Graduate Public Finance

Transcription

1 Graduate Public Finance Taxing Top Earners Owen Zidar Princeton Fall 2017 Lecture 5 Thanks to Emmanuel Saez and David Card for sharing his slides/notes, many of which are reproduced here. Stephanie Kestelman provided excellent assistance making these slides. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 1 / 101

2 Outline 1 Motivation 2 Policy Federal US income tax policy State and local tax deduction Mortgage interest deduction Pass-throughs, taxes, and inequality Recent top income tax reforms 3 Theory Labor supply theory Optimal labor income tax progressivity 4 Evidence Empirical estimation of e and identification issues Evidence from Zidar (2017) Tax cuts for whom? Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 2 / 101

3 Outline 1 Motivation 2 Policy Federal US income tax policy State and local tax deduction Mortgage interest deduction Pass-throughs, taxes, and inequality Recent top income tax reforms 3 Theory Labor supply theory Optimal labor income tax progressivity 4 Evidence Empirical estimation of e and identification issues Evidence from Zidar (2017) Tax cuts for whom? Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 3 / 101

4 Credit to Heathcote Storesletten Violante (QJE, forthcoming) for the quote. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 4 / 101

5 Tax Cuts and Jobs Act Source: Tax Policy Center. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 5 / 101

6 Tax Cuts and Jobs Act Source: Tax Policy Center. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 6 / 101

7 Current top income tax policy debate Mr. Johnson had become the first Senate Republican to say publicly that he could not vote for the Senate s version of the tax bill. During the phone call on Wednesday afternoon, Mr. Ryan, who had campaigned heavily for Mr. Johnson in 2016, posed an essential question, according to the senator: What are you going to need? Source: NYTimes. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 7 / 101

8 Current top income tax policy debate What Mr. Johnson needs, he said in an interview from Wisconsin on Friday, is for the bill to treat more favorably small businesses and other so-called pass-through entities businesses whose profits are distributed to their owners and taxed at rates for individuals. Such entities, including Mr. Johnson s family-run plastics manufacturing business, account for more than half of the nation s business income, and the senator says the tax bill would give an unfair advantage to larger corporations. I just have in my heart a real affinity for these owner-operated pass-throughs, he said. We need to make American businesses competitive they re not right now. But in making businesses competitive, we can t leave behind the pass-throughs. Source: NYTimes. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 8 / 101

9 Rising Top 1% income shares 9% 8% Pre-Tax Income Share 7% 6% 5% 4% 3% 2% 1% 0% Year Dividends Business income Other capital income Salaries Source: Smith, Yagan, Zidar, Zwick (2017). Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 9 / 101

10 Outline 1 Motivation 2 Policy Federal US income tax policy State and local tax deduction Mortgage interest deduction Pass-throughs, taxes, and inequality Recent top income tax reforms 3 Theory Labor supply theory Optimal labor income tax progressivity 4 Evidence Empirical estimation of e and identification issues Evidence from Zidar (2017) Tax cuts for whom? Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 10 / 101

11 Federal US Income tax US income tax assessed on annual family income (not individual) [most other OECD countries have shifted to individual assessment] Sum all cash income sources from family members (both from labor and capital income sources) = called Adjusted Gross Income (AGI) Main exclusions: fringe benefits (health insurance, pension contributions), imputed rent of homeowners, unrealized capital gains Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 11 / 101

12 Federal US Income tax Taxable income = AGI - personal exemptions - deduction personal exemptions = $4K * # family members (in 2016) deduction is max of standard deduction or itemized deductions Standard deduction is a fixed amount depending on family structure ($12.6K for couple, $6.3K for single in 2016) Itemized deductions: (a) state and local taxes paid, (b) mortgage interest payments, (c) charitable giving, various small other items About 10% of AGI lost through itemized deductions, called tax expenditures Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 12 / 101

13 Federal US Income tax deductions Source: Tax Policy Center. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 13 / 101

14 Federal US Income tax deductions [$0, $25K) [$25K, $50K) [$50K, $75K) [$75K, 100K) [$100K, $200K) $200K Share (%) of National Total Returns Itemized Deductions AGI Source: Zidar s calculations of IRS SOI 2013 data Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 14 / 101

