Static: Individual and Payroll
PWBM-TM uses income information from PWBMsim to subject each filing unit to the tax code. PWBM-TM calculates tax liability for each filing unit by accounting for the relevant income tax bracket, preferred tax rate, deduction, credits and the alternative minimum tax (AMT). By utilizing the associated schedules, PWBM-TM also accounts for business income/loss derived from corporate and non-corporate entities.
A tax filer’s labor income is subject to either Federal Insurance Contributions Act (FECA) or Self Employment Contributions Act (SECA)1 taxes. The tax rate applied depends on the total amount of labor income. The Social Security portion of FICA or SECA taxes is applied to income below a limit set by the IRS. PWBM forecasts this limit beyond the current tax year using PWBMsim’s estimate of the growth of nominal wages. The Medicare portion of FICA and SECA is not subject to an income limit.
A tax filer’s capital income is also subject to the requisite taxes. These taxes include the preferential rate on capital gains and dividends and the Net Investment Income Tax (NIIT). Capital income is derived from either corporate or non-corporate entities. Most corporations pay dividends or capital gains to owners net of a corporate level tax. Pass-through entities, sole proprietorship, partnerships and S corporations are not subject to an entity level tax. However, sole proprietorship and most partnership income is subject to payroll tax. Only S corporation income is subject to neither payroll nor an entity-level tax. PWBM-TM accounts for each of these tax situations.
The application of the tax rates under current law to the income projected from PWBMsim results in the baseline or current law projection. The current law projection is then adjusted as one or more proposed changes to the tax code are implemented. When changes to the tax code are considered, PWBM addresses potential behavior of tax filers.
Income Shifting due to Organizational Form
As an example, PWBM-TM is calibrated to reflect the current structure of business organization. The structure is dependent upon both the taxes faced by capital income received from both corporate and pass-through entities. As the relative difference in these taxes change, PWBM-TM applies an income-shifting elasticity to the baseline of business income. The result is a new income allocation between corporate and pass-through business form and therefore, new growth rates for corporate and pass-through income. This methodology is set forth in the literature and described in more detail here.
Proposals affecting Types of pass-through businesses
PWBM uses available data to account for changes in the tax code that affect certain industries or sectors. A recent proposal limited the types of pass-through businesses that benefit from a lower tax rate.2 PWBM uses the aggregate share of net income by industry to limit the amount of income subject to the lower rate.
In both the above cases, PWBM is limited by the available data. A tax filer’s schedule E contains aggregate amounts of pass-through income. That is, if a tax filer is in multiple businesses, the data will reveal only the total net income. It does not allow a decomposition into X net income from business A and Y income from business B. As such, the income shifted to or from corporate form cannot be properly allocated to certain businesses and certain tax filers. Therefore, PWBM allocates the income shift by shares of aggregate net income. This difficulty is also present in limiting pass-through businesses subject to certain proposed provisions. Given the absence of information on specific pass-through businesses, the income subject to the relevant provisions is limited by determining the aggregate share of net income of those businesses and then applying that share to all pass-through income.
PWBM accounts for behavior related to income reclassification. As the relative tax rates change, tax filers may be induced to not only change the organizational form of their businesses but also change their employment status and form a pass-through business to take advantage of lower tax rates. PWBM considers the effort involved in starting a business as well as the non-monetary benefits of employment in determining the amount of this income reclassification. The model randomly selects wage earners with high enough income and subsequently reclassifies the wage income. The percentage of wage earners selected increases over time. The share of wage earners reclassifying does not equal one since PWBM believes there are certain occupations and jobs that will not allow this reclassification.
The economics literature has found evidence that individuals respond to tax changes by adjusting the timing of income realization. Therefore, PWBM-TM models this behavior. PWBM-TM uses a supporting model to adjust income levels across time. The amount of income that moves across time is dependent upon the Elasticity of Taxable Income (ETI). PWBM-TM implements an elasticity in the middle of the range of estimates.3
The individual side of PWBM-TM produces two distributional measures. The first measure is the traditional distributional measure. It indicates the share of the total value of the tax change that accrues to various income groups. The second measure is the share of tax paid by certain income groups. Both measures are calculated directly as part of PWBM-TM's standard output. PWBM is equipped to provide any output that relates taxes to filing status, income group or type of income.
PWBM-TM also accounts for the associated SECA deduction. ↩
This proposal was included in the Tax Cuts and Job Act of 2017. ↩
"The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review," Emmanuel Saez, Joel Slemrod and Seth Giertz, Journal of Economic Literature 50(1), 2012, 3-50 ↩