Effects of taxes on economic behavior.

Although there is much to recommend the marginal self-financing rule that Congress has imposed on itself, it should not be an excuse for using grossly incorrect revenue estimates. At a minimum, for proposals with large revenue implications (e.g., static revenue effects of more than ten billion dollars a year), the members of Congress should see the revenue estimates based on plausible behavioral assumptions as well as the traditional static analysis. The budget committees should then have the option to replace the traditional static revenue estimate with the more accurate (although imprecise) behavioral estimate.

CALCULATING DEAD WEIGHT LOSSES

Efficiency calculations are central to the analysis that public finance economists bring to tax policy. But introducing these ideas into the actual Congressional evaluation of tax policies involves three separate challenges. First, the politically responsible officials and their staffs must come to understand the basic idea of deadweight loss. Second, the nature of the distortion that gives rise to the deadweight loss must be correctly identified. And, third, the relevant parameters must be estimated.

In my experience, the concept of deadweight loss is difficult to explain because it does not correspond to any observable number. Perhaps that is why the staff of the Joint Tax Committee, even in its theoretical infinite horizon dynamic simulations, summarizes the economic effects of alternative tax systems by the change in GDP rather than by an estimated deadweight loss or gain. But a tax change could create deadweight losses even though it caused GDP to rise (e.g., because of income effects or even because of incentives that lead to more labor input than individuals would otherwise choose to supply). So economists have still not gotten across the notion that taxes distort choices and that the revenue that the government collects understates how much worse off an individual is because of a tax.

Perhaps an example would help non-economists to grasp the idea. Consider a law that prevented people from buying apples. That law would not transfer money to the government, but individuals would consider themselves worse off than in the absence of such a law. The amount that the government would have to give people to make them feel as well off as they would have been without the law is its deadweight loss, i.e., the loss to the individuals in excess of the revenue to the government. Now consider a less draconian law that merely reduces the number of apples that anyone can buy. That implies a smaller deadweight loss. But what if, instead of a law limiting the purchase of apples, the government levies a tax on apples that reduces the number of apples that the individual chooses to buy? The individual would then be worse off relative to no law for two reasons: he consumes fewer apples and he must pay a higher price per apple (which goes to the government as tax revenue). The extent to which the individual is worse off because of the tax can be divided into two parts--the revenue transferred to the government and the deadweight loss due to the reduced consumption of apples. Similarly, a tax that induces someone to work less not only transfers revenue to the government, but also causes a distortion in the individual's behavior (reduces the extent to which the individual supplies labor and obtains money with which to buy goods and services) and, therefore, a deadweight loss.

More generally, the income tax causes a much broader set of distortions, reducing all aspects of labor supply, causing a shift in the form of compensation, and inducing individuals to substitute tax favored consumption (i.e., deductible expenditures) for other types of consumption. Fortunately, despite the multiple sources of deadweight loss, the total deadweight loss can be easily calculated by focusing on the elasticity of taxable income with respect to the net-of-tax rate. This simplification is appropriate because each of the three sources of distortion is based on the same marginal tax rate: the individual buys "leisure" at one-minus the marginal tax rate, he buys fringe benefits at this rate, and he buys tax deductible consumption at this rate. The marginal deadweight loss is, thus, the same for any behavior that reduces taxable income. More technically, the three forms of behavior that reduce taxable income constitute a Hicksian composite good and, therefore, can be treated as if they are one good for the purpose of welfare analysis (Feldstein, 1999).

Using an estimated compensated elasticity of 0.4 and the usual formula based on the square of the marginal tax rate for approximating the incremental deadweight loss implies that the one percent across the board increase in all tax rates that yielded incremental revenue of $4.6 billion would result in a deadweight loss of three and one-half billion dollars. The deadweight loss is, thus, 76 percent of the incremental revenue. This means that the total cost of an additional billion dollars of government spending financed by an across the board increase in tax rates is $1.76 billion. Similarly, cutting government spending by a billion dollars and passing the funds back in the form of an across the board proportional tax cut would raise taxpayers real incomes--including the reduced deadweight losses--by $1.76 billion. Wouldn't the Congressional process of setting tax rates and authorizing government spending be improved if this were better understood?

The implications of this analysis are even more striking when applied to a possible non-proportional change in the payroll tax. Recall that the proposal to raise the maximum income subject to the Social Security payroll tax from $87,900 to $110,000 would result in net revenue of five billion dollars when the behavioral response is taken into account. The deadweight loss calculation in this case implies an increased deadweight loss of nine billion dollars. The total cost of the five billion dollars of additional revenue is, thus, $14 billion, nearly three times as much as the revenue itself. It is useful to contrast this with the implications of the static revenue analysis that implies additional revenue of $19 billion and that ignores the deadweight loss.

An alternative way to raise payroll tax revenue by five billion dollars would be to raise the payroll tax rate instead of increasing the ceiling on the taxable payroll. With a payroll tax base of approximately five trillion dollars, the required increase in the tax rate is only 0.1 percent. The overall marginal tax rate--including personal income tax, state income tax and payroll taxes--would rise from about 45 percent to 45.1 percent, depending on the individual's particular situation. The resulting deadweight loss would be only about $1.6 billion, less than one-fifth of the deadweight loss that would result from increasing the ceiling on taxable payroll. I believe the political process should consider these two ways of raising the five billion dollars, noting the difference in the distribution of the increased tax burden and the difference in the deadweight losses.

TAXES ON INVESTMENT INCOME

I turn briefly now to the taxation of investment income. Tax rules affect many types of behavior that influence investment income: the volume of saving, the allocation of that saving among alternative investments, the realization of capital gains, etc. I will focus on just one of these: the effect of taxes on household saving.

I want to make a single important point about the deadweight loss associated with taxing the return to saving. For a discussion of how taxes on the return to saving interacts with taxes on labor income, see Feldstein (2006).

A common fallacy in discussing taxes on the return to saving is to note that the elasticity of saving with respect to the net-of-tax interest rate is very low and to conclude from that observation that taxing the return to saving has very little adverse efficiency effect (Feldstein, 1978). Even if one accepts the premise that the elasticity of saving with respect to the net-of-tax interest rate is very low, the conclusion about the deadweight loss does not follow.

Why? Because the deadweight loss in this case depends not on the change in the level of saving but on the distortion in the timing of consumption. It is consumption that matters for this because it is consumption that enters the individual's utility function. Even if saving is not changed at all in response to a higher rate of tax on investment income, the level of future consumption can fall substantially. It is that fall in future consumption that is the source of the deadweight loss.

An analogy may help to clarify this point. Consider a simple excise tax on the consumption of apples. If the pretax price of apples remains constant, an individual with a unit elasticity of demand for apples will consume fewer apples, but spend the same total amount on the purchase of apples. It is clear in this case that the deadweight loss depends on the change in the number of apples consumed and not on the unchanged spending on apples. By analogy, saving is the "expenditure" today to purchase future consumption. The welfare loss depends on the change in that future consumption and not on the spending today to purchase that future consumption.

FUTURE RESEARCH

I will conclude by pointing to some fruitful directions for future research in the study of taxpayer behavior.