15 Federal US Income tax brackets Tax T (z) is piecewise linear and continuous function of taxable income z with constant marginal tax rates (MTR) T (z) by brackets In , 6 brackets with MTR 10%,15%,25%,28%,33%,35%, 39.6% (top bracket for z above $470K), indexed on price inflation Lower preferential rates (up to a max of 20%) apply to dividends (since 2003) and realized capital gains [in part to offset double taxation of corporate profits] Tax rates change frequently over time. Top MTRs have declined drastically since 1960s (as in many OECD countries) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 15 / 101

16 Federal US Income tax schedule Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 16 / 101

17 Federal US Income marginal tax schedule Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 17 / 101

18 Federal US top income tax rate Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 18 / 101

19 Federal US Income tax deductions Source: Tax Policy Center. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 19 / 101

20 State and Local Tax Deduction Major tax reform proposals, such as the Tax Reform Act of 1986, the 2005 President s Advisory Panel on Federal Tax Reform, and Tax Cuts and Job Acts 2017, often propose eliminating or reducing the state and local tax deduction (SALT), which is one of the largest tax expenditures in the U.S. tax code and was deemed by President Reagan the most sacred of cows. SALT enables taxpayers to deduct state and local income taxes, which lowers tax liabilities by reducing the amount of taxable income that is subject to federal income tax. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 20 / 101

21 State and Local Tax Deduction 2015 data from Tax Policy Center California New York New Jersey Illinois Texas Pennsylvania Massachusetts Maryland Virginia Florida Ohio Connecticut Georgia North Carolina Minnesota Michigan Wisconsin Oregon Colorado Washington Missouri Indiana Arizona South Carolina Kentucky Iowa Utah Kansas Oklahoma Tennessee Alabama Louisiana Nebraska Arkansas District of Columbia New Hampshire Rhode Island Hawaii Maine Nevada Idaho Mississippi New Mexico Delaware Montana West Virginia Vermont North Dakota Alaska South Dakota Wyoming State and local tax deduction (billions) Source: Graduate Public TPCFinance 2015 (Econ data 523) Taxing Top Earners Lecture 5 21 / 101

22 Source: Graduate Public TPCFinance 2015 (Econ data 523) Taxing Top Earners Lecture 5 22 / 101 State and Local Tax Deduction 2015 data from Tax Policy Center California New York New Jersey Illinois Texas Pennsylvania Massachusetts Maryland Virginia Florida Ohio Connecticut Georgia Michigan Minnesota North Carolina Wisconsin Oregon Colorado Washington Share of Total (%) SALT Share Fed Income Tax Share

23 State and Local Tax Deduction 2015 data from Tax Policy Center New York Connecticut California New Jersey District of Columbia Massachusetts Minnesota Maryland Oregon Illinois Rhode Island Vermont Wisconsin Maine Virginia Pennsylvania Nebraska Ohio Iowa New Hampshire Kentucky Hawaii Missouri Michigan North Carolina West Virginia Kansas Montana Delaware Georgia Arkansas Colorado Idaho South Carolina Indiana Utah Oklahoma Texas Arizona Washington Florida New Mexico North Dakota Louisiana Wyoming Mississippi South Dakota Nevada Alabama Tennessee Alaska 0 5,000 10,000 15,000 20,000 Average State and local tax deduction Source: Graduate Public TPCFinance 2015 (Econ data 523) Taxing Top Earners Lecture 5 23 / 101

24 State and Local Tax Deduction 2015 data from Tax Policy Center New York New Jersey Connecticut California Maryland Oregon District of Columbia Massachusetts Rhode Island Minnesota Wisconsin Vermont Maine Virginia Illinois Georgia Iowa Nebraska Pennsylvania Kentucky Hawaii Montana North Carolina Ohio Utah Delaware Idaho Missouri New Hampshire South Carolina Michigan Colorado Kansas Arkansas Arizona Indiana Oklahoma West Virginia Mississippi New Mexico Washington Alabama Louisiana Texas Florida Nevada Tennessee North Dakota Wyoming South Dakota Alaska SALT as % of AGI Source: Graduate Public TPCFinance 2015 (Econ data 523) Taxing Top Earners Lecture 5 24 / 101

