Equity Estimates Before and After the Tax Re-
form Act of 1986 ” Journal of Pohcy Analyss and Manage-
ment 12 (WlntEr 1993) 9-43
Burtless, Gary. ‘Introduction and Summary ” In 4 Future of
Lousy Jobs, edited by Gary Burtless WashIngton, D C :
Brooklngs Institution, 1990
Courant, Paul N. and Edward M. Gramlich. “The Impact
of the Tax Reform Act of 1986 on State and Local Fiscal Be-
havior ” In Do i,lxes Matter7 The impact of the T,?x Reform
Act ol 1986, eclied by Joel Slemrod Cambridge MIT Press,
1990
Dalton, Hugh. F’nnaples of Pub//c Fmance, 9th t-dltlon Lon-
don George RoLltledge and Sons, 1936
Feenberg, Daniel R. and Harvey 5. Rosen. “State Personal Income and Sales Tax Systems, 1977--1983 ” In Studjes m
IO4
I INDIVIDUAL INCOME TAX PROGRESSIVITY
State and Local Pub//c Anance, edited by Harvey Rosen Chr-
cage. Unrversrty of Chrcago Press, 1985
Formby, John P., W. James Smith, and Paul D. Thistle.
“The Average Tax Burden and the Welfare lmplrcatrons of
Global Tax Progressrvrty ” Pub//c Finance Quarterly 18 (Janu-
ary, 1990) 3-24
Gold, Steven D. “A Review of Recent State Tax Reform Ac-
trvity.” In The Unfimshed Agenda for State Tax Reform, ed-
ited by Steven D Gold WashIngton. D C National Confer-
ence of State Legislatures, 1988
Kakwani, Nanak C. “Measurement of Tax Progressrvrty An
International Comparison ” The Econom/c Journal 87 (March,
1977). 71-80
-. “On the Measurement of Tax Progressrvrty and Re-
distnbutrve Effect of Taxes wrth Applrcatrons to Honzontal
and Vertrcal Equity ” In Advances In Econometrics, edited by
R. L Basmann and G F Rhodes Greenwrch, CT JAI Press,
1984, vol. 3, pp 149-68
Khetan, C. P. and 5. P. Poddar. “Measurement of Income
Tax Progressron In a Growrng Economy The Canadian Expe-
rience.” Canadian Journal of Econom/cs 9 (November, 1976)
613-29
Kiefer, Donald W. “Drstnbutronal Tax Progressrvrty Indexes ”
NatIonal Tax Journal 37 (September, 1983) 4977513
Metcalf, Gilbert E. “Tax Exportrng, Federal Deductlbllrty,
and State Tax Structure ” Journal of PO/KY Analysfs and Man-
agement 12 (Winter, 1993). 109-126.
-. “The Lifetime Incidence of State and Local Taxes
Measunng Changes During the 1980s ” In Tax Progress/wty
and income lnequallty, edited by Joel Slemrod Cambridge
Cambridge Universrty Press, forthcomrng
Musgrave, R.A. and T. Thin. “Income Tax Progression,
1929-48 ” Journal of Polka/ Economy 56 (December
1948) 498-514
Pechman, Joseph A. and Benjamin A. Okner. Who Bears
the Tax Burden Washington, D C : Brookrngs Institution,
1980.
Reynolds, Morgan and Eugene Smolensky. “Post FISC DIS-
tnbutions of Income in 1950, 1961, and 1970 ” Pub//c h-
nance Quarterly 5 (October 1977) 419-38.
Suits, Daniel 6. “Measurement of Tax Progressrvrty ”
can Economic Review 67 (September, 1977). 747-52
APPENDIX: TAX IMPUTATION MEASURE CALCULATIONS
PROGRESSIVITY
The source of the income and deductions distribu- tion rnformation was the 1984 Statistics of Income Individual Tax Returns data set. This data set con- tains most of the information from a sample of over 70,000 federal individual income tax returns (form 1040, 1040A, or 1040EZ, and accompanyrng sched- ules). We used this data to impute both federal and state income tax payments for each filing unit in the sample (after applying selection criteria described subsequently) for 1979, 1984, and 1989. All Income
and deduction amounts were adjusted for rnflatron using the GNP deflator In calculatrng tax payments for 1979 and 1989
Due to the complexrty of the lmputatron procedure, we analyzed only returns from married couples frlrng jorntly and single taxpayers. We also omitted returns from taxpayers living In Washington, D.C , U 5 tern- tories, and outside the United States. Observations with AGI less than $6,000 were omitted from the analysis, since only a nonrandom portion of those with low incomes file returns. Observattons with AGI (by the 1989 defrnrtron) greater than $197,000 were also omitted, since state of residence was not con- sistently reported for these observations.
