TAXABLE INCOME RESPONSES
Henrik Jacobsen Kleven
London School of Economics
Lecture Notes for MSc Public Economics (EC426): Lent Term 2014
AGENDA
The Elasticity of Taxable Income (ETI): concept and policy relevance.
The long-run evolution of top marginal tax rates and top income shares.
Estimating the ETI: empirical strategies, identification problems, and
findings.
The high-income Laffer curve.
MOVING BEYOND LABOR SUPPLY
A large literature estimates the elasticity of labor supply.
Estimated labor supply elasticities are close to zero, which suggests that
the efficiency cost of taxation is very small.
But there are many other dimensions of behavioral response, which
might create efficiency losses.
A shift in focus from labor supply responses to taxable income re-
sponses, which capture the full range of responses to taxation.
CHANNELS OF TAXABLE INCOME RESPONSE
(1) Quantitative labor supply responses: hours worked, participation.
(2) Qualitative labor supply responses: effort on the job, type of job,training, education.
(3) Changes in savings and portfolio choice.
(4) Legal shifting of income into untaxed or lower-taxed form[tax avoidance].
(5) Illegal under-reporting of income [tax evasion].
ELASTICITY OF TAXABLE INCOME (ETI)
Feldstein (1995, 1999) first pointed out the potential importance of the
ETI: he argued that the ETI provides a sufficient statistic for revenue
effects, deadweight loss, and optimal taxation.
Joel Slemrod (1998): "recently . . . much attention has been focused on
an elasticity that arguably is more important than all others, because
it summarizes all of what needs to be known for many of the central
normative questions of taxation. This is the elasticity of taxable income
with respect to the tax rate."
Is the ETI really that important?
ETI AND DEADWEIGHT LOSS
The deadweight loss is given by =− , where is the utility
loss from taxation (in monetary units) and is collected tax revenue.
The marginal DWL is given by = − .
We have = + where is themechanical revenue effectand is the behavioral revenue effect. We have = using
the envelope theorem.
⇒ = − ( + ) = −.
⇒ marginal DWL equals behavioral revenue loss, which is determined
by tax base elasticities (ETI in the context of income taxation).
REAL RESPONSES VS. AVOIDANCE/EVASION
Model makes sense for real responses, but what about avoidance/evasion?
Key assumption: fiscal externality arising from the tax wedge is the
only externality from taxable income responses.
This requires that the private costs of avoidance/evasion equal the social
costs. This is not satisfied for e.g. fines for evasion, but may be for real
tax sheltering costs and moral costs.
Fully including evasion/avoidance in DWL calculations may overstate
efficiency effects→ estimate both real income elasticities and ETIs.
ETI LITERATURE
Lindsey (1987) andFeldstein (1995) were first to estimate the ETI, using
the Reagan 81-reform (Lindsey) and Reagan 86-reform (Feldstein) as
natural experiments.
Since then, a large literature has estimated the ETI using US data.
More recently, there has been work on other countries.
Excellent surveys and critical discussions of the ETI literature:
Slemrod (1998), National Tax Journal.
Saez (2004), Tax Policy and the Economy.
Saez, Slemrod, & Giertz (2012), Journal of Economic Literature.
A CENTURY OF U.S. INCOME TAXATION
US income tax starts in 1913. Marginal tax rates (MTRs) are very low
initially, but increase sharply in the interwar period. Large exemption
levels implied that less than 10% of the population paid income tax.
After 1942, exemption levels were lowered and more people included in
the tax net. Top MTR was extremely high (94% in 1944-45).
Since then, the top MTR has been changed as follows:91% to 70% 1963-65 Kennedy: RA6470% to 50% 1980-82 Reagan: ERTA8150% to 28% 1986-88 Reagan: TRA8628% to 31% 1990-1991 Bush Sr: OBRA9031% to 39.6% 1992-1993 Clinton: OBRA9339.6% to 35% 2000-2003 Bush Jr: EGTRRA01
TOP INCOME SHARE ANALYSIS
Denote by the top income share and by the top MTR at time .
If a legislated change in occurs between time 0 and 1, the ETI can
be estimated as
=ln 1 − ln 0
ln(1− 1)− ln(1− 0)
Identifying assumption: absent the tax change, the top incomeshare would have remained constant.
This is a dif-in-dif using the whole population as a control group:∆ ln = %-change in top income − %-change in population income.
