INCOME AVERAGING: 

EVIDENCE ON BENEFITS AND UTILIZATION 

Eugene Steuerle 

U.S. Treasury Department 

Richard McHugh

University of Missouri--Columbia 

Emil Sunley 

U.S. Treasury Department 

OTA Paper 24 August 1977 

Office of Tax Analysis

U.S. Treasury Department, Room 1104 

Washington, D.C. 20220 

Issued: August 1977 
TABLE OF CONTENTS 

Page 

Abstract ................... 

Income Averaging -- Evidence on Benefits and 

Utilization. ................. I. Background .................. 11. The Panel Study of Federal ,Individual Income / 

TaxFilers . ................. 111. Characteristics of Averagers ......... IV. Proposals to Amend the Current Law ...... V. Interaction With Other Tax and Non-tax 

Parameters .................. VI. Conclusion -- Alternative Approaches to 

Income Averaging Reform ........... Foqtnotes ................ Bibliography ................ 

-i1 

3 

5 

9 

26 

29 

35 

40 

42 
ABSTRACT 

In 1964, the Congress passed an income averaging law to 

alleviate the burden which a progressive income tax places on 

taxpayers with fluctuating incomes. Using a panel file of 

U.S. Treasury Income Tax Return data, the authors find that 

the benefits of this law have not accrued to the targeted 

population and also that new sources of inequity have been 

introduced by the law. 
-1-

INCOME AVERAGING -- EVIDENCE ON BENEFITS AND UTILIZATION 

Under a progressive income tax, taxpayers with 

fluctuating incomes are subject to relatively higher tax 

rates than are those with more stable incomes of equal 

size.l/ - To alleviate the added burden placed on those with

greater fluctuations, Congress passed in 1964, and amended in 

1969, an income-averaging law which grants tax relief to a 

limited number of filers. 

Since its introduction into the tax laws, averaging has 

been increasingly utilized by larger and larger percentages 

of taxpayers. Yet despite the growing importance of its use, 

literature on the subject of averaging has remained sparse, 

primarily because of the lack of available data to study 

averagers. The few studies that do exist often suggest 

improvements and alterations in the law, yet the effect of 

such changes on the number and characteristics of filers is 

seldom provided. 

A five-year panel study of U.S. income tax returns now 

provides data appropriate to generate evidence on 
-2-

characteristics of taxpayers that utilize this 

income-averaging option. This paper examines the extent to 

which benefits of the existing income-averaging law, and some 

commonly proposed amendments to the law, accrue to various 

categories of beneficiaries, especially those with 

substantial fluctuations in income. 

In Section 1 the current law is described and data are 

provided on the increase in the number of taxpayers electing 

income-averaging over time. Section 2 contains a brief 

description of the five year panel study, notes some of its 

limitations, and provides summary statistics on 

characteristics of members of the sample. Section 3 examines 

in detail the characteristics of averagers, qualified 

nonelectors, and other non-averagers, with particular 

attention to characteristics of averagers in years subsequent 

to averaging and to growth rates of the various components of 

income for avesagers. Section 4 details the impact of two 

proposed changes in the income-averaging law -- the inclusion 

of downside as well as upside averaging, and the elimination 

of any minimum amount of averagable income -- upon the number 

of persons eligible to average. Section 5 examines the 
-3-

impact on eligibility for income-averaging of other tax and 

non-tax parameters such as inflation and the relationship of 

taxable income to economic income. Finally, Section 6 

discusses whether or not the limitations of the current 

income-averaging law can be eliminated without adding further 

complexity to the Internal Revenue Code. 

Ia Background 

In 1964 Congress adopted the first broad 

income-averaging provision applicable to income from most 

sources. Essentially, this provision allowed lower marginal 

tax rates to apply to a portion of this years income in 

excess of prior years' income. Specifically, "averagable 

income'Ir or income eligible for averaging, was defined to 

equal the portion of current adjusted taxable income which 

exceeded average base period income, while average base 

period income was defined as 133 percent of average adjusted 

taxable income in the previous four years. Averagable income 

was also required to be $3,000 or greater. Total tax 

equalled tax on average base period income plus the tax on 

averagable income. The tax on averagable income was then 
-4-

computed by finding the tax on average base period income 

plus one-fifth of "averagable income", subtracting the tax on 

average base period income, and multiplying that result by 

five. In effect, the tax brackets were made five times as 

wide for averagable income. 

The Tax Reform Act of 1969 further liberalized the 

provisions for income averaging by lowering the floor for 

non-averagable income, i.e. average base period income, from 

133 percent to 120 percent of average taxable income for the 

previous four years and by permitting long-term capital gains 

to be included in income eligible for averaging. 2/ 

The combined effect of the 1964 law and the 1969 

amendments was to allow averaging for growth in income 

without distinction as to source of income and to apply a 

common five year period to the averaging of income. Prior to 

1964, relief was allowed only for certain types of income 

attributable to efforts made prior to the current tax year. 

For instance, in the case of inventions or artistic work, the 

income could be spread back to the period over which the work 

was performed. 
-5-

Table 1 presents data on the use of the income averaging 

provisions from 1964 to 1974. 

Since the introduction of an averaging provision in 

1964, there has been a substantial increase in the proportion 

of all filers utilizing these provisions. This proportion 

has grown eight-fold in eleven years and reached 3.29% by 

1974. As might be expected, the largest increase occured in 

1970, the first year in which the amendments in the 1969 Tax 

Act became fully effective. However, other prominent 

increases came in recent years even with no changes in the 

law. This growth in the use of the averaging provision over 

time may be attributed to several factors, primarily growth 

in nominal income and greater knowledge and familiarity with 

the law. The particular impact which growth of income has on 

the use of income averaging will be discussed in the text of 

this paper. 

