Tax bases, tax rates and the elasticity of reported income

Abstract

Tax reforms usually change both tax rates and tax bases. Using a panel of income tax returns spanning the two major U.S. tax reforms of the 1980s and a number of smaller tax law changes, I find that the elasticity of income reported on personal income tax returns depends on the available deductions. This highlights that this key behavioral elasticity is not a structural parameter but rather that it can be to some extent controlled by policy makers. The results suggest that base broadening reduces the marginal efficiency cost of taxation. The point estimates indicate that the Tax Reform Act of 1986 reduced the marginal cost of collecting a dollar of tax revenue by 2 cents, with roughly half of this reduction due to the base broadening and the other half due to the tax rate reduction. As a by-product, the analysis in this paper offers a reconciliation of disparate estimates obtained by previous studies of the tax responsiveness of income.

Public Provision of Private Goods and Nondistortionary Marginal Tax Rates

“…By estimating how total taxable income reacts to changes in the marginal tax one would be able to capture distortions of all relevant margins. Feldstein's own estimates indicated large welfare losses whereas many later studies arrived at estimates of the welfare loss that was larger than those obtained in preFeldstein studies, but considerably lower than the estimates obtained by Feldstein (Gruber and Saez, 2002, Saez, 2003, Kopczuk, 2005. See also Chetty (2008) for a recent re-assessment of the taxable income elasticity as the correct measure of excess burden in the presence of evasion and avoidance.…”

Labor income responds differently to income-tax and payroll-tax reforms

“…For instance, tax reforms in Denmark in the 1980s concern the whole income distribution; inside income-groups, they increase the marginal tax rate for some individuals while decreasing it for others. Indeed, Kleven and Shultz (2012) using Danish data find much more robust estimates than Kopczuk (2005) using US data. As the French tax reforms we use generate up-and-down movements in marginal tax rates that are nonlinear functions of pre-reform income (see Section II), we expect the issue of controlling for the effects of pre-reform income to be less severe than in US studies (see our robustness checks in Section VI.2).…”

“…However, as pointed out by Kopczuk (2005), mean reversion and heterogeneous income trends across income groups are two separate phenomena, and it is unlikely that a function of base-year income alone can capture both effects. Kopczuk (2005) thus proposes to include two separate variables: a 10-piece spline of the log difference between base-year income and income in the preceding year, log(w i,t-1 )-log(w i,t-2 ), to account for mean reversion and other transitory income effects, and a 10-piece spline of the gross labor income in the year preceding the base year, log(w i,t-2 ), to control for heterogeneous shifts in the income distribution.…”

“…Kopczuk (2005) thus proposes to include two separate variables: a 10-piece spline of the log difference between base-year income and income in the preceding year, log(w i,t-1 )-log(w i,t-2 ), to account for mean reversion and other transitory income effects, and a 10-piece spline of the gross labor income in the year preceding the base year, log(w i,t-2 ), to control for heterogeneous shifts in the income distribution. Since our dataset provides information on gross labor income in year t-2, we follow the latter strategy in our baseline specification.…”

“…For instance, Kopczuk (2005) illustrates how sensitive the estimates of taxable income elasticity for the US are to the specification of pre-reform income controls. This issue is less severe when changes in marginal tax rates are not systematically correlated with pre-reform income.…”