25 State and Local Tax Deduction 2015 data from Tax Policy Center California New York Texas Florida Illinois New Jersey Pennsylvania Georgia Ohio Virginia Maryland Massachusetts Michigan North Carolina Washington Colorado Minnesota Wisconsin Arizona Connecticut Indiana Missouri Oregon South Carolina Tennessee Alabama Kentucky Louisiana Iowa Oklahoma Utah Arkansas Kansas Mississippi Nevada Hawaii Idaho Maine Nebraska New Hampshire New Mexico Rhode Island Alaska Delaware District of Columbia Montana North Dakota South Dakota Vermont West Virginia Wyoming Share of returns in state with deduction (%) Source: Graduate Public TPCFinance 2015 (Econ data 523) Taxing Top Earners Lecture 5 25 / 101

26 Mortgage interest deduction (MID) People who itemize their deductions can deduct interest payments on the first $1 million of outstanding mortgage loan principal for a primary or secondary home and on the interest for up to $100,000 of home equity debt. Dollars: 7 percent of the benefits go the middle 20 percent of households, compared to roughly three-quarters that go to the top quintile. Participation: 17 percent of those in the middle quintile take the deduction, compared to about 70 percent in the top quintile. Source: Tax policy center. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 26 / 101

27 Mortgage interest deduction (MID) Source: Tax Policy Center. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 27 / 101

28 Mortgage interest deduction (MID) Source: Tax Policy Center. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 28 / 101

29 Recent top income tax reforms Source: Saez (TPE, 2017). Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 29 / 101

30 Recent top income tax reforms Source: Saez (TPE, 2017). Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 30 / 101

31 Outline 1 Motivation 2 Policy Federal US income tax policy State and local tax deduction Mortgage interest deduction Pass-throughs, taxes, and inequality Recent top income tax reforms 3 Theory Labor supply theory Optimal labor income tax progressivity 4 Evidence Empirical estimation of e and identification issues Evidence from Zidar (2017) Tax cuts for whom? Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 31 / 101

32 Progressive tax distorts consumption-leisure choices A key question: how much do hours of work (H 2 vs H 1 ) increase when tax schedule becomes flatter? Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 32 / 101

33 Outline Review of basic consumer theory Demand function Expenditure and indirect utility Using the expenditure function Applications Static labor supply Deadweight loss of labor income taxation Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 33 / 101

34 Demand function Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 34 / 101

35 Expenditure function Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 35 / 101

36 Indirect utility function Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 36 / 101

37 Slutsky decomposition Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 37 / 101

38 Using the expenditure function: setup Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 38 / 101

39 Static labor supply: direct approach The maximized value function (i.e., the indirect utility function) is: where v(p, w, y) = max u(x, T h) s.t. px = wh + y (1) x,h x is consumption of goods and services sold at price p h = T l are hours of work y is non labor income w is the hourly wage The budget constraint is px = wh + y or rearranging px + wh = wt + y Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 39 / 101

40 Static labor supply: direct approach to solve for h(p, w, y) Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 40 / 101

41 Static labor supply: indirect expenditure function approach to solve for h c (p, w, u) Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 41 / 101

42 Static labor supply: slutsky equation Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 42 / 101

43 Income effect w h y and the budget constraint From the budget constraint where px = wh + y (2) p x y = w h y + 1 (3) (1 p x ) = w h y y }{{} (4) mpe mpe is marginal increase in total spending on goods and services if non-labor income goes up by 1 dollar 1 mpe is marginal increase in total spending on leisure when non-labor income raises by 1 dollar Leisure is a normal good so 1 mpe > 0 Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 43 / 101

44 Slutsky equation ɛ = ɛ C + w 0 h y (5) where the classic benchmarks for US male workers are: ɛ [.1,.2] ɛ c.1 to.3 1 mpe.1 to.2 Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 44 / 101

45 Application of expenditure function: DWL Source: Card. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 45 / 101

46 How progressive should labor income tax be? What is the optimal degree of tax progressivity when households economic outcomes are determined by their initial ability, partially insurable wage shocks, taste for work, and human capital investment? Argument in favor of progressivity: missing markets Social insurance of privately-uninsurable lifecycle shocks Redistribution with respect to unequal initial conditions Argument against progressivity: distortions Labor supply Human capital investment Another consideration - fiscal externality Financing of public good provision Source: Heathcote Storesletten Violante (QJE, forthcoming) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 46 / 101