11. The Panel Study of Federal Individual Income Tax Filers 

TO analyze the characteristics of income tax averagers, 

this study used the Treasury Panel Study of Income Tax 
Table 1 

Returns Electing Income Averaging, 1964-1973 

: Percentage : 

: Growth from : Percent : Adjusted : : Average 

: Number of Previous : of All Gross Tax Tax 

Year Returns 

(Thousands) 

Year : Returns : Income 

(.....% .....) (...%. ..) ($ Millions) 

: Savings : 

($ Millions) 

Savings 

(...$. ..) 

1964 246 

1965 306 

1966 382 

1967 442 

1968 528 

1969 593 

1970 1,006 

1971 1,191 

1972 1,383 

1973 2,174 

1974 2,745 

- 0.38% $ 7,218 $133 $539 

+24.4 0.45 9,670 171 558 

+24.8 0.54 12,505 210 550 

+15.7 0.74 15,065 253 572 

+19.5 0.72 17,490 291 552 

+12.3 0.78 18,960 294 495 I 

QI

I 

+69.6 1.35 31,464 536 533 

+18.4 1.60 39,138 681 572 

+16.1 1.78 47,023 897 649 

+57.2 2.69 70,131 1,418 652 

+26.3 3.29 89,340 1,710 622 

Office of the Secretary of the Treasury March, 1977 

Office of Tax Analysis 

Source: Statistics of Income 
-7-

Filers. This panel represents a 1 in 5,000 sample of all 

individual tax returns for the years 1967 through 1971. The 

panel was chosen by the last four digits of individuals' 

Social Security Numbers and the number of returns filed 

remains fairly constant at about 14,500. 

Since this study compares the effect of various 

averaging provisions on the number of taxpayers eligible to 

average, it is first necessary to limit the sample to the 

approximately 10,000 filers for whom taxable income in all 

five years is known. Unfortunately, it is impossible to know 

the reasons for which the remaining filers drop from the 

sample in any given year. It may be due to death, to 

retirement, to family reorganizations,3/ - or merely to

inability to trace the principal filer on tax records from 

year to year. However, note that non-liability for taxes 

will not necessarily remove someone from the panel file, 

since, as long as some tax is withheld during any portion Of 

the year, a tax return will usually be filed. 

Two further restrictions in the sample are sometimes 

necessary. Since it is impossible to trace the portion of 
-8-

taxable income attributable to the principle filer, it is 

also impossible to determine eligibility for a filer with a 

change in marital status. 8,338 records had no change in 

filing status over the five years. Secondly, whenever the 

subsample of eligible filers is to be examined, the sample 

file is further reduced by eliminating filers under the age 

of 25 with less than $3,000 in taxable income in any year. 

This age and income limitation serves as a proxy for the 

support test in the current law. A/ 

Statistics reported in this paper will therefore be 

based upon various subsamples of thq original sample, e.g. a 

subsample of returns with no change in marital status who 

were present in the file for all five years, and who met a 

proxy for the support test in the current law. The 

subsamples cannot be considered as purely representative of 

the population as a whole, and therefore no estimates 

reported here will be stated as population estimates. 

Nonetheless, a large portion of the population sample is 

represented in the data comparisons, and the characteristics 

of the subsamples (especially in relationship to income 

averaging) should depict similar characteristics in the 

population. 
111. Characteristics of Averagers 

The intent of the income averaging law is to correct for 

the inequities created by progressive taxation of fluctuating 

incomes: it is not meant to introduce any new inequities. 

New inequity, however, can be created when the benefits of 

income averaging are not received by the targeted population, 

or when differential patterns of utilization tend to provide 

varying benefits to individuals otherwise equally qualified 

to average. 

This section will detail the characteristics of 

averagers, those eligible but not electing to average, and 

other nonaveragers. Eligibility is determined by use of the 

income eligibility requirement of current law, I/ by 

satisfaction of the proxy for the support test, and by the 

requirement that tax savings from averaging be greater than 

zero. -6/ 

Table 2 illustrates the characteristics -7/ of all income 

averagers in the sample over the years 1967 to 1971. 
-10-

Table 2 

Characteristics of Averagers 

in the Panel File 

. 

: 1967 : 1968 : 1969 : 1970 : 1971 

Number of Averagers 84 107 111 198 231 

Percent of Total Sample 0.60% 0.73% 0.75% 1.35% 1.56% 

Average Amwunt of Tax $ 747 $ 631 $ 319 $ 588 $ 501

Savings 

Age - Averager 

Age - Non-Averager 

Race of Averager: 

White 

Black 

Other 

Unknown 

45 43 41 47 46 

36 37 38 39 40 

78 102 110 191 224 

1 4 0 4 2 

0 1 0 1 2 

5 0 1 2 3 

AGI - Averager $ 34,004 $ 33,427 $ 28,704 $ 31,562 $ 31,093 

AGI - Non-Averager $ 5,129 $ 5,596 $ 6,110 $ 6,340 $ 6,740 

Office of the Secretary of the Treasury March, 1977 

Office of Tax Analysis 
-11-

Compared to the total sample, a much greater proportion of 

averagers are white. In addition, the averager is a few 

years older than the population average, and has adjusted 

gross income in the averaging year 5 times larger than the 

adjusted gross income of non-averagers. His average tax 

savings was $501 in 1971. 

Distributional breakdowns of eligible filers by age, 

race, and adjusted gross income are provided in Table 3. 

This table also separates eligible filers electing to average 

(electors) -8/ from those eligible but not electing to average 

(eligible nonelectors). In total, only 31.1 percent of all 

eligible averagers actually elected to average. 

