Pretax Factor Income

Pretax factor income, which for simplicity we often refer to as “factor income,” is equal to the sum of all pretax income flows accruing directly or indirectly to the owners of the factors of production (labor and capital), before the operation of the tax and transfer system (including indirect taxes), and before the operation of social insurance systems.

One good aspect of the factor income concept is that it is relatively easy to compute using national accounts data, and it is reasonably homogeneous across countries. Its main drawback, however, is that old-age individuals generally have little factor income, so that cross-sectional

inequality of factor incomes look artificially large in countries and time periods with an older population. One way to overcome that issue, when the data allows it, is to restrict the analysis to the working-age population.

Aggregate pretax factor income is by construction equal to net national income, and can be defined as the sum of the primary income of the household sector (B5n, S14), the primary income of the corporate sector (B5n, S11+S12, i.e., pretax undistributed profits), the primary income of the government sector (B5n, S13), and the primary income of NPISH (B5n, S15).

The primary income of the household sector (B5n, S14) corresponds to the full compensa-tion of employees (including employers’ social contribucompensa-tions, both actual and imputed), self-employment income, and distributed capital income (including imputed rents). The primary income of the corporate sector (B5n, S11+S12) corresponds to pretax undistributed profits and includes the corporate income tax. The primary income of the government (B5n, S13) is made up of two main components: taxes on production (D2–D3, S13) and property income (D4, S13).

We naturally distribute the compensation of employees and property income to the respective owners of these household income flows. We distribute the income of NPISH — usually a very small amount — proportionally to the rest of factor income. The remaining questions concern undistributed profits, production taxes and the property income of the government.

2.2.2.1 Distribution of Undistributed Profits

The undistributed profits are recorded in national accounts as (1) primary income of corporations (B5n, S11+S12) and (2) dividends and withdrawals from quasi-corporations (D422, S14), if any.

We recommend to distribute these undistributed profits in proportion to stock ownership, be they held directly or indirectly, in privately or publicly traded companies. More refined imputations are possible whenever more detailed data is available — for example, data that matches the income tax records of individual shareholders to the firms they own (see also section 5.3.2).

2.2.2.2 Distribution of Taxes

The general principle that guides the allocation of taxes in pretax DINA series is that taxes are paid by the factor of production on which the tax depends, in line with distributional tax analysis (Saez and Zucman, 2019). We stress that this approach is different from nominal incidence:

for example, employers’ (actual and imputed) social contributions are allocated to employee compensation even though they are nominally paid by employers, because the amount of the contribution depends on the employee’s wage. Our approach is also different from a complete

tax incidence study, one that would try to establish a full counterfactual of what the economy would look like if the taxes were changed or did not exist. Such studies can be useful, but they are not the point of DINA — or of national accounts in general. First, they require many behavioral assumptions and the effects are far from obvious. (Indeed, for every type of tax, there is a contentious literature on the second-order behavioral effects that would identify complete tax incidence in this sense. Such effects depend on highly context-specific elasticities.) Second, these counterfactual studies are fundamentally at odds with the accounting framework we work with, because under these types of models, national income will in general be different on a pretax (or no tax) basis compared to a post-tax basis. DINA series can be used as an input for such models, by providing the relevant parameters, but they are not meant to answer such questions directly.

Direct Taxes For direct taxes, the implication of this framework is straightforward: social contributions are paid by the employees, the personal income tax by the respective income earners, etc. The same is true for certain (so-called “other”) direct taxes on production, such as property taxes, which are attributed to whoever owns the corresponding property.

Corporate Taxes The corporate tax is paid on business profits. We assume that undistributed profits belong to the shareholders of the corresponding companies. Thus, the corporate tax is paid by those same shareholders.

