JCT Explains Income Definition Used in Distributional Analyses

The SOI division prepares several distributional analyses tables. In most of SOI's distribution tables, tax returns are distributed according to adjusted gross income ("AGI"). AGI includes all sources of taxable money income, reduced by adjustments such as contributions to certain retirement accounts and alimony paid. However, as discussed below, AGI, a tax return concept, does not lend itself to comprehensive distributional analyses, because it does not fully reflect the taxpayer's command over economic resources, and, therefore, it creates an incomplete picture of economic well-being.

When preparing distributional analyses, the Joint Committee staff uses an income concept meant to measure economic income, not just taxable income, since economic income is the conceptually appropriate measure of economic well-being. Economic income includes the annual flow of all resources at the command of an individual and represents an individual's total well-being. However, the measurement of economic income involves some difficult issues. In general, the approach taken by the Joint Committee staff is to resolve these issues so that people in similar economic situations are treated similarly.

As a practical matter, the income concept used in distributional analyses needs to balance the goal of a measure that accurately reflects economic well-being with a measure that can be accurately constructed using available data sources. When preparing distributional analyses, the Joint Committee staff uses an income concept that starts with AGI but includes several additional sources of income which are generally easy to measure. Although theoretical ambiguities and data constraints prevent the Joint Committee staff from constructing a perfect measure of economic income, the JCT income classifier represents an attempt to come as close as possible to matching this income concept. The concept developed by the Joint Committee staff is referred to as expanded income. Expanded income is defined as follows:

Because of data limitations, the formulation of expanded income embodies significant departures from the Haig-Simons concept. For instance, it includes realized, not accrued, income from capital gains and pension benefits, and it ignores the rental value of owner-occupied housing and other durable goods. The most economically significant departure from the Haig-Simons concept is the inclusion of nominal, rather than real, capital income. Both interest income and capital gains are overstated in the presence of inflation. For example, if a taxpayer has a $1,000 savings account that pays a five percent annual interest rate, the taxpayer has $50 of nominal interest income. This nominal interest income is included in AGI and in expanded income. However, if the annual inflation rate is four percent, then the annual real interest rate is only one percent and the taxpayer's real interest income is only $10. The real interest income is equal to the $50 nominal interest income minus the $40 decline in real value of the savings account balance due to the four percent inflation.³ Similar mis-measurement occurs with respect to capital gains, because AGI and expanded income measure the difference between the nominal sales price of the asset and its nominal purchase price, with no adjustment for any inflation that occurs between the date of purchase and the date of sale. Similarly, depreciation allowances are based on original costs, with no adjustments for inflation occurring from the time of purchase, to the time the depreciation allowance is claimed.

These departures from the Haig-Simons concept mean that expanded income does not accurately reflect this broad measure of economic income. However, because expanded income starts with AGI as a base, and adds other income components not included in AGI, it is a closer approximation of economic income than AGI.

      Table 1. -- Estimated Distribution of Number of Returns by

There are also differences in the distribution of amounts of employer contributions for health plans and life insurance when using AGI as opposed to expanded income. These amounts are larger using AGI versus expanded income for income levels below $75,000 and smaller for income levels greater than $75,000. In other words, using AGI to measure income masks the fact that for some taxpayers, nominal wage earnings understate the compensation they receive for their labor because they also receive significant forms of other income, such as employer contributions for health plans and life insurance. There is a similar pattern of differences in the employer share of payroll taxes depending on whether income is measured using AGI or expanded income. Together, these discrepancies indicate that including nontaxable Social Security benefits, employer contributions for health plans and life insurance, and the employer share of payroll taxes in measures of income can significantly alter the measurement of the income distribution.

   Table 2. -- Estimated Distributions of Nontaxable Social Security

Items added to AGI

Workers' compensation. -- Workers' compensation is an insurance program that provides income replacement and medical benefits when employees are injured in the course of employment. Employers contribute to this program on behalf of their workers, and these contributions represent a portion of total compensation. The insurance value of this program is difficult to assess and the dollar value of the benefit approximately reflects the value of the program to the worker, so the Joint Committee staff includes program payments in expanded income. These payments represent the taxpayer's potential to command economic resources and the inclusion of these payments in these calculations allows for a closer approximation of economic income.