Between the ages of 30 and 70, there are few differences 

in the proportion of eligibles electing to average (29.5 -

36.7 percent). Whether the smaller percentage (19.7 percent) 

of eligibles under 30 electing to average is due to a 

learning process, differences in income, low potential tax 

savings from averaging or an inadequate proxy for the support 

test cannot be ascertained. The increase in the rate of 
-12-

Table 3 

Characteristics of Taxpayersk 

Eligible for Income Averaging -1971-

: Total : Number : Percentage 

: Eligible : Electing : Electing 

Age of Principal Filer 

3C or less 61 12 19.7 

3C - 40 138 44 31.9 

4c - .40 193 57 29.5 

50 - 60 117 37 31.6 

60 - 70 49 18 36.7 

70 - 80 23 12 52.2 

Over 80 10 4 40.0 

All. Ages 591 184 31.1 

IRace of Principal Filer 

Whlte 596 182 30.5 

Non-Whi te 24 '1 4.2 

Unkriown 2 1 50.0 

Total 591 184 31.1 

Adjusted Gross Income-1971 

: Average : Average 

: Savings : Potential 

: for : Savings for 

: Electors: Non-Electors 

$ 217 $ 81 

416 140 

435 107 

669 86 

444 150 

986 214 

412 110 

499 114 

502 109 

121 194 

454 98 

499 114 

- - - 71 

58 70 

117 62 

129 71 

338 176 

1,933 751 

2,257 1,153 

499 114 

March, 1977 

Less than 65,,000 

5,000 - 6,999 

7,000 - 9,999 

10,000 - 14,999 

15,000 - 19,999 

20,000 - 49,999 

50,000 - 99,999 

100,000 or more 

All Incomes 

0 0 - 4 0 0.0 

35 1 2.9 

134 23 17.2 

151 31 20.5 

236 104 44.1 

25 20 80.0 

6 5 83.3 

591 184 31.1 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

* Panel returns present all five years with no change in marital status and meeting 

proxy for support test in the current law. 
-13-

election by eligible taxpayers over the age of 70 might be 

explained by the higher than average tax savings which this 

group obtains from averaging. 

Differences by race are more significant. Not only do 

non-whites comprise an exceedingly small portion (4.1%) of 

those eligible to average but they are almost non-existent in 

the sample of electors. Even though the sample size for 

non-whites is small, the differences are still statistically 

significant. The eligibility factor might be explained by 

the lower-than-average income and by the lower-than-average 

variance in income of nonwhites. -9/ The low election rate of 

non-whites (4.2%) relative to whites (32.2%) is not so easy 

to explain, except that a similarly low election rate is 

exhibited by tax filers with adjusted gross income less than 

$10,000 in 1971. However, foregone tax savings by 

non-electors among the non-whites is higher than that of the 

low income class, so that other factors may be involved. 

The differences in the proportion of eligible taxpayers 

who elect to average by income level can be explained by 

several factors. First, it is less likely that low income 
-14-

filers use outside tax preparers to prepare their returns. 

Secondly, the complication involved in calculating taxes 

under income averaging can be more serious for those without 

adequate record-keeping or those with less education, a 

factor highly correlated with income. Finally, the potential 

savings for low-income individuals are likely to be smaller. 

Table 3 demonstrates that average realized savings for 

electors ($499) is over four times as large as the potential 

gains of eligible non-electors ($114). 

Note the sharp increase in numbers of both eligibles and 

electors as adjusted gross income increases. This increase 

in eligibility is primarily due to the $3,000 minimum 

averagable income requirement of the law. Compare a tax filer 

with income of $10,000 in the year of filing to one with 

$50,000. The former must have an increase in taxable income 

of at least 91 percent over average taxable income in the 

previous four years to meet the $3,000 requirement, while the 

batter needs to have an increase of only 28 percent. As 

income rises further, the required increase falls to 20 

percent and the $3,000 limitation becomes of trifling 

importance. Thus, the $3,000 limitation substantially limits 
-15-

eligibility for low income taxpayers but not for those with 

high incomes. A more detailed discussion of this aspect Of 

the law is presented in Section V. 

The principal justification for upside averaging is 

either that income in the averaging year represents an 

anomaly, a sizable payment in one year which is due to past 

efforts, or that this income is in large part composed of 

transitory, not permanent income, i.e., that it is an above 

average observation of a long-run income with large annual 

fluctuations. The sample file allows several tests of 

whether averagers display these characteristics. 

First, if high income in the year of averaging truly 

represents an extraordinary amount of transitory income, then 

it would be unlikely that the averager would repeat averaging 

in the next year and even more unlikely in subsequent years. 

In fact, one would expect that his income might decline 

sharply in the year following the one in which he averaged. 

However, as demonstrated in Table 4, of those filers who 

averaged in any of the years 1967 through 1970, 34 percent 

averaged again in the following year. The pattern continues 
-16-

for those who average more than one year in succession. 

About 43 percent of filers utilizing the averaging provision 

in two consecutive years between 1967 and 1970 also elected 

averaging in a third consecutive year. Similarly, 32 percent 

of those who averaged three years in succession averaged 

again in the fourth year. -101 Clearly, for these people, the 

growth in income which made averaging possible was due not to 

unusual circumstances but rather to sustained growth in 

income. 

Repetition of income averaging from year-to-year implies 

that income grew over the period in which averaging was 

elected. However, the growth in income of averagers does not 

mean that their fluctuations in income differ substantially 

from those of non-averagers. Nor does it mean that 

averagers' fluctuations represent unstable or irregular 

realizations of income. 

One method of comparing relative variations in income is 

to use the coefficient of variation -- the standard deviation 

of income divided by the mean. However, as mentioned above, 

deviation from a simple five-year mean may be caused by rapid 
-18-

growth as well as fluctuating income. Therefore, in 

measuring deviations or variances in income for averagers, it 

is also desirable to distinguish between growth in income and 

random deviations from that pattern of growth. Accordingly, 

for each member of the panel, income was regressed against 

time. This regression yielded a trend line which closely fit 

the pattern of income growth or decline for the panel 

member.ll/ - The standard deviation around the expected value

of income or the trend line was then calculated. This 

deviation divided by mean income is a measure of the 

randomness of income relative to actual income. Table 5 

provides the data on the coefficient of variation around both 

mean income and trend income for averagers and non-averagers. 

