The Flexibility of Income-Tax Yield Under Averaging

Abstract

AVERAGING of income for tax purposes has been proposed from time to time as a means of (i) improving equity of burden distribution, (2) protecting incentives from impact of progressive rates on fruits of successful activity, (3) simplifying administration and compliance by waiving questions as to timing of income and deduction items, and (4) laying groundwork for a more effective approach to capital-gain-and-loss problem. In a recent article in this Journal William Vickrey finds new merit in at least one family of averaging devices-his own cumulative averaging scheme-and, to a lesser degree, in Simons-Groves five-year fixed-period average. Vickrey's analysis indicates that under certain conditions yield of individual income tax under a given schedule of rates will be more sensitive to income changes under averaging than on an annual accounting period basis. This is stated to be contrary to prevalent notions that averaging would impair cyclical sensitivity of income tax and so increase difficulty of coping with booms and depressions by fiscal means. Actually, Vickrey's counterdemonstration largely consists of attacking a straw man, since it is generally recognized that individual income tax possesses substantial built-in flexibility of yield in response to income variations which would be increased automatically by certain types of averaging devices.3 The fiscal-policy case against income-tax averaging rests on reduced effectiveness of rate changes, which Vickrey concedes. As an offset to reduced effectiveness of rate increases designed to curb inflation, Vickrey states that the greater equity attained under averaging will permit more drastic rate increases to be made in times of boom or threatened The weakness in this position is that averaging would result in a shift of burden to fixed-income recipients, who already constitute a major obstacle to adequate tax increases in time of inflation. Thus, implicit taxation of income increases during war, through imposition of higher rates than would have been feasible or acceptable in absence of widespread income increases, was limited as much by intolerable strain on fixedincome recipients as by production and incentive considerations. Of course, averaging in effect makes rate reductions in low-income years retroactive to high-income years and so enhances revenue cut for a given rate decrease. But this is not a persuasive consideration. It is easy enough to reduce taxes. Whatever difficulties are involved relate to political process of allocating decrease, and these would be greater under averaging, with its retroactive features, than on an annual basis. Moreover, decrease can be distributed more effectively and certainly on an annual basis.