47 An answer from Heathcote Storesletten Violante Source: Heathcote Storesletten Violante (QJE, forthcoming) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 47 / 101

48 Saez and Diamond JEP 2011 Source: Saez and Diamond (JEP, 2011). Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 48 / 101

49 Saez and Diamond JEP 2011 Source: Graduate Public SaezFinance and Diamond (Econ 523) (JEP, 2011). Taxing Top Earners Lecture 5 49 / 101

50 Saez and Diamond JEP 2011 Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 50 / 101

51 Saez and Diamond JEP 2011 Source: Saez and Diamond (JEP, 2011). Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 51 / 101

52 Saez and Diamond JEP 2011 Source: Saez and Diamond (JEP, 2011). Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 52 / 101

53 Outline 1 Motivation 2 Policy Federal US income tax policy State and local tax deduction Mortgage interest deduction Pass-throughs, taxes, and inequality Recent top income tax reforms 3 Theory Labor supply theory Optimal labor income tax progressivity 4 Evidence Empirical estimation of e and identification issues Evidence from Zidar (2017) Tax cuts for whom? Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 53 / 101

54 Basic empirical strategy Assume: No income effects on reported income Immediate and permanent response to tax rates e constant over time and uniform across individuals at all income levels Individuals have perfect knowledge of the tax structure and choose z it after they know z 0 it exactly In year t, i individual reports income z it and faces τ it = T (z it ). Reported income z it = zit 0(1 τ it) e, where e is ETI and zit 0 is income reported when τ it = 0 (i.e., potential income) We can estimate e using log z it = e log(1 τ it ) + log z 0 it The last equation cannot be identified using OLS if τ is correlated with income z 0 it, so need to instrument τ it Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 54 / 101

55 Share Analysis Estimating ETI using 2+ years/periods of data Assume that no tax change for individuals outside the top groups Estimate elasticity of reported income around a tax reform episode, where t 0 and t 1 are pre- and post-reform years e = log s t1 log s t0 log(1 τ s,t1 ) log(1 τ s,t0 ) s t : share of income accruing to the top 1% earners in t τ s,t : income-weighted avg marginal tax rate faced by taxpayers in this income group in t Identification assumption: Absent the tax change, the share would have remained constant from year t 0 to t 1 (on average) Using full time series: estimate a time-series regression of the form log s t = e log(1 τ s,t ) + ε t Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 55 / 101

56 Saez (TPE, 2017) Taxing the Rich More Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 56 / 101

57 Use a share analysis Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 57 / 101

58 Relate share changes to 2013 tax rate changes Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 58 / 101

59 Shifting Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 59 / 101

60 Shifting Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 60 / 101

61 Shifting Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 61 / 101

62 Shifting Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 62 / 101

63 A control group? Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 63 / 101

64 Standard share analysis Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 64 / 101

65 Elasticity estimate with shifting Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 65 / 101

66 Shares by income group Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 66 / 101

67 Elasticity estimate with shifting for top 1% to top 0.1% Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 67 / 101

68 Elasticity estimate with shifting by income group Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 68 / 101

69 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 69 / 101

70 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 70 / 101

71 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 71 / 101

72 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 72 / 101

73 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 73 / 101

74 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 74 / 101

75 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 75 / 101

76 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 76 / 101

77 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 77 / 101

78 Medium-term elasticity Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 78 / 101

79 Income composition Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 79 / 101

80 Which trend? Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 80 / 101

81 Which trend? Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 81 / 101

82 Which trend? Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 82 / 101

83 Which trend? Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 83 / 101

84 Implied elasticity depends on trend Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 84 / 101

85 Implied elasticity depends on trend Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 85 / 101

86 Medium-term elasticity estimates Source: Saez (TPE, 2017) Taxing the Rich More: Evidence from the 2013 Tax Increase Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 86 / 101

87 Medium-term elasticity estimates These estimates have implications for top rate When a = 1.5, If e =.25, then τ =.73 If e =.5, then τ =.57 If e = 1, then τ =.40 τ = ae Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 87 / 101