As would be expected the variation in income is generally 

larger for the averagers. However, above the categories with 

the least income variation, the percent distributions are not 

strikingly different. When trend in incomes is explicitly 

taken into account, the two distributions become more 

similar. The large number of averagers in the lower 

categories indicates that many averagers have experienced 
-19-

steady, albeit rapid, growth in income. Under either measure 

of variation, an overwhelming number of non-averagers 

demonstrate fluctuations in income greater than or equal to 

those of averagers. 

Another comparison of averagers and non-averagers is 

provided by separating the panel returns into taxpayers 

electing and not electing averaging in a year and examining 

changes in their taxable incomes for the following year. If 

averaging mainly benefits taxpayers with fluctuating incomes, 

then taxpayers electing averaging will have either a decrease 

in income or a slower rate of increase in income than 

taxpayers not electing averaging. 

For panel returns present all five years with no change 

in marital status, Table 6 gives the taxable income in 1970 

and 1971 for returns electing and not electing averaging in 

1970. 121 Taxpayers electing averaging had a 7.7% decrease 

in taxable income between 1970 and 1971. Non-electing 

taxpayers had a 3.3% increase. For each income class except 

the $100,000 and over class, electing taxpayers had a smaller 

increase in income between 1970 and 1971 than did 
-17-

Table 4 

Examination of Repeat Averagers 

. : 1967 : 1968 : 1969 : 1970 : Total 

Averaged in current year 84 107 111 198 500 

Averaged in following year 32 33 38 67 170 

Proportion of averagers who 

Averaged the next year 38.1% 30.8% 34.2% 33.8% 34.0% 

Averaged in Third Consecutive 

Year 12 13 19 - 44 

Proportion of Two Year 

Averagers Averaging Third 

Consecutive Year 37.5% 39.4% 50.0% - 42.7% 

Averaged in Fourth 

Consecutive Year 3 5 -

Proportion of Three Year 

Averagers Averaging Fourth 

Consecutive Year 25.0% 38.5% - - 32.0%

Office of the Secretary of the Treasury March 17, 1977 

Off ice of Tax Analysis 

8 
-20-

Table 5 

Income Averagers and Non-Averagers * 

in 1971 by Coefficient of Variation in 

Adjusted Gross Income for Five Years of the Panel 

Normal Corrected for Trend 

Coefficient : Averagers :. Nan-Averagers : Averagers : Ban-Averagers of : mu B umulatlve'

: Number ?oB"ercen$ umu at ve Variation i Number ,'Peke% ve:Wumber :c Percent uPat ve :Number :'Per:e$ 

0 - .10 

.10 - .20 

-20 - .30 

.30 - .40 

-40 - .50 

.50 - .60 

-60 - .70 

270 - -80 

-80- .90 

.90 - 1.00 

1.00 - 1.25 

1.25 - 1.50 

1.50 - 1.75 

1.75 and over 

0 0 1,557 19.1 48 25.5 4,292 52.7 

23 12.2 3,181 58.1 62 58.5 1,990 77.1 

51 39.4 1,451 75.9 28 73.4 893 88.0 

46 63.8 738 85.0 23 85.6 462 93.7 

19 73r9 423 90.1 7 89.4 208 96.3 

18 83.5 295 93.8 12 95.7 127 97.8 

12 89.9 213 96.4 5 98.4 73 98.7 

6 93.1 111 97.8 0 98.4 30 99.1 

5 95.7 66 98.6 0 98.4 18 99.3 

1 96.3 41 99.1 1 98.9 17 99.5 

3 97.9 37 99.6 0 98.9 17 99.7 

2 -98.9 10 99.7 0 98.9 4 99.8 

0 98.9 3 .99.7 0 98.9 4 99.8 

2 100.0 24 100.0 2 100.0 15 100.0 

TOTAL 188 100.0 8,150 100.0 188 100.0 8,150 100.0 

Office of the Secretary of the Treasury March 17, 1977 

Office of Tax Analysis 

* Panel Returns present all five years with no change in marital status. 
-21-

non-electing taxpayers. Given the small average amount of 

decrease for taxpayers electing averaging, apparently many 

averagers qualify because of a one-time quantum jump to a 

higher permanent income level. 

Table 7 is the same as Table 6 except taxpayers are 

classified by date of birth instead of size of income. For 

taxpayers born before 1935, those electing averaging in 1970 

had a smaller increase (or greater decrease) in income 

between 1970 and 1971 than those not electing averaging. 

However, for taxpayers born after 1934, the opposite is the 

case. Electing taxpayers had a greater increase in income 

than taxpayers not electing. The conclusion from Table 7 is 

that income averaging benefits many younger taxpayers with 

rapidly rising income. 

