High Income Taxpayers are More Responsive to Marginal Tax Rates
To justify tax systems with rising marginal rates requires assumptions that give an extraordinarily low weight to the interests of higher-income groups.
In The Elasticity of Taxable Income: Evidence and Implications (NBER Working Paper No. 7512), NBER Research Associate Jonathan Gruber and co-author Emmanuel Saez show that the overall elasticity of taxable income with respect to changes in net-of-tax marginal rates is 0.4. That is, a 10 percent change in the marginal net-of-tax rate (that is, the difference between 100 percent and the marginal tax rate) leads to a 4 percent change in taxable income. Gruber and Saez demonstrate that this elasticity is primarily the result of a greater response by taxpayers with high incomes.
Their analysis is based on a study of U.S.tax reforms in the 1980s. There were two major federal tax reforms, the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986. As a result, the top marginal tax rate at the federal level fell from 70 percent in 1980 to 28 percent by 1988, and the income tax schedule was reduced from 15 brackets to four. The authors also assess the parallel impact of numerous state reforms over the period.
They show that taxpayers with incomes above $100,000 per year (in 1992 dollars) have an elasticity of 0.57, much higher than the 0.4 result for the whole sample. Below $100,000, the elasticity is much lower; it is 0.11 for those in the $50,000-$100,000 group and 0.18 for those in the $10,000-$50,000. These results are based on a study of the NBER's panel of tax returns over the 1979-90 period.
For lower income groups, labor income accounts for most of their income. Since labor income tax is withheld, the only way to manipulate income is to work more, or less. For higher income groups, capital income is more important, and this is more readily manipulated for tax purposes through asset allocation decisions. The researchers show that taxpayers with itemized returns have particularly high elasticity.
Gruber and Saez go on to explore optimal income tax structures. Their results imply that, in general, the optimal tax system should be progressive on average but not at the margin. There could be a negative income tax for those with the lowest incomes, but this would be taxed away rapidly as income rises.
The high responsiveness of taxable income to changes in taxes among the highest income taxpayers suggests that the optimal tax system would feature declining marginal tax rates. To justify tax systems with rising marginal rates requires assumptions that give an extraordinarily low weight to the interests of higher-income groups.
The researchers build on a 1995 study by NBER President Martin Feldstein which showed that standard behavioral responses, such as working fewer hours or saving less, are only one component of what drives taxable income, and that other responses include the form of compensation and compliance. Feldstein found that the overall elasticity of taxable income was very high for the Tax Reform Act of 1986. Subsequent empirical research has generated a lower range of estimated elasticities, from one to zero.
Gruber and Saez's estimate for the overall elasticity of taxable income of 0.4, below the original Feldstein findings, is roughly at the midpoint of the subsequent literature. One problem with earlier studies, corrected by Gruber and Saez, is that they tended to look at all income groups together. A second improvement in this work is that by drawing on the entire set of federal and state reforms in the 1980s, Gruber and Saez are better able to control for other factors in the that contributed to rising taxable income for high-income groups in the 1980 - such as the general widening of the income distribution owing to factors such as skill-biased demand shocks.
-- Andrew Balls