Innovation and the Long‐Run Elasticity of Total Taxable Income

Abstract

The elasticity of taxable income determines revenue and welfare responses to taxes. Measurement of this elasticity is an ongoing focus of tax policy research. Empirical studies report short‐run elasticities. However, general equilibrium relationships can cause short‐run and long‐run elasticities to diverge. This paper uses a Computable General Equilibrium simulation model to construct long‐run taxable income elasticities. The model differs from most previous simulation analyses of tax policy by its inclusion of endogenous, profit‐motivated Research and Development and innovation. The results indicate that (i) taxable income elasticities can be relatively large, even if tax rate changes initially have only modest effects on labor supply and saving; (ii) total taxable income could be much more responsive to the corporate tax than to the individual tax; and (iii) the elasticities are substantially larger under endogenous innovation than under exogenous innovation. Together the results indicate an increase in the likelihood that the incidence of capital income taxes shifts away from capital as economies evolve toward higher levels of innovation.