Of course, to qualify for income averaging under the 

current law there -must be growth in taxable income in the 

averaging year over the average of taxable income in the 

previous four years. In order to identify specific sources 

of growth, various components of income for income averagers 

in 1971 were examined. For each of nine components of 
--- 

Table 6 

Changes-in Taxahle Income for Electors and 

Non-electors by Adjusted Gross Income Class* 

1970 Taxpayerr Electing Averaging in 1970 , Taxpayers Not Electing Averaging in IYIU 

Mjurtrd : Percent Change : : Percent Change 

aroma Xnc- : 

Number : 

: Average Taxable : Average Taxable: in Average : : Average Taxable Average Taxable: in Average

: 

Tauble ratmu: 

- 0 - 5 0 0 1,040 $ 1,761 $ 1,850 5.1 

5 - 10 3 $ 5,110 $ 1,974 -61.4 2,668 4,377 4,4 96 2.,7 I 10 - 15 24 9,288 8 ,123 -12.5 2,235 7,929 7,959 0.4 N’ 

15 - 20 32 13,136 13,337 1.5 846 11,864 12 ,128 2.2 h) 

20 - 25 34 16,647 17,277 3.8 305 15,842 16,583 4.7 I 

25 - 30 19 20,427 16,331 -20.1 102 20,563 21,077 2.5 

30- 50 30 31,315 25,736 -17.8 96 28,713 29,716 3.5 

50 - 100 15 52,397 45,439 -13.3 48 50,584 51,413 1.6 

100 or more 7 111,802 115,782 3.6 10 132,777 128,878 - 2.9 

Routuable returnr: 0 0 - 824 26 806 3307 7 

Total 164 25,126 23,197 - 7.7 a, 174 6,896 6,914 3.9 

Office of the Secretary of the Treasury

Office of Tax Analysis 

March, 1977 

*.-Panel returns present all five years with no change in marital status. 
--- --- 

Table 7 

Changes in Taxable Income for Electors and 

Non-electors-by Date of Birth of Taxpayer* 

. Taxpayere EJecting Averaging in ,UlO Taxpayers Not Electing Averaging in 1970 

: Percent Change : Percent Change

Date of : : Average Taxable : Average Taxable : in Average : : Average Taxable : Average Taxable: in Average 

B#h : &&or : lplp : ~a~pl~e. 1971 :-: Income. 1970 : Incoma.1971 : Taxable Ill~ppp~ 

Taxable retune: 

1904 or before 18 $ 31,049 $ 27,291 - 12.1 532 $ 6,946 $ 6,579 - 5.3 

,1905 - 1909 10 53,131 39,070 - 26.5 556 7,029 6,375 - 9.3 

1910 - 1814 16 27,511 25,341 - 7.9 7 03 8,538 8,741 2.4 

1915 - 1919 20 19,164 

1920 - 1924 28 21,206 

17,578 

17,949 

- 8.3 

- 15.4 

821 

886 

9,550 

9,005 

9,626 

9,544 

d.8 

6.0 

I 

h) 

W 

I 

1925 - 1929 23 21,110 20,707 - 1.9 870 8,364 8,659 3.5 

1930 - 3934 21 30,851 30,709 - 0.5 7 22 7,513 7,968 6.1 

1935 - 1939 20 18,530 19,848 7.1 7 36 6,827 7,157 4.8 

1940 - 1971 8' 13,659 16,234 18.9 1,524 4,960 5,042 1.7 

Nontaxable returns: 0 e--. 824 26 886 3307.7 

Total 164 25,126 23,107 - 8.0 8,174 6,696 6,914 3.3 

Office of the Secretary of the Treasury July, 1977 

Office 04 ?ax 3na'yeie 

* Panel returns present all five years with no change in marital status. 
-24-

income, Table 8 presents the distribution of averagers by 

increase in income for 1971 over average income from that 

source for the previous four years. Increases in wages and 

salaries are dominant; in fact, over 60 percent of all 

averagers had increases in wages and salaries of over $3,000. 

Other sources of growth are important to much smaller groups 

of averagers. The increase in net capital gains over losses 

exceeds $3,000 for only 14 percent of all averagers, while 

for business profits and losses the corresponding percentage 

is 15 percent. No other component of income exhibits a 

$3,000 increase for more than 10 percent of all averagers. 

This section has demonstrated that averaging is confined 

to a subset of the taxpaying population that is predominantly 

white and, on average, slightly older, much richer, and with 

only slightly less stable income than the population as a 

whole. Many taxpayers eligible to average -- especially 

those in lower income and minority groups -- do not elect to 

do so. Of those who do elect, the majority have 

extraordinary growth only in wage and salary income. 

Clearly, then, the current income averaging provision for the 

most part does not provide benefits to those taxpayers 
.. .. .. 

Table 8 

Frequency of Occurrence of Extraordinary Growth From Specific Income Sources 

--1971 Income Averagere-­

: Salaries :: Dividends :: .. Net :: Business :: .. Small :: :: Estate 

Change in Income : and :: before :: Interest :: Capital :: Profits/ :: Rent/ :: Business :: Farm .. & Trust 

in 1971 From : Wages :: Exclusions :: Received :: Gain/Loss :: Loss :: Royalty :: Gain/Loss :: Gain/Loss :: Gain/Loss 

Average Income : :cum. :: ; cum. :: : Cum. :: : Cum. :: : Cum. :: : Cum.:: : Cum. :: : cum. :: : cum. 

1967-1970 : II : % :: # : % :: # : % :: II : % :: I : % :: II : % :: # : % :: # : % :: # : x 

0 or less 51 27.1 96 51.1 74 39.4 126 67.0 145 77.1 162 86.2 157 83.5 170 90.4 183 

0.1 - 1,000 10 32.5 64 85.1 84 84.0 26 80.9 12 83.5 20 96.8 - 7 87.2 6 93.6 3 

1,000 - 2,000 5 55.1 11 91.0 12 90.4 2 81.9 0 83.5 2 97.8 5 90.0 1 94.1 1 99.5 

2,000 - 3,000 11 41.0 9 95.7 4 92.6 5 84.6 2 84.6 1 98.4 2 91.0 0 94.1 0 99.5 

3,000 - 4,000 2 42.0 2 96.8 2 93.6 4 86.7 1 85.1 2 99.5 4 93.1 1 94.7 0 99.5 

4,000 - 5,000 6 45.2 0 96.8 4 95.7 1 87.2 0 85.1 0 99.5 2 94.1 1 95.2 0 99.5 

5,000 - 7,500 32 62.2 2 97.9 1 96.3 3 88.8 2 86.2 0 99.5 0 94.1 1 95.7 0 99.5 

7,500 - 10,000 24 75.0 2 98.9 1 96.8 8 93.1 2 87.2 1 100.0 2 95.2 1 96.3 0 99.5 

10,000 - 20,000 34 93.1 2 100.0 5 99.5 7 96.8 15 95.2 0 100.0 5 97.9 4 98.4 0 99.5 

