Academic journal article Journal of Forensic Economics

A Statistical Analysis of Federal Income Tax Rate Stability over Time and Implications for Valuing Lifetime Earnings

Academic journal article Journal of Forensic Economics

A Statistical Analysis of Federal Income Tax Rate Stability over Time and Implications for Valuing Lifetime Earnings

Article excerpt

I. Introduction

The objectives of this paper are to: (1) estimate the relationship between federal income taxes and adjusted gross income (i.e., the tax function) over the period 1958-96; (2) evaluate the stability of that function over time; (3) evaluate the implications of tax function instability in determining the appropriate compensation for an injured party in tort, discrimination, or contract actions; and (4) demonstrate the advantages of using a function to determine potential tax liability.

The importance of federal and state income taxes on welfare and decision-making can hardly be overstated. With marginal tax rates ranging from 15 to 39.6% at the federal level and up to 12% at the state level, there is a significant influence of taxes on resource allocation. Recent research has included comparative evaluations of various alternatives to the existing federal tax system (Christensen 1995); the sensitivity of taxable income to changes in tax rates (Feldstein 1995); the effect of differential state and local tax burdens on migration rates (Hsing 1995/96); the relationship of economic growth to changes in marginal tax rates (Hakkio and Rush 1996); and the stability of tax rates over time (Kiley 1998; Burman and Gale 1998). The intertemporal stability of tax rates and of their predictability is a key focus of this paper. Specifically, the concept of the endogeneity of the tax rate in determining tax-adjusted awards is articulated; a tax function is estimated for years 1958-96; and the stability of that function is determined. The sensitivity of the tax implications of using alternative tax functions is evaluated using two hypothetical case examples.

II. Background

In assessing pecuniary losses in personal injury tort actions, some states require that lost earnings be determined on an after-tax basis so that the measure represents the true pecuniary losses to the injured person and/or his dependent survivors. Obviously, to be consistent, income taxes due on returns to the fund used to replace losses (which typically include other damage components such as the value of lost nonmarket services) should be added back. Judicial direction in other states essentially requires that the tax implications be ignored perhaps under the misguided assumption that the two-tax components are inherently offsetting.(1) These tax issues are well known and formed the basis for a special section of articles in the Journal of Forensic Economics in 1994.(2) In nonphysical injury cases (e.g., discrimination-based employment actions), not only do these adjustments need to be made, but also the amount awarded to the plaintiff should include a component to pay the taxes imposed on the award itself.(3)

The following equation can be used to calculate a tax-adjusted award, A, to replace future lost wages:

(1) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where

[k.sub.1] = tax rate on wage earnings,

[k.sub.2] = tax rate on interest earnings on award,

[k.sub.3] = tax rate on the award,

[E.sub.o] = base period value of wage earnings,

g = growth rate of wage earnings,

r = discount rate, and

n = number of years of loss.

If the applicable average tax rates on the award, interest earnings, and future wages are constant, the calculation of awards adjusted for taxes is straightforward. Unfortunately, the average tax rate is not a parameter, but a function of the level of future wages, interest earnings, and the size of award. At least conceptually, the calculation of a tax-adjusted award requires that each [k.sub.i] be specified as an endogenous variable(4) and an equation for the tax function be added to equation (1) to simultaneously determine the award and tax liability on future wages, interest, and award. This approach has been demonstrated previously (See Lewis and Bowles 1996).

III. Tax Function Estimates

Although using some sort of tax function is an effective method to account for taxes in calculating awards, there remains the question of which function to use. …

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