Reply to comment number 47 of What Now for "Fiscal Responsibility?"

SteveinCH wrote:

Actually B Davis, if you read the cite I linked above, you’ll find the CBO does a Vivian describes including imputed corporate taxes as well as taxes on realized capital gains in its calculations.

One can quibble with the method of imputation but it’s in the numbers.

Yes it's in the numbers but I don't think that you understand the problem that I'm describing. It's probably best done with an example. Suppose that in one year, a person earns $1,000,000 that is taxed as regular income and $500,000 that is taxed as long-term capital gains. Then, suppose that the next year that person earns the same $1,000,000 but just earns $250,000 in long-term capital gains due to a down market. Also, suppose that the regular income rate is 35% and the long-term capital gains rate is 15%. Then the estimate of taxes paid for the two years is as follows: 

year 1: 1,000,000 * 0.35 + 500,000 * 0.15 = 350,000 + 75,000 = 425,000 total tax


year 2: 1,000,000 * 0.35 + 250,000 * 0.15 = 350,000 + 37,500 = 387,500 total tax
The effective rate is the total tax divided by the income which would be: 
year 1: 425,000 / 1,500,000 = 28.3 % effective tax rate


year 2: 387,500 / 1,250,000 = 31 %   effective tax rate
Hence, the fact that a larger percentage of this person's income is now taxed as regular income (due to falling capital gains) causes their effective tax rate to rise. However, a low-wage person who has no stocks or mutual funds and therefore has no capital gains would pay the same effective tax rate in both years.

Now, suppose that a "tax cut" which does absolutely nothing was passed between these two years. Could one properly say that this do-nothing tax cut was progressive because the effective tax rate of high-wage workers went up while that of low-wage workers stayed the same? Of course not. The entire change in the effective tax rate in this case was due to the falling capital gains of the high-wage worker. In the case of the Bush tax cuts, it appears that a part of the perceived increase in progressiveness was simply due to the drop in long-term capital gains.

The above example could be made more precise. According to the 2004 instructions for the 1040, the actual tax on $1,000,000 of regular taxable income would be 324,643 (for married, filing jointly), not 350,000. In this case, the effective rate would increase from about 26.6% to 29% by my calculations. Hence, the same principle holds.

So, once again, do you concede that, without making any adjustments for the effect of the lower capital gains, the effective rates may be too flawed to estimate progressivity?