20,000 - 30,000 6 96.3 0 100.0 0 99.5 3 98.4 6 98.4 0 100.0 2 98.9 3 100.0 0 99.5 

30,000 - 50,000 5 98.9 0 100.0 1 100.0 2 99.5 1 98.9 0 100.0 1 99.5 0 100.0 0 99.5 3

I 

50,000 -100,000 0 98.9 0 100.0 0 100.0 1 100.0 1 99.9 0 100.0 1 100.0 0 100.0 1 100.0 

over 100,000 2 100.0 0 100.0 0 100.0 0 100.0 1 100.0 0 100.0 0 100.0 0 100.0 0 100.0 

Total over 300,000 111 59.0 8 4.3 14 7.4 29 15.4 24 12.8 3 1.6 17 9.0 11 5.9 1 0.5 

Office of the Secretary of the Treasury March 17, 1977 

Office of Tax Analysis 

I 
-26-

deserving of relief because of large fluctuations in income. 

It mainly benefits those with rapidly rising incomes. 

IV. Proposals to Amend the Current Law 

Since the adoption of the 1964 law, several proposals 

have been made to extend or liberalize its provisions. The 

most frequently mentioned proposals are: (1) allowance of 

downside averaging for those with negative fluctuations in 

income, and (2) elimination of the $3,000 minimum for 

averagable income. The effect of these proposals on the 

number and characteristics of averagers will be examined in 

this section. 

Even if the averaging provisions of the current law were 

to benefit those with fluctuations in income, the benefits 

would accrue only to those with positive fluctuations. Such 

a bias against those with negative fluctuations has been 

criticized elsewhere; in fact, some have concluded that 

relief should be granted only to a taxpayer whose income has 

decreased in relation to his average income in previous 

years . z/ 
-27-

The panel sample allows calculation of the number of tax 

filers who would be eligible to downside average under 

particular conditions. The reverse of the current law was 

therefore simulated. That is, where a tax filer's taxable 

income in the averaging year falls short of 5/6ths (or 83.3%) 

-14/ of the previous four years' average taxable income by an 

amount greater than $3,000, he was considered as eligible to 

downside average. 

As Table 9 reveals, downside averagers under this 

provision would be older than the population and also older 

than eligible upside averagers. They would have incomes 

slightly less than those who currently use upside averaging. 

These results are in line with expectations. Declines in 

income are more frequent in years approaching and immediately 

following retirement, and the $3,000 minimum decline in 

income restricts the population of potential averagers to 

those with a fair amount of income in the base year. 

There were probably two major reasons why Congress 

excluded downside averaging: (1) Downside averaging would 
-28-

Table 9 

Changes in Eligibility Resulting 

From Changes in the Existing Law 

: Percent : Average : Average 

: Number : Of . AGI : AGI 

(5 VP-AV_O.) : (1971) 

Current Law 591 7.1 X 15,339 45 

Elimination of 3,000 

minimum 1,551 18.6 11,672 45 

Downside Averaging Only 251 11 3.0 18,321 54 

Downside Averaging with 

3,000 eliminated 1,346 lJ 16.1 10,434 50 

Office of the Secretary of the Treasury March 17, 1977 

Office of Tax Analysis 

1/ These numbers include taxfilers who may meet all eligibility requirements,yet 

realize no tax savings from downside averaging. 
-29-

imply negative tax liability for many in the year of 

averaging. For the most part, the tax laws do not allow 

refundability -- not only for taxes that might be averaged, 

but also for exemptions, deductions and credits, which could 

reduce taxes due or taxable income below zero. (2) Downside 

averaging would provide tax rewards for those retiring, 

leaving the labor force or converting their assets to sources 

from which income is not reported for tax purposes. 

As demonstrated in Table 9, elimination of the $3,000 

limitation would more than double the number of eligible 

averagers -15/ and would lower the average income of averagers 

considerably. The potential tax savings would naturally be 

much lower and, because of this, the increase in the number 

of electors would probably be less than the increase in 

number of eligibles. 

V. Interaction With Other Tax and Non-Tax Parameters 

The income averaging provisions do not operate in a 

vacuum but are affected by changes in the tax law and by 

conditions in the economy. This section will consider 
-30-

possible interactions of the current law on income averaging 

with: 1) the rate of growth of per capita income; 2) the 

elasticity of taxable income with respect to nominal income; 

and 3) a negative income tax. 

A crucial parameter interacting with income averaging is 

the rate of growth of per capita income. Because of 

increases in productivity, per capita real income grows even 

in the absence of inflation. In an inflationary economy, 

most workers also experience an annual rise in income due to 

the effect of inflation. While the requirement for income 

averaging is growth in taxable income, that growth may 

reflect either inflationary or real gains in per capita 

income. In fact, it is possible to show a direct 

correspondence between the level of taxable income in a base 

year and the minimum annual rate of growth in income 

necessary to make a taxpayer perpetually eligible to 

average. E/ 

In the absence of the $3,000 limitation, the required 

rate of growth for perpetual eligibility would be invariant 

with respect to base year income levels and would be constant 
-31-

at a little above 7.5 percent. However, for reasons stated 

above, there exists a negative relationship between base year 

taxable income and the required rate of growth in taxable 

income. To be exact, with the $3,000 limitation, 

is the condition necessary for averaging when Yo is base year 

taxable income, and R is the constant rate of growth in 

taxable income. 