88 Summary of empirical evidence of ETI e Estimation Feldstein (1995) 1-3 Tabulated diff-in-diff, OLS. The difference in the % change in taxable income between T and C is divided by the difference in the % change in the average net-of-tax-rate between T and C. Auten and Carroll (1999) SLS, regress change in log AGI between 1985 and 1989 against change in log net-of-tax rate. Instrument for change in net-of-tax rate by inflating adjusted 1985 incomes by the CPI to 1989 levels and then applying 1989 law to these incomes. Moffitt and Wilhelm (2000) Moffitt and Wilhelm calculate e using Feldstein s (1995) approach, which yields e rom 1.76 to 1.99, and a 2SLS regression approach, employing alternative instruments for the change in the net-of-tax rate. Those instruments that are successful yield e [0.35, 0.97]. Gruber and Saez (2002) 0.17 (broad income 2SLS. Instrument for the change in the net-of-tax rate of top earners) using an instrument very similar to that used by Auten and Carroll (1999). They also construct an analogous instrument for capturing the income effect, the log change in after-tax income assuming that base year income grows at the same rate as total income. Kopczuk (2005) 0.12 (no deductions) and Investigates the hypothesis that the ETI is not a structural parameter (deductible-share Includes instrumented changes in marginal tax rates and an interaction interaction term) term between the change in tax rate and change in tax base. Giertz (2007) , depending Methods of Gruber and Saez (2002) to larger panel data sets of tax returns on years included from 1979 to Results vary if using taxable vs. broad income. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 88 / 101

89 Explaining empirical findings No reason to expect a universal parameter: Kopczuk (2002) argues that the ETI is a function of preferences and the breadth of the tax base and tax enforcement) Giertz (2007): elasticity w.r.t. taxable income varies much more by decade than the elasticity w.r.t. broad income changing rules for deductions affects the taxable income elasticity Methodological issues drive the differences between decades: Model is unable to adequately control for exogenous income trends non-tax-related aspects of income inequality trend could bias ETI estimates upward when top tax rates fall and downward when they rise Models fail to capture important types of income shifting, such as the shifting between the corporate and individual income tax base Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 89 / 101

90 A classic debate There are two ideas of government. There are those who believe that if you just legislate to make the well-to-do prosperous, that their prosperity will leak through on those below. The Democratic idea has been that if you legislate to make the masses prosperous their prosperity will find its way up and through every class that rests upon it. William Jennings Bryan (July, 1896) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 90 / 101

91 Two views Consequences of changing tax policy for different groups are fiercely debated 1 Tax changes for high income earners trickle down and are the most effective way to affect prosperity Higher marginal tax rates for top-income taxpayers lead to large distortions in labor supply, investment, and hiring, so tax cuts for top-income taxpayers most effectively increase aggregate economic activity. 2 Others contend the opposite Lower-income groups have higher marginal propensities to consume and disincentives to work from means-tested benefits, so tax cuts for lower-income groups generate sizable consumption and labor supply responses, and thereby, more overall activity Source: Zidar (2017) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 91 / 101

92 Research Question Question: Do tax changes for high-income earners trickle down? Would these effects be larger if the tax changes were less targeted at the top? Variation in income tax policy in the U.S. can help us answer these questions and inform this debate Source: Zidar (2017) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 92 / 101

93 Tax changes for each income percentile Source: Zidar (2017) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 93 / 101

94 Zidar (2017) Quantifies the importance of the distribution of tax changes for their overall impact on economic activity New data using tax returns from NBER TAXSIM New variation from federal tax shocks variation in income distribution across states Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 94 / 101

95 Federal tax changes by income group Source: Zidar (2017) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 95 / 101

96 Geographic variation in top income shares Source: Zidar (2017) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 96 / 101

97 Findings 1 The positive relationship between tax cuts and employment growth is largely driven by tax cuts for lower-income groups 2 The effect of tax cuts for the top 10% on employment growth is small Holds at both the state and federal level Not confounded by changes in progressive spending, state trends, prior economic conditions Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 97 / 101

98 State: employment to populaiton Source: Zidar (2017) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 98 / 101

99 State: employment Source: Zidar (2017) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 99 / 101

100 State: real wage increase L S response Source: Zidar (2017) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

101 State: consumption effects demand response Source: Zidar (2017) Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

102 Appendix Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

103 Basic model of top income taxation Top-income individual solves max u(c, l) s.t. c = wl(1 τ) + E c,l c: disposable income l: labor supply measured in hours of work w: the exogenous wage rate τ is the top marginal tax rate E is non-taxable endowment/virtual income Issue: w might depend on individual effort, tax rates and opportunities for evasion reported taxable income might differ from wl Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

