Effects of taxes on economic behavior.

Several studies have now used the Treasury's public use files of individual tax returns to estimate the elasticity of taxable income with respect to the net-of-tax rate (i.e., one minus the marginal tax rate). In an early paper, I used panel data that followed the same individuals before and after the major tax rate reductions of the 1987 Tax Reform Act in which the top tax rate fell from 50 percent to 28 percent (Feldstein, 1995). The difference in difference estimates based on comparing incomes in 1985 and in 1988 implied a compensated elasticity of about one. Subsequent work by others (e.g., Auten and Carroll, 1998 and Gruber and Saez, 2002) using different data sets and different estimating methods, found a range of estimates from about 0.4 to 1.0 for middle- and upper-income taxpayers.

There are of course disputes about the interpretation of this behavioral response. Gordon and Slemrod (2000) have suggested that some of this reaction may reflect a shift between corporate and personal income. In the opposite direction, it should be noted that this relatively short-run response does not allow for the effect of the tax rate reduction on decisions about the choice of occupation and the accumulation of human capital.

A more fundamental issue in the estimation of behavioral response is that it assumes that the taxpaying unit is the decision-making unit even when there are two working adults in the unit. This is of practical importance when the husband and wife face different marginal tax rates as they do in the United States when one, but not both of them, is earning below the ceiling on Social Security taxable income. Because of the ceiling on the payroll tax base, some couples will have different marginal tax rates for the husband and wife. In a study of data on Swedish households Gelber (2007) has shown that there are important differences between husbands and wives in their income and substitution elasticities and in cross-elasticities.

My judgement, based on the existing studies, is that an elasticity of 0.5 for middle- and upper-income taxpayers (who pay the overwhelming bulk of income taxes) is a reasonable estimate and probably a conservative one. It is substantially higher than the response implicit in the revenue estimates of the Treasury and the Joint Tax Committee. In presenting illustrative calculations of tax proposals, such as the ones discussed below, I have generally been cautious and assumed elasticities of 0.4 and 0.5.

The official estimates used by the Treasury and the Joint Tax Committee are generally depressed by the quite remarkable self-imposed restriction that the changes of behavior implied by changes in tax rates do not result in any change in GDP. In their analysis, a change in tax rates can change the form of compensation, can change the realization of capital gains, and can shift portfolios between taxable and tax exempt securities, but it cannot alter the supply of labor or the level of real compensation. To the extent that any change is admitted that alters GDP, some offsetting assumption is made to keep GDP unchanged.

This "constant GDP" assumption eliminates the important effect of changes in labor supply broadly defined, i.e., changes in labor force participation rates, in hours worked, in the choice of jobs, in the degree of effort, etc. Although the revenue estimators wish to allow for changes in the form of compensation, the restriction that there be no change in GDP makes it impossible to use the tax return data to estimate the change in the form of compensation since the observed changes in taxable incomes reflect both the change in total labor supply (i.e., in potential labor income) and in the extent to which the resulting change in potential income is taken in the form of taxable cash. Since the changes in the form of compensation cannot be observed or estimated separately, the revenue estimators are forced to make a judgement based on their intuition, something very difficult for a civil servant whose working conditions and degree of discretion in the form of compensation are quite different from those in many private sector jobs.

The rationale for the "constant GDP" assumption is that the projected level of GDP is established by the administration or the Congressional Budget Office and, therefore, must be taken as a fixed parameter by the revenue estimators. In my judgement, this makes no sense at all. The GDP forecast could be taken as a baseline number on which the effects of proposed tax changes can be superimposed. I wonder how many members of Congress realize that the "revenue estimates" given by the Joint Tax Committee staff have made this arbitrary assumption of constant GDP.

Fortunately, the restricted nature of the estimated behavioral effects is beginning to change and the official estimates of some proposed tax changes do attempt to use the accumulating evidence on behavioral responses. It would be good to have more transparent descriptions of these changes so that the economics profession could comment on the assumptions and the resulting estimates.

TWO EXAMPLES

Before turning to other aspects of taxpayer behavior, I will illustrate the importance of behavioral responses by looking at two examples. First consider an across the board tax increase in which every tax rate is raised by one percent: the ten percent marginal tax rate goes to 10.1 percent, the 25 percent to 25.25 percent, etc. My NBER colleague, Dan Feenberg, used the NBER's TAXSIM model to estimate how taxpayer behavior alters the estimated revenue effect of this tax change. The analysis, based on 100,000 random tax returns for 2001 adjusted to income levels of 2004, calculates that with no behavioral response (i.e., the so-called "static" estimate) tax revenue would rise by seven and one-half billion dollars.

Using a very conservative compensated elasticity of tax revenue with respect to the net of tax rate of 0.4 and an income elasticity of 0.15 (implying an uncompensated behavioral response elasticity of less than 0.4) implied that the additional personal income tax revenue would be only five billion dollars or two-thirds of the "static" revenue estimate. The reduced taxable income would also lower payroll tax revenue by some $400 million, bringing the total additional revenue to just $4.6 billion or 57 percent of the "static" revenue estimate (Feldstein, 2004).

The effect of taxpayer behavior on revenue can be even more dramatic when the proposed tax change is not simply proportional. A few years ago, I analyzed the proposal to raise the maximum taxable income for the Social Security payroll tax by 25 percent, from $87,900 to $110,000 (Feldstein, 2004). For someone with initial income at the top of the new range, i.e., of $110,000, the tax base would rise by $22,100 if there were no behavioral response. In that case, the tax revenue would rise by 12.4 percent (the payroll tax rate) of this increased tax base or $2,740. But with a behavioral elasticity of 0.5 with respect to the net of tax rate--a reasonable assumption for these high-income individuals--the taxpayer would reduce taxable earnings (by working less and taking more income as fringe benefits) to $102,000. This lowers the extra payroll tax and, more importantly, also lowers the personal income tax revenue and the Medicare payroll tax revenue. Calculations show that the reductions in the personal tax revenue and in the Medicare payroll revenue would actually exceed the extra Social Security payroll tax revenue. The total taxes paid by this high-income individual would actually decline if the payroll tax base were increased in this way.

Extending this type of calculation to the entire population of taxpayers with incomes of more than $87,900, Feenberg and I found that the rise in the payroll tax revenue would be $19 billion a year with no behavioral response, but only $16 billion with a taxable income elasticity of 0.5. The lower tax base shrinks the Medicare and Personal Income tax revenue by a total of $11 billion, bringing the total revenue gain down to just five billion dollars instead of the $19 billion "static" estimate, implying that some two-thirds of the extra Social Security funds would come as the result of a back door transfer from personal income taxes and Medicare taxes.

Although these examples show the importance of taking behavioral responses into account when calculating the revenue effects of major changes in tax rates, there are strong advocates of continuing to use the current "static" revenue estimates. They make two arguments. First, since the behavioral elasticity is only a rough estimate, it is inappropriate for use in revenue estimation. Second, there are a very large number of detailed and complex tax proposals for which revenue estimates must be produced. There would never be enough time to do the research on the needed behavioral elasticities for these many proposals. These arguments carry particular force because of the legislative requirement that any projected increase in the budget deficit (through a tax cut or spending increase) must be financed by a decrease in the projected deficit (by a tax increase or spending cut). In this context, revenue "scoring" must be "precise" and must apply to all proposals.