Household Income Volatility and Tax Policy: Helping More and Hurting Less, Testimony Before the U.S. Joint Economic Committee

Abstract

This testimony makes three main points. First, income volatility, especially when it involves income declines, imposes significant hardships on American families. It heightens stress about finances and may increase household living expenses. These hardships are most pronounced for middle-and low-income families, whose incomes tend to be more volatile, and who tend to have less access to low-cost borrowing.

Second, currently the income tax system simultaneously helps and hurts families trying to cope with these burdens. It helps in that it softens annual income fluctuations on an after-tax basis by timing tax payments so that a larger share of a family’s income is due in taxes in its higher-income years, and smaller share in its lower-income years. It hurts because over time it imposes higher average tax rates on households with relatively volatile incomes, than it does on others whose income is the same over time but more stable.

Finally, it outlines two potential reforms to make the tax system help more and hurt less when a family’s income fluctuates. The first is a limited form of income averaging that would permit taxpayers to elect to carryback unused standard deductions and personal and dependent exemptions for one year, and to average their income over two years when calculating the Earned Income Tax Credit. The second, much broader proposal would involve converting the roughly $500 billion per year spent on tax incentives into uniform refundable tax credits. These reforms could be implemented on a revenue-neutral basis. Both would reduce the penalties that the tax system currently imposes on families with volatile incomes, and would provide relief when families need it most – when their income has fallen.

Keywords: income volatility, income fluctuations, economic security, household income shocks, tax policy, automatic stabilizers, fiscal stabilizers, fiscal stimulus, income averaging

JEL Classification: D31, D63, E24, E32, E61, E62, E63, H20, H21, H24, I38, J31, J38, J65, J68, K34