Table 10 demonstrates these minimum constant rates of 

growth in taxable income and the base year taxable income 

necessary for eligibility to average. Below a 7.5 percent 

rate of growth of taxable income, no amount of taxable income 

is sufficient for eligibility. Yet at 10.0 percent, $41,783 

is sufficient; at 12 percent, $21,471; and at 15 percent, 

$11,953. Even under normal conditions these are not 
-32-

Table 10 

Taxable Income and Annual Growth Rates in 

Taxable Income Sufficient for Eligibility to Income Average 

Taxable Income Sufficient for Eligibility 

Rate of Growth i n

Taxable Income Base Year . Fifth Year 

( in percent ) 

8.0 $ 346,607 $ 471,558 

8.5 124,977 173,193 

9.0 79,677 112,472 

9.5 53,984 77,607 

10.0 41,783 61,174 

11.0 28,530 43,311 

12.0 21,471 33,785 

13.0 17,091 27,867 

14.0 14,110 23,832 

15.0 11,954 20,908 

20.0 6,478 13,433 

25.0 4,215 10,291 

Office of the Secretary of the Treasury March 17, 1977 

Office of Tax Analysis 
-33-

extraordinary growth rates for a substantial part of the 

population, and in a highly inflationary climate they could 

become ordinary for the majority. 

Treating the inflationary part of growth in income 

alone, it was possible to re-examine the sample of filers to 

determine the extent to which eligibility for income 

averaging would decrease if all taxable incomes for the years 

1967-1971 were stated in constant 1971 dollars. Taxable 

income prior to 1971 was therefore adjusted by the rate of 

growth in the Consumer Price Index to 1971. A re-examination 

of the number of filers eligible to average when all relevant 

quantities are in real terms reveals that the number of 

eligible income averagers is cut in half. g/The years 1967 

to 1971 were not years of unusually rapid growth in the price 

level, particularly in light of more recent experience, yet 

the impact of that inflation on the volume af averaging is 

remarkable. 

The elasticity of taxable income with respect to nominal 

income also affects eligibility for income averaging. As 

nominal income grows, taxable income grows, but often at a 
-34-

very different rate. Except in years when the tax statutes 

explicitly call for increases in the personal exemption or 

allowed deductions, the growth in taxable income will outpace 

growth in nominal income of the tax filer. One study 18/ of L 

the impact of inflation on income taxes finds that a one 

percent increase in income due solely to inflation can lead 

to a 1.5 percent growth in nominal taxable income. Also, 

whenever Congress changes the law on credits, exemptions, 

allowed deductions' etc., it also changes the relationship of 

taxable income to adjusted gross income. Thus taxable income 

may show fluctuations because of legal changes in definitions 

rather than actual changes in income. -19/

One final interaction of income averaging with the tax 

laws should be noted. Under a negative income tax, marginal 

tax rates are usually higher in low income brackets than they 

are in middle income brackets. At certain levels of income, 

then, taxpayers with higher variances in income will pay 

lower taxes or receive greater payments than those with low 

variances in income -- the reverse of the case for taxpayers 

with positive taxes. 
-35-

VI. Conclusion -- Alternative Approaches to Income Averaging 

Reform 

Income averaging was originally proposed to eliminate 

the inequitable treatment (inherent in a progressive tax 

system) of those whose incomes are more volatile than others. 

Yet, in attending to these inequities, current income 

averaging provisions have been found to discriminate across 

socio-economic classes, to benefit primarily those with 

rising rather than variable incomes, to provide no benefits 

in case of falling incomes, to be so complex that a large 

portion of those taxpayers who are eligible to average do not 

actually elect to do so. In addition these provisions 

provide unintended benefits in the case of inflation or of 

normal growth in the economy, and interact poorly with other 

portions of the Code, especially those affecting the 

nontaxable population and those dealing with credits, 

deductions, exemptions, and other adjustments from adjusted 

gross income to taxable income. 

There are four alternative approaches to meeting these 

problems: (1) eliminate the current income averaging 
-36-

provision; (2) adopt detailed provisions to deal with each 

inequity or deficiency in the current law; (3) extend the 

accounting period for measuring income; or (4) 

comprehensively revise the entire averaging system. 

From the previous section it is clear that the current 

law is inadequate for meeting the inequity at which it is 

directed, and that, in fact, it may be fairer and less 

complex to simply drop the current provision. If desired, 

extraordinary rises or falls in certain incomes could still 

be given special treatment (as with lump-sum payments from 

pension plans) without the complexity of a comprehensive 

income averaging scheme. 

Of course, the deficiencies in current averaging 

provisions theoretically could be corrected in piecemeal 

fashion. Inflation adjustments, IRS calculation of taxes 

due, 2J/ elimination of minimum averagable income 

requirements, downside averaging, carryover of exemptions and 

deductions, etc., might better direct the benefits of income 

averaging to a subset of the population for whom they were 

originally intended. However, such adjustments would be 
-37-

complex, require much greater record-keeping and calculation, 

and would likely lead to sizable increases in the number of 

averagers. It is not at all obvious that the administrative 

costs inherent in such proposals would be justified given the 

tax savings that would go to beneficiaries. 

Failing the adoption of complex provisions, a simpler 

method to lessen the effect of varying income on effective 

tax rates would be to extend the income accounting period 

beyond one year. An annual period is as arbitrary as any 

other one and is a compromise between a shorter period which 

better measures current welfare or means and a longer period 

which better measures long-run or permanent income. Biannual 

or triannual variance in income is substantially less than 

the annual variance, and therefore much of the inequity 

caused by a progressive tax system on those with highly 

variable incomes is lessened by a simple extension of the 

income accounting period. However, it would probably prove 

rather difficult to break the habit of using an annual period 

for income accounting purposes. 
-38-

Finally, comprehensive revision of the averaging system 

could be undertaken. Two such revisions have been suggested 

elsewhere. William Vickrey's [61 cumulative averaging 

proposal solves some problems by simply making averaging 

apply to the universe of taxpayers, but it also requires 

interest rate adjustment for past income and taxes, more 

extensive record-keeping by the IRS, and it complicates 

greatly the necessary provisions dealing with family 

reorganizations and the allocation of income to members of 

the different family units. 

