An alternative approach utilizes estimates of lifetime income as a measure of the taxpaying unit’s economic well-being. Invoking Friedman’s (1957) permanent income hypothesis as well as life-cycle considerations, economists have long recognized that annual income may not be a very good measure of an individual’s potential to consume. With perfect capital markets, individuals should be grouped according to the present discounted value of earnings plus gifts received. This theory makes the difficulties with the annual incidence approach readily apparent. People tend to earn the highest incomes in their life around middle age and the lowest incomes in their youth and old age. Consequently in a cross section (annual) analysis, lower income groups are likely to include some young and elderly people (as well as some people with volatile incomes who have obtained a low realization) who are not poor in a lifetime sense. Similarly, higher annual income groups are likely to contain some people at the peak of their age earnings profile for whom peak earnings are a poor measure of annual ability to consume.
Relative to annual income, lifetime income is more difficult to measure. Poterba (1989, 1991) has proposed using consumption as a proxy for lifetime income, arguing that since household consumption tends to be smoother than income, total annual consumption is likely to be a better measure of household well-being than total annual income. Using data on total expenditures from the Consumer Expenditure Survey, Poterba finds that excise taxes on alcohol, tobacco, and gasoline are much less regressive than they appear when viewed in an annual income framework. Metcalf (1993a) has used a similar approach to analyze state and local tax systems. Like Poterba’s findings for excise taxes, he finds that the system of state and local taxes is less regressive when consumption is used to proxy for lifetime income. Feenberg, Mitrusi, and Poterba (1996) also use the consumption proxy for lifetime income in a detailed analysis of a shift from the current income tax system to a national sales tax.