In imputing federal tax payments, we allowed for changes In the values of personal exemptions, the standard deduction, the earned Income tax credit, the tax treatment of socral security benefits, the tax treatment of capital gains realizations, the tax treat- ment of unemployment benefits, and tax rates and bracket Irmrts. We also allowed for changes In the following deductrons followrng TRA86: sales taxes, consumer Interest payments, medical and dental ex- penses, employee business expenses, movrng ex- penses, and charitable contnbutrons by nonitemizers. Due to lack of information on potential deductions, we assumed that frlrng units taking the standard de- duction In 1984 also did not Itemize In 1979 and 1989. Although the percentage of returns with Itemized deductions increased In the early 1980s. this was probably due to a shift in the distnbutron of income. We did allow for the possrbilrty that 1984 Itemizers might have switched to takrng the standard deduction In 1989. Since most of the com- ponents of itemized deductions are available for itemizers In the SO1 file, we were able to compute their potential itemized deductions in 1979 and 1989 and then impute their Itemization status This is important since the TRA86 made itemization less desirable In 1989 than it had been in 1984. In order to utrlrze a consistent methodology for calculatrng taxes for all three years, imputed rather than actual tax payments for 1984 were used In our progressrv- ity calculations.
The Suits measure for federal Income taxes In 1984 IS 0 165 using imputed taxes and 0.161 using actual tax payments. The Reynolds-Smolensky measure IS 0.0220 using Imputed taxes and 0.0178 using ac- tual taxes. Thus, our imputation procedure seems to be somewhat biased toward overstating progressrv- lty.
In rmputrng state tax payments, we allowed for
105
ctlanges In personal exemptions and standard de- duction amounts (which take the form of credits In some states), changes In rates and bracket limits, and changes in thie tax treatment of social security benefits, unemployment benefits, and capital gains reallzatlons We also allowed for possible differences from the federal tax treatment of the followmg de- ductions’ medical expenses, stale and local taxes, federal Income taxes, real estate taxes, sales taxes, personal property taxes, mortgage interest pay- ments, consumer Interest r)ayments, charitable con- trlbutlons, and casualty losses. IDue to data limita- tlons, we assumecl that tax:payers taking the st<lndard deductioil on their 1984 federal return did not Itemize deductions on their state return In any year. However, we allowed for the possrblllty that 1984 federal Itemizers did not Itemize on therr state reiurn. The Advisory Commission on Intergovern- mental Relations’ 5gmfmrrt Features of Fwal Feder- d//im series was the primary source of Information regarding state tax systems
Strlce both the Sutts and Reynolds-Smolensky pro- gressivlty measures require knowledge of the dtstn- bution of income, we used the sample weights avarlable in the SO1 file to construct an empirical cu- mulative dlstributlon function. We assumed the rela- ttve sample weights were not aftected by the sam- ple selection procedures; for the within-state measures, we assumed that the relative weights for obc;ervatlons wlthln each state were valtd Adjusted gross Income according to the post-l 986 defmltion, Includtng the full value of capital gains realizations, was used as the measure of before-tax income In all of the progressivlty calculations.
Average state and federal tax rates by pretax In- come decile are presented In Table A.l. Each tax rate reported is the mean (weighted using the sam- ple weights) of the #average (rather than marginal) tax rate paid by taxpayers wlthln an income decile. The Income deciles were determined using the em- plncal cumulative distribution function.
For each within-state progresstvlty measure, we first sor:ed the observations for that state by pretax In- come In ascending order. We then divided each ob- servation’s sample weight by the sum of the sample vvelghts for that state The sum of the transformed sample weights over the first n observations is then an estimate of the cumulative distribution function for pretax Income in that state evaluated at the In- come of the nth observation.