104 Feldstein (1999): Using reported income Feldstein (1999): Individual problem is max u(c, z(l)) s.t. c = z(l)(1 τ) + E c,z(l) z: reported taxable income s.t. u/ z < 0 τ: top marginal tax rate for earners with income above z Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

105 Elasticity of taxable income (ETI) in basic framework Individual ETI e is e i = 1 τ z i z i (1 τ) Aggregate ETI is the weighted average of individual ETI e = 1 τ z m z m (1 τ) z m : average reported taxable income across N individuals in the top bracket e captures not only the hours of work response, but also all other behavioral responses to marginal tax rates Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

106 Effects of tax change in basic framework Suppose gov increases top rate τ Assume no income effects, revenue changes through two channels: 1 Mechanical effect M: mechanical increase in tax revenue due higher tax rate, absent behavioral response dm N(z m z)dτ > 0 2 Behavioral response B: changes in reported income due to greater incentive to evade and lower incentive to generate income db Nez m τ 1 τ dτ < 0 Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

107 Impact of tax change on total revenue in basic framework Total change in revenue R is the sum of the mechanical and behavioral effects: dr = dm + db [ = N(z m z m ] τ z) 1 e z m dτ z 1 τ Define a = zm z m z to measure the thinness of the top tail of the income distribution. Rewrite the above equation as [ dr = dm 1 τ ] 1 τ ea The fraction of tax revenue lost through behavioral responses is a function increasing in τ, e and a Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

108 Measuring efficiency costs (abstracted from distributional considerations) Marginal excess burden (MEB): for each extra dollar of taxes raised, the government imposes an extra cost equal to MEB > 0 on taxpayers MEB = db dr = τea 1 τ τea Marginal efficiency cost of funds (MECF): MECF = 1 MEB = 1 db dr 1 τ = 1 τ τea Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

109 Revenue maximizing τ in basic framework Revenue maximizing τ is the rate when dr = dm + db = 0: τ = ae Using e = 0.25 and a = 1.5, τ = 72.7% >> 42.5% when combining all taxes In the basic model e is a sufficient statistic to estimate the efficiency costs of taxation Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

110 Deviation from basic framework: income shifting Reduction in reported incomes is due in part to a shift away from taxable individual income toward other forms of taxable income Assume a fraction s < 1 of taxable income disappears from the tax base after dτ sz is now taxed as a different type of income at t Behavioral response now generates a tax revenue change of (τ st)dz Change in tax revenue through the behavioral mechanism is db = Nez m τ 1 τ dτ + Nezm st 1 τ dτ Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

111 Deviation from basic framework: income shifting Total revenue change dr is MEB is dr = dm MEB s = Revenue maximizing tax rate τ is [ 1 τ st ] 1 τ ea (τ st)ea 1 τ (τ st)ea τ s = 1 + stae 1 + ae > τ Using e = 0.25, a = 1.5, τ = 42.5%, s =.5 and t = 30%, τ s = 76.8% Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

112 Deviation from basic framework: income shifting Implications of income shifting: s and t must be included in the calculations about DWL of taxation Individual vs Corporate taxation Responsiveness of income classification to tax rates on different bases Timing responses: if individuals and firms expect tax changes, they have incentives to accelerate or slow taxable income realizations before the tax change takes place. Similarly, if current vs. future income taxes change, individuals have an incentive to change their behavior Short vs long run responses may differ due to adjustment costs. LR responses are particularly important for understanding savings and capital accumulation Tax evasion: elasticity of reported vs. actual income may differ Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

113 Deviation from basic framework: classic externalities Suppose a fraction s of taxable income response to a tax rate increase dτ is due to higher expenditures on activities that create an externality Externality has social marginal value of exactly t dollars per dollar of additional expenditure Behavioral effect is the same as when income shifts db = Nez m τ 1 τ dτ + Nezm st 1 τ dτ Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

114 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

115 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

116 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

117 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

118 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

119 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

120 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

121 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

122 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

123 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101

124 Labor Supply Theory Source: Saez. Graduate Public Finance (Econ 523) Taxing Top Earners Lecture / 101