Indirect Taxes For indirect taxes, especially sales taxes and VATs (i.e., the majority of taxes on production), the implications are more subtle, and to add indirect taxes to a pretax income distribution is more delicate. In essence, the VAT acts as the wedge between factor prices and market prices: therefore, its direct, mechanical effect is on prices.¹⁵ The question then becomes:

15Indeed, let us first follow the convention of measuring total value added at market prices (i.e., including VAT).

If we follow this convention, then GDP is equal to the sum of all the value added in the economy. A firm’s value added is measured as the difference between its production and intermediate consumption. But the value of a firm’s output is measured at its selling price, which includes VATs: a fall in VATs therefore mechanically leads to a fall in prices. This has the effect of lowering nominal GDP. Conversely, GDP in volume is always calculated on the basis of prices prior to the VATs cut, and therefore remains unchanged. The VATs cut therefore has the effect of lowering nominal GDP without changing real GDP: in other words, it reduces the GDP deflator.

We reach the exact same conclusion if we follow the SNA convention of measuring value added at factor prices.

In this case, GDP is equal to the sum of value added and taxes on products. By construction, the VATs is excluded from value added, so its mechanical impact on value added is zero. A reduction in VATs therefore reduces the value of taxes on products without changing the value added, which reduces nominal GDP. What about real GDP? The amount of VATs in volume is calculated by national accounts statisticians by applying the prices and the VATs rate before the decrease to volumes after the decrease. In other words, the VATs cut does not affect GDP in volume terms. The mechanical impact of VATs is, once again, only observed on the deflator, i.e., prices.

what is the distributional impact of price changes? Here, we believe it is useful to make a distinction between the distribution of indirect taxes in pretax income and their distribution when moving from pretax to post-tax income.

Let us start with pretax income. Factor price national income (national income excluding indirect taxes) can buy the full production at pretax prices (prices received by producers that do not include indirect taxes). Market price national income (national income including indirect taxes) can buy the entire production at post-tax prices (prices paid by consumers, which include indirect taxes). In national accounts, prices are always measured post-tax (i.e., including VATs, sales taxes, etc.) which is why standard national income includes indirect taxes. Factor price income cannot buy full production at post-tax prices precisely because indirect taxes create a wedge between pretax and post-tax prices. Therefore, for pretax national income, factor incomes should be inflated uniformly to line up with the national income aggregate. That way, they reflect the purchasing power of pretax income at the post-tax prices that exist in the economy.

Because this is pretax (before any consumption decision is made), it makes the most sense to do a uniform rescaling, so as preserve the same distribution as factor income. In other words, going from factor price to market price national income is about changing the price index, and not about distributing taxes to individuals.

The issue is different when we consider moving from pretax income to post-tax income. At this stage, we are effectively removing the amount of tax paid by each individual from their income, so it makes sense to ask the amount of sales or VAT paid by each specific person. For that, we favor the view that these taxes are taxes on consumption, and should therefore be assigned to specific consumers. Concretely, in absence of direct data on consumption and savings, indirect taxes would be assigned based on disposable cash income minus saving (where saving rates are set by income groups based on external evidence and are typically growing with income). When more precise data is available, one should consider how different baskets of goods and services that are consumed at different income levels are taxed differently (because of preferential tax rates, e.g., on basic necessities).

Therefore, to summarize, benchmark DINA series should distribute indirect taxes proportionally to factor income in pretax series, and remove them proportionally to consumption when moving from pretax to post-tax series (see sections 2.2.4 and 2.2.5 for a more general discussion of post-tax series).

2.2.2.3 Distribution of the Property Income of the Government

For the property income of the government, we recommend the simplest solution, which is to allocate it in proportion to the distribution of factor income, as a level shifter. We could also think of more sophisticated rules, such as an imputation in proportion to taxes paid and benefits received, or different imputation rules for public and private pension surpluses (see Piketty, Saez, and Zucman (2018) for a more detailed discussion in the case of the United States). Note that the same approach applies to the public share of corporate retained earnings (see section 2.2.1.1), which effectively acts as capital income for the government.