The Reynolds and Smolensky measure IS the dlffer- ence between the pretax and after-tax Glnr coeffl-
E(x) was approxlrnated by the weighted (using the transformed sample weights) mean of the sample income observations. The incomplete mean, $x f(x) c/x, was calculated for each observation by sumrning income (x) times the transformed sample weight (f(x)) over all observations with income less than or equal to that observation’s Income (x). JTF, (x) f(x) dx was similarly calculated by taking a weighted (using the transformed sample weights) sum of the incomplete means for all observations
Like the Reynolds-Smolensky measure, the Suits measure is defined in terms of a Lorenz-type curve, but one which maps the relationship between the cumulative percentage of taxes paid (vertical axls) and the cumulative percentage of Income (horizon- tal axis); this Lorenz-type curve IS often referred to the concentratbon curve of taxes with respect to irl- come (the Lorenz curve is the concentration curve of Income). The Suits measure IS equal to one minus the ratio of the area under tile tax conceniratlon curve to the area under the 45 degree line. Thus, the Suits measure IS analogolJs to the Gint coeffi- cient. The Suits measure is positive for progressive taxes (those where the concentration curve of taxes with respect to Income is concave from earlier) and negative for regresstve taxes.
z n
TABL
E A.
1 P
AVER
AGE
TAX
RAT
ES B
Y D
ECIL
E O
F PR
ETAX
IN
CO
ME
2 Fi
rst
Seco
nd
Third
Fo
urth
Fi
fth
Sixt
h Se
vent
h Ei
ghth
N
inth
- T
enth
2
Dec
ile
Dec
ile
Dec
ile
Dec
ile
Dec
ile
Dec
ile
Dec
ile
Dec
ile
Dec
ile
Dec
ile
z1
Min
imum
pr
etax
in
com
e in
6,
003
8,68
3 11
,530
14
,690
18
,220
22
,270
26
,849
32
,209
39
,221
50
,564
R
de
cile
s
Max
imum
pr
etax
in
com
e in
8,
681
11,5
30
14,6
86
18,2
20
22,2
70
26,8
47
32,2
08
39,2
20
50,5
62
196,
678
z
deci
le
2
Mea
n co
mbi
ned
stat
e an
d 19
79
3.7
6.4
8.8
10.4
12
.0
13.6
14
.8
16.0
17
.9
22.3
fede
ral
aver
age
tax
rate
19
84
1989
4.
5 5.
4 6.
8 7.
6 9.
3 8.
8 10
.6
11.8
13
.1
14.1
15
.1
16.8
(p
erce
nt)
10.0
11
.1
12.5
13
.3
13.8
15
.6
20.7
19
.7
Mea
n fe
dera
l av
erag
e 19
79
2.6
5.0
7.1
8.6
9.9
11.2
12
.2
13.2
14
.6
18.6
ta
x ra
te
(per
cent
) 19
84
4.0
5.9
7.4
8.4
9.5
10.5
11
.3
12.2
13
.6
17.2
19
89
3.0
5.0
6.7
7.8
8.7
9.8
10.3
10
.8
12.2
15
.9
Mea
n st
ate
(act
ual
paym
ents
) 19
79
1.1
1.4
1.6
1.9
2.1
2.4
2.6
2.8
3.2
3.6
aver
age
tax
rate
(p
erce
nt)
1984
1.
4 1.
6 1.
9 2.
1 2.
3 2.
6 2.
8 2.
9 3.
2 3.
5 19
89
1.6
1.8
2.0
2.3
2.5
2.7
3.0
3.1
3.4
3.7
Mea
n st
ate
(effe
ctiv
e pa
ymen
ts)
1979
1.
1 1.
4 1.
6 1.
8 2.
0 2.
2 2.
3 2.
3 2.
4 2.
3 av
erag
e ta
x ra
te
(per
cent
) 19
84
1.4
1.6
1.8
2.0
2.2
2.3
2.4
2.3
2.3
2.3
1989
1.
5 1.
8 2.
0 2.
2 2.
4 2.
6 2.
7 2.
8 2.
8 2.
8
Algebraically, the ‘Suits measure IS equal to As with the Gin! coefficient calculations, discrete an-
alogues to the Integrals were used. E(g(x)) was ap- proximated for each state by the weighted (by the
transformed sample weights) mean of imputed tax Jo
where x IS income, g(x) Is equal to tax payments, f(e) is the probablillty density function of Income, and F,(g(x)) is defined as
WY(X)) = J- I
x
,E(g(x)) o g(x) f(x) dx
payments f&(x)) was calculated for each observa- tion by summIng tax payments (g(x)) times the
transformed sample weight (f(x)) over all observa-
tions with income less than or equal to that obser-
vatlon’s Income (x). JTF,(g(x)) dF,(x) was calculated by summing F,(g(x)) times the product of Income (x) and the transformed sample weight (f(x)) divided by