6%
8%
10%
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14%
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60%
Top
1% In
com
e Sh
are
p 1%
Mar
gina
l Tax
Rat
eTOP 1% INCOME SHARE AND MARGINAL TAX RATE IN THE US
Source: Saez, Slemrod, and Giertz (2009)
0%
2%
4%
6%
8%
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0%
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60%19
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Top
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argi
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ax R
ate
TOP 1% INCOME SHARE AND MARGINAL TAX RATE IN THE US
Top 1% Marginal Tax Rate Top 1% Income Share
10%
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50%
60%
Nex
t 9%
Inco
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Shar
e
xt 9
% M
argi
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ax R
ate
NEXT 9% INCOME SHARE AND MARGINAL TAX RATE IN THE US
Source: Saez, Slemrod, and Giertz (2009)
0%
5%
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25%
30%
0%
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60%19
60
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t 9%
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Rat
eNEXT 9% INCOME SHARE AND MARGINAL TAX RATE IN THE US
Next 9% Marginal Tax Rate Next 9% Income Share
INSIGHTS FROM TOP INCOME SHARE ANALYSIS
1. The top-percentile share started to increase precisely in 1981 when
the top MTR started to decline.
2. A sharp jump in the top-percentile share in 1986-1988 corresponds
exactly to the sharp drop in the top MTR enacted by TRA86.
3. The top-percentile share continues to increase in the 1990s despite
increases in the top MTR.
4. The income share for the 90th-99th percentile is very smooth and
displays no correlation with the MTR for this group.
⇒ Circumstantial evidence that the ETIwill be strongly heterogeneous
across reforms/time periods and across income groups.
FELDSTEIN (1995): TRA86
Studies TRA86 as a natural experiment.
TRA86 is the most fundamental tax reform in the US since WWII.
TRA86 lowered the top MTR from 50% to 28% phased in over two
years, with smaller tax cuts further down the distribution.
The reform also involved substantial base-broadening by repealing ex-
emptions and preferential tax treatment.
FELDSTEIN (1995): EMPIRICAL STRATEGY
Uses a panel of individual tax returns. Compares years 1985 and 1988.
Exploit differences in marginal tax cuts across the income distribution:
Treatment group = highest-income taxpayers in 1985: 85 = 49-50%
Control group 1 = high-income taxpayers in 1985: 85 = 42-45%
Control group 2 = medium-income taxpayers in 1985: 85 = 22-38%
A dif-in-dif is then used to estimate the ETI:
=∆ ln −∆ ln
∆ ln¡1−
¢−∆ ln
¡1−
¢where is taxable income.
CHANGES IN TAX RATES AND REPORTEDINCOMES BETWEEN 1985 AND 1988INCOMES BETWEEN 1985 AND 1988
Source: Feldstein (1995)
DIFFERENCE-IN-DIFFERENCES:THE ELASTICITY OF TAXABLE INCOMETHE ELASTICITY OF TAXABLE INCOME
Source: Feldstein (1995)
PROBLEMS WITH FELDSTEIN’S APPROACH
(1) If inequality increases for non-tax reasons, the ETI is biasedupwards as the dif-in-dif attributes all of the differential increase in top
incomes to the tax reform.
(2) Defining treatment and control by pre-reform income level creates
a mean-reversion problem. For tax cuts at the top, this biases theETI downwards.
(3) When both treatments and controls are affected, dif-in-dif requires
homogeneous elasticities. If elasticities are increasing in income,the ETI is biased upwards.
THE HOMOGENEOUS ELASTICITY ASSUMPTION
Our estimate:
=∆ ln −∆ ln
∆ ln(1− )−∆ ln(1− )
Suppose true elasticities are for the -group and zero for the -group.
Then, given parallel trends, we have
∆ ln −∆ ln = ·∆ ln(1− )
If ∆ ln(1− ) = ·∆ ln(1− ) where ∈ [0 1), we obtain
=1
1− ·
In Feldstein, we have ' 14 −
12.
PROBLEMS WITH FELDSTEIN’S APPROACH
(4) A very small sample. Results driven by very few observations.
(5) TRA86 changed both the tax rate and the tax base → a
concurrent definition of taxable income would confound behavioral and
definitional effects→ use a constant pre- or post-definition, but this is
not without bias.
(6) Increase in top incomes partly driven by income shifting fromcorporate to personal tax bases (Gordon-Slemrod, 2000). As corporate
income is also taxed (albeit at a lower rate), the ETI overstates the
revenue and efficiency effects.