Social Security benefits. -- Social Security exhibits characteristics of both a tax-based retirement plan and a system of social welfare transfers: Social Security benefits are based on lifetime earnings in covered employment, but the relationship between payroll taxes paid on covered earnings and the benefits ultimately received varies greatly among taxpayers depending on their income and marital status. Because of the loose association between payroll taxes paid in and benefits received, and the mandatory nature of payroll taxes, Social Security contributions more closely resemble a tax than a payment to a retirement system. As a tax, it should not be treated as basis in a retirement benefit. Thus, the Joint Committee staff treats the entire Social Security benefit as part of expanded income."

Excluded income of U.S. citizens living abroad. -- For tax year 2011, U.S. citizens living abroad are entitled to exclude from gross income up to $92,900 of earned income from foreign sources, as well as a housing allowance. The amount of the housing allowance is based on employer-provided foreign housing costs. This compensation is clearly economic income, and the excluded income is incorporated in the Joint Committee staff income classifier.

Employer expenditures for health and life insurance plans and health FSA's increase the economic well-being of workers, and should therefore be included in income. However, it is not clear how the value of these expenditures should be computed for purposes of inclusion in income. If the expenditures are on commodities that the workers would otherwise have purchased themselves, they should be valued at cost divided by (1.0 - tax rate), since they are not taxed. For instance, a one dollar expenditure on health insurance would have the same value as $1.54 in wages for a worker with a 35-percent marginal tax rate who would have purchased the insurance if his or her employer did not provide health coverage. However, because these benefits are non-taxable, compensation packages will oversupply benefits relative to what workers would choose in the absence of a tax advantage. At the margin, the value of one dollar of benefits is one dollar in wages, since workers will choose to be compensated in benefits until the value of the last dollar spent on benefits is just equal to one dollar of wage income. Thus, on average, the value of benefits exceeds its cost to the worker. However, because it is not possible to know the magnitude of the excess of value over cost, and because the implicit tax paid on these benefits is not actually paid (see discussion in (1) above), these benefits are valued at cost in the income classifier.

Employer share of payroll taxes. -- The employer share of payroll taxes (contributions to FICA) are included in expanded income, as is the above-the-line deduction for 50 percent of SECA taxes. The employers' share of the FICA tax includes Old Age, Survivors, and Disability Insurance (commonly thought of as Social Security) and Hospital Insurance (Medicare, part A). This represents a significant portion of total compensation.

Items not included in expanded income

Because income is taxed only upon realization, unrealized capital gains on financial assets and on tangible assets (housing, real estate, etc.) are not reported on the tax return. Consequently, data on gain and loss accruals are not available for the individual taxpayer, and estimates of accrued wealth are imprecise. Realizations of capital income reported on the tax return, however, are included in the income classifier. As a result, the Joint Committee staff expanded income measure only partially reflects accrued wealth in each year.

The most significant of untaxed increments to wealth includes accrued capital gains and tax-deferred contributions to savings and retirement plans. Although annual changes in wealth constitute a significant part of Haig-Simons income, it is not clear that estimated valuations of accrued wealth should be incorporated in an income classifier. Estimations of the nominal value of assets are often uncertain. Moreover, the conversion of these assets into income can involve large transactions costs reducing the realized value of the asset. Additionally, the convertibility of assets at the current market value is never guaranteed.

In theory, the Joint Committee staff could impute capital gains and losses on corporate equity with corporate income information in an effort to create an accrued wealth concept. Allocating corporate profits and retained earnings to stockholders can only be done by making many assumptions about the distribution of stock ownership and then imputing corporate income based on these assumptions. Among the assumptions would be those that reflect "who" holds "what." These rules would then be applied to allocate corporate earnings among taxpayers on the tax model. For non corporate assets, imputing accrued gains and losses is even more uncertain.