David, et. al., [ll propose a 3-year averaging period 

(except where averaging took place in the past year, in which 

case the taxpayer would average current income and last 

year's average income), the broadening of the tax base to 

include retirement benefits and transfer payments, and 

lowering the minimum averagable income to $1,000 above or 

below the tax bracket applying to average base period income. 

To eliminate the complex calculations caused by family 

reorganizations, they recommend that a person only be allowed 

to average if labor force status and marital status remains 
-39-

unchanged. Under their proposal, some inequities are 

eliminated but new ones are created for those with changes in 

marital status, calculating minimum averagable income becomes 

even more complex than under current law, the interactions 

with other tax or non-tax parameters are ignored, and 

unintended benefits still accrue to those with rapidly rising 

incomes. 

The authors believe that the first alternative 

--elimination of income averaging -- may be the simplest, 

fairest, and least costly approach. All other schemes at a 

minimum are inordinately complex, deal inadequately with 

family reorganizations,21/ - interact poorly with the tax

system as a whole, and give unwarranted benefits to many 

taxpayers. However, each of the four alternatives would be 

more equitable (although not always simpler) than the current 

provision for income averaging. 
-40-

Footnotes 

-1/ See, for instance, Vickrey, [7]. 

-2/ The exact formula is as fOllOWS: if Yt= taxable income 

in the,yeaq t, and Y= 30 (Yt-l+Y -2+Yt-3+Yt-ja; ) -then 

averaging is allowed when Averagabfe Income - - Yt-Y 

-

> $3,000. The tax itself can be computed as follows: 

Tax(Yt) = Tax [(Y)] + 5 [Tax (Y + .20.YaV) - Tax (y) 1. 

3/ under current law when there is a change in a taxpayer's -? marital or filing status, complex procedures are often 

required for allocating or combining income over the 

period of computation. For instance, newly married 

spouses are required to combine their incomes in 

previous years, while newly divorced individuals must 

allocate their income from prior years between 

themselves. 

-4/ For filers who have been full-time students in the year

of averaging or in any of the prior four years, current 

law requires as a condition of eligibility that they

provide 50 percent or more of their own support in those 

years . -5/ See Footnote 2. 

-6/ An individual with eligibility may still receive no tax 

savings from averaging in certain years despite $3,000 

or more in "averagable income." In this case, his 

averagable income all falls within the same tax rate 

bracket. 

-7/ qemographic characteristics were obtained through a link 

of income tax return data with Social Security data. 

-8/ See, for iqstance, Steuerle and McClung [5]. 

-

9/ For purposes of this Table, only those electors who met 

the eligibility criteria are examined. 

-10/ Of the three filers in the qample who averaged four 

years in succession, none were found to average again in 

the fifth year. The sample size by this time was too 

small for any meaningful comparisons. 
-41-

The trend line which results from the regression is that 

line for which the variance in actual income from trend 

is minimized. 

The data would be much the same if the year chosen had 

bden 1967, 1968, or 1969. 

See Martin David, et. a1 [l], p. 279. 

Current averaging requires that taxable income in the 

averaging year be 6/5th (or 120%) of the previous four 

years' average taxable income. This downside provision

requires that the previous four years' average taxable 

income be 6/5ths of taxable income in the averaging 

year. Thus the ratio of income in high income years to 

income in low income years must remain at 6 to 5 or 

higher. 

The numbers of eligible averagers provided here exclude 

those who would realize no tax savings as a result of 

averaging despite satisfaction of-all eligibility

requirements. 

See footnote 5. 

If taxable income had been calculated in constant 1967 

dollars, the decrease would have been even more 

dr amatic . See [31 

If Congress were to replace deductions or exemptions

with credits, it would increase taxable income 

substantially for many filers. The Tax Reform Act of 

1976 added a general tax credit of $35 or 2 percent of 

taxable income up to $9,000 and added a child care 

credit, but did not change the averaging provisions. On 

the other hand, the Tax Reduction and Simplification Act 

of 1977, made adjustments in the definition of the 

income eligible for averaging along with adjustments in 

definition of taxable income. 

IRS would have to keep records on filers for longer

periods of time than the three years currently

maintained. 

See footnote 3. 
-42-

B IBLI O G W 

(11 David, Martin; Groves, Harold; Miller, Roger; and 

Wiegner, Edward. "Optimal Choices for an Averaging

System -- A Simulation Analysis of the Federal Averaging

Formula of 1964," National Tax Journal, 23 (September

1975): 279. 

[21 Goldberg, Arthur L. "Income Averaging Under the Revenue 

Act of 1964." Yale Law Journal, 74 (September 1964):

465-481. 

[3] Greytak, David and McHugh, Richard. "Inflation and the 

Individual Income Tax," unpublished manuscript,

Syracuse, New York: Syracuse University, 1977. 

(41 Steger, Wilbur A., "Averaging Income for Tax Purposes,tt

National Tax Journal, 9 (June 1956): 97-114. 

[5] Steuerle, Eugene and McClung, Nelson D. "Wealth and the 

Accounting Period in the Measurement of Means." 

Technical Paper Number VI to The Measure of Poverty,

Washington: U.S. Department of Health, Education, and 

Welfare, 1977. 

[6] Vickrey, William, "Averaging Income for Income Tax 

Purposes," Journal of Political Economy, 47 (June 1939):

379-397. 

[7] Vickrey, William, Agenda for Progressive Taxation. New 

York: Ronald Press, 1947.