(7) Short-term vs long-term responses and the timing of income.
GRUBER AND SAEZ (2002)
Panel data from 1979 to 1990, including federal (ERTA81, TRA86)
and state tax reforms. Relate changes in taxable income to changes in
marginal tax rates in three-year intervals (1979-1982, ..., 1987-1990).
Basic specification without income effects:
∆ ln () = ·∆ ln (1− ) + controls+
Nonlinear tax system→ endogenous to → simulate instrument
for ∆ ln (1− ) using mechanical tax changes.
Control for the (possibly nonlinear) relationship between income changes
and base-year income levels (inequality trends, mean reversion).
GRUBER AND SAEZ (2002)
Find an ETI of around 0.4 and an elasticity of "broad income" of 0.12.
Larger elasticities at the top than at the bottom.
Identifying assumption: the relationship between income changesand base-year income levels is not changing over time in a way which
is correlated with the tax reforms.
Problem: estimates are very sensitive to specification, especially theform of base-year income controls (Kopczuk 2005). We do not know
which specification adequately controls for non-tax related income trends
and mean reversion.
ANATOMY OF BEHAVIORAL RESPONSE
If part of the change in taxable income is driven by income shiftingbetween corporate and personal tax bases, the ETI is not a sufficient
statistic to calculate revenue and welfare effects.
In a tax system with several tax bases, we have to know the elasticity
for each tax base as well as cross-elasticities between bases (tax shifting)
in order to evaluate revenue, welfare, and optimal taxation.
Illuminating to consider the composition of the top 0.01% income share
in the US over time.
80%
90%3.5%
TOP 0.01% INCOME SHARE, COMPOSITION, AND MTR IN THE US, 1960-2006
60%
70%
80%
90%
2.5%
3.0%
3.5%
op 0
.01%
posi
tion
TOP 0.01% INCOME SHARE, COMPOSITION, AND MTR IN THE US, 1960-2006
50%
60%
70%
80%
90%
2.0%
2.5%
3.0%
3.5%
te fo
r the
top
0.01
%
e an
d co
mpo
sitio
nTOP 0.01% INCOME SHARE, COMPOSITION, AND MTR IN THE US, 1960-2006
Other Interest Dividends
30%
40%
50%
60%
70%
80%
90%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
gina
l Tax
Rat
e fo
r the
top
0.01
%
p 0.
01%
sha
re a
nd c
ompo
sitio
nTOP 0.01% INCOME SHARE, COMPOSITION, AND MTR IN THE US, 1960-2006
Other Interest Dividends
Sole Prop. Partnership S-Corp.
Wages MTR
10%
20%
30%
40%
50%
60%
70%
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90%
0.5%
1.0%
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2.0%
2.5%
3.0%
3.5%
Mar
gina
l Tax
Rat
e fo
r the
top
0.01
%
Top
0.01
% s
hare
and
com
posi
tion
TOP 0.01% INCOME SHARE, COMPOSITION, AND MTR IN THE US, 1960-2006
Other Interest Dividends
Sole Prop. Partnership S-Corp.
Wages MTR
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
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Mar
gina
l Tax
Rat
e fo
r the
top
0.01
%
Top
0.01
% s
hare
and
com
posi
tion
TOP 0.01% INCOME SHARE, COMPOSITION, AND MTR IN THE US, 1960-2006
Other Interest Dividends
Sole Prop. Partnership S-Corp.
Wages MTR
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
1960
1962
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1966
1968
1970
1972
1974
1976
1978
1980
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1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Mar
gina
l Tax
Rat
e fo
r the
top
0.01
%
Top
0.01
% s
hare
and
com
posi
tion
TOP 0.01% INCOME SHARE, COMPOSITION, AND MTR IN THE US, 1960-2006
Other Interest Dividends
Sole Prop. Partnership S-Corp.
Wages MTR
Source: Saez, Slemrod, and Giertz (2009)
ANATOMY OF TOP INCOMES OVER TIME
1. The top income share remains flat in the 1960s and well into the
1970s despite very substantial tax cuts.
2. About 1/3 of the surge in taxable income around TRA86 is driven by
S-corporation income. This suggests shifting from C-corp to S-corp.
3. Partnership income rises dramatically after TRA86 as partnership
loss tax shelters are closed.