It is important to note that capital gains realizations included in expanded income, a nominal income concept, mis-measures real income from capital. Gains are calculated by subtracting the nominal sales price of the asset from the nominal basis. Resource constraints prevent the Joint Committee staff from routinely obtaining acquisition information to express the basis and the sales price in constant dollars,⁴ so the resulting gain is greater than the increase in the real value of the asset. Increases in the price level are also reflected in the "capital gain."

Funds contributed to an employer-sponsored pension plan, whether by an employer or employee, are not included in the income classifier for a number of reasons. First, it is difficult to determine the value of defined-benefit pension plans, since it depends on wage growth, employee turnover, and current and future rates of interest and inflation. Second, not all employees covered by pension plans are vested; this also makes it difficult to value the economic income associated with employer-sponsored pension plans. The Joint Committee staff does not include pension contributions as income when contributed, but rather includes distributions of principal and earnings when withdrawn.⁵

Although it is generally agreed that pension contributions represent a decision to save income, such contributions are tax-deductible at the employer level and excludible at the employee level, and this tax-sheltered income is not included in reported income from wages and salaries. Information on these contributions, therefore, would have to be estimated. Employer contributions to pensions and savings plans are another element of income that must be estimated, because this information is not reported on tax returns. Further, accrued earnings on these funds represent additions to wealth that would be considered a component of Haig-Simons income. Again, this income would have to be approximated, because earnings on such funds are not reported. Further, because plans and associated earnings vary greatly, estimates of these income components are too inexact to warrant imputation.

Pension income that escapes taxation when earned is reported on the tax return of the recipient when it is distributed. Including these funds in expanded income allows the Joint Committee staff to rely on tax data. This method also ensures that company-matched funds are included in income when they are withdrawn. This information is accurate and includes accrued interest as well as employer contributions. Expanded income, therefore, captures income from pensions by ignoring contributions and including distributions.

The rental income implicit in home ownership represents considerable economic resources. Because imputed rent is not taxed, its value may exceed the dollar amount of rent on an equivalent house. In the past several years, falling real estate prices have resulted in negative estimates of the aggregate value of imputed rental income. Tax returns do not include any information about house values. As a result, it is only possible to know if a taxpayer owns a home if the taxpayer claims an itemized deduction for mortgage interest expenses or a deduction for state and local real property tax expenses, or receives a Form 1098 Information return with the amount of home mortgage interest expense paid by the taxpayer. Therefore, the Joint Committee staff has decided that too little information exists to accurately impute rental values to owner-occupants.

Adding under-reported income to the income classifier would enable the Joint Committee staff to more accurately estimate the distribution of taxes. Data limitations, however, make the imputation of this income very imprecise. Therefore, unreported income is not currently included in expanded income.

Special problem areas

² Robert M. Haig. "The Concept of Income-Economic and Legal Aspects;" The Federal Income Tax. New York: Columbia University Press, 1921, pp. 1-28; Henry Simons. Personal Income Taxation: the Definition of Income as a Problem of Fiscal Policy. Chicago: University of Chicago Press, 1938, p. 49.

³ The computation of real interest may even be more complicated. If a bond sells at premium or discount compared to its face value, the coupon payment does not even measure nominal interest income correctly. Since the taxpayer's tax return does not report whether the bond was purchased at premium or discount (nor the value of the premium or discount), it is not possible to adjust reported interest for inflation in such a case.

⁴ This is also done to maintain consistency with other income such as interest. All distributional measures use nominal dollars.

⁵ Lump-sum pension distributions are not included in the Joint Committee staff income classifier, however, because they represent one-time realizations that distort the distribution of income. Generally taxpayers receiving a lump-sum distribution roll over the distribution into an IRA. The income from lump-sum distributions is included in AGI according to distribution rules applicable to IRAs and, therefore, in expanded income.

⁶ The Joint Committee staff generally does not modify the IRS sample in distributional analyses. There are no differences in the number of returns in the sample or any return's base-year sample weight. However, taxpayers with negative AGI are classified as non-itemizers in the Statistics of Income (SOI) data. The Joint Committee staff restores the deductions and returns these taxpayers to a more accurate classification as itemizers. As a result, the total itemized deductions, by type, conducted by the Joint Committee staff will differ from the IRS published totals.