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TAXABLE INCOME RESPONSES

Camille Landais

London School of Economics

Lecture Notes for MSc Public Economics (EC426)

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 byGZO =Z−W , whereZ is the utility

loss from taxation (in monetary units) and W is collected tax revenue.

The marginal DWL is given by gGZO = gZ − gW .

We have gW = gP+gE where gP is themechanical revenue effectand gE is the behavioral revenue effect. We have gZ = gP using

the envelope theorem.

⇒ gGZO = gP − (gP + gE) = −gE.

⇒ 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 vw the top income share and by � w the top MTR at time w.

If a legislated change in � w occurs between time 0 and 1, the ETI can

be estimated as

%̂ =ln v1 − ln v0

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 vw = %-change in top income − %-change in population income.

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eTOP 1% INCOME SHARE AND MARGINAL TAX RATE IN THE US

Source: Saez, Slemrod, and Giertz (2009)

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TOP 1% INCOME SHARE AND MARGINAL TAX RATE IN THE US

Top 1% Marginal Tax Rate Top 1% Income Share

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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 }W −∆ ln }F

∆ ln¡1− �W

¢−∆ ln

¡1− �F

¢>

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 }W −∆ ln }F

∆ ln(1− �W )−∆ ln(1− �F)=

Suppose true elasticities are % for the W -group and zero for the F-group.

Then, given parallel trends, we have

∆ ln }W −∆ ln }F = % ·∆ ln(1− �W )=

If ∆ ln(1− �F) = � ·∆ ln(1− �W ) 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 (}lw) = % ·∆ ln (1− � lw) + controls+ �lw=

Nonlinear tax system→ � lw endogenous to }lw → simulate instrument

for ∆ ln (1− � lw) 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

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op 0

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nTOP 0.01% INCOME SHARE, COMPOSITION, AND MTR IN THE US, 1960-2006

Other Interest Dividends

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Sole Prop. Partnership S-Corp.

Wages MTR

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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 (2014)

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)


GRAPHICAL EVIDENCE ON TAXABLE INCOME RESPONSES TO THE DANISH 1987-REFORM


Labor Income



Labor Income: Large vs Small Tax Cuts



Capital Income

KLEVEN AND SCHULTZ (2014): 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 Q tax payers above }̄.

Tax revenue raised by the top MTR is given by U = � · (} − }̄) · Q .Consider a marginal change, g� , in the top rate.

Themechanical revenue effect is given by gP = g� · (} − }̄) ·Q=

The behavioral revenue effect is given by gE = � · g} ·Q=

The high-income Laffer rate �∗ is determined by gU = gP + gE = 0.

HIGH-INCOME LAFFER RATE

The high-income Laffer rate:

�∗ =1

1 + % · �>

where % ≡ g}@}g(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 � ≈ 1=6.

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).