4. Dramatic shift in the composition of top income from dividends to
wage and S-corp [rentiers→ working rich]
5. Dramatic secular growth in top wage income since the early 1970s,
with short-term spikes around 1988 and 1992 due to timing effects.
OVERALL CONCLUSIONS FROM U.S. STUDIES
Generic problem: identifying variation comes from tax cuts to the
top, which are correlated with non-tax factors driving top incomes. Tax
return data does not offer direct controls for non-tax factors.
ETI estimates seem to be driven mostly by two phenomena:
1. Dramatic secular growth in top wage incomes.
Question: what are the deep reasons for this phenomenon?
Possible answers: (i) tax policy, (ii) skill-biased technical progress, (iii)
international trade, (iv) superstar markets, (v) social norms.
2. Shift from C-corporations to S-corporations.
Question: how important is income shifting relative to income creation?
EVIDENCE FROM OTHER COUNTRIES
United Kingdom: Brewer, Saez, and Shepard (2010)
• Thatcher tax cuts: top MTR reduced from 83% to 60% in 1979, andto 40% in 1988.
• Top income share analysis 1962-2003.
• UK setting yields qualitatively similar results and poses the same
key problems as US setting.
EVIDENCE FROM OTHER COUNTRIES
Denmark: Kleven and Schultz (2013)
1. Full-population administrative data over 25 years [link taxreturn information with detailed socioeconomic information]
2. A stable income distribution avoids bias from non-tax changesin inequality
3. Tax reforms that create large and compelling tax variationacross different income levels and different income forms
4. Clear graphical panel evidence of taxable income responses aroundlarge 1987-reform
5. Findings are very robust to specification
EVOLUTION OF TOP INCOME SHARES IN DENMARK
Source: Kleven and Schultz (2013)
MECHANICAL TAX VARIATION FOR LABOR INCOME AROUND 1987-REFORM (1986-1989 DIFFERENCE)
Source: Kleven and Schultz (2013)
GRAPHICAL EVIDENCE ON TAXABLE INCOME RESPONSES TO THE DANISH 1987-REFORM
Source: Kleven and Schultz (2013)
Labor Income
GRAPHICAL EVIDENCE ON TAXABLE INCOME RESPONSES TO THE DANISH 1987-REFORM
Source: Kleven and Schultz (2013)
Labor Income: Large vs Small Tax Cuts
GRAPHICAL EVIDENCE ON TAXABLE INCOME RESPONSES TO THE DANISH 1987-REFORM
Source: Kleven and Schultz (2013)
Capital Income
KLEVEN AND SCHULTZ (2013): KEY FINDINGS
1. Modest labor income elasticities (.05-.20)
2. Larger capital income elasticities (.10-.30)
3. Larger elasticities when estimated from larger reforms (frictions)
4. Modest income shifting between labor and capital income
Policy implication: broad tax bases and strong enforcement (smallavoidance/evasion opportunities) ensures modest behavioral responses
even under very high marginal tax rates.
HIGH-INCOME LAFFER RATE
Top marginal tax rate is and applies to income above . Denote by
the average income for the tax payers above .
Tax revenue raised by the top MTR is given by = · ( − ) · .Consider a marginal change, , in the top rate.
Themechanical revenue effect is given by = · ( − ) ·
The behavioral revenue effect is given by = · ·
The high-income Laffer rate ∗ is determined by = + = 0.
HIGH-INCOME LAFFER RATE
The high-income Laffer rate:
∗ =1
1 + ·
where ≡ (1−)(1− ) is the ETI and ≡
− ≥ 1 reflects how close
top-rate taxpayers are to the bracket threshold on average.
Top tail is approximately Pareto distributed→ does not vary with
and is equal to the Pareto parameter. In the U.S., we have ≈ 16.
The different ETI estimates we’ve seen imply huge differences in Laffer
rates and policy conclusions. But this overstates the importance of the
ETI as it is not a structural parameter.
ETI AS A POLICY INSTRUMENT
The ETI is not a structural parameter. It depends on avoidanceand evasion, which depend on the tax and enforcement system (Slemrod
and Kopczuk 2002).
The ETI will be low under (i) a broad tax base that offers limitedopportunity for income shifting, (ii) rigorous tax enforcement thatoffers limited opportunity for evasion.
If the ETI is very high (Laffer rate very low), what is the best policy
response?
Two possibilities: (i) reduce the MTR, (ii) reduce the ETI. Optimal
policy depends on the marginal costs and benefits of (i) and (ii).