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Graduate Public FinanceTaxing Top Earners
Owen ZidarPrincetonFall 2017
Lecture 5
Thanks to Emmanuel Saez and David Card for sharing his slides/notes, many of whichare reproduced here. Stephanie Kestelman provided excellent assistance making theseslides.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 1 / 101
Outline
1 Motivation
2 PolicyFederal US income tax policyState and local tax deductionMortgage interest deductionPass-throughs, taxes, and inequalityRecent top income tax reforms
3 TheoryLabor supply theoryOptimal labor income tax progressivity
4 EvidenceEmpirical estimation of e and identification issuesEvidence from Zidar (2017) “Tax cuts for whom?”
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 2 / 101
Outline
1 Motivation
2 PolicyFederal US income tax policyState and local tax deductionMortgage interest deductionPass-throughs, taxes, and inequalityRecent top income tax reforms
3 TheoryLabor supply theoryOptimal labor income tax progressivity
4 EvidenceEmpirical estimation of e and identification issuesEvidence from Zidar (2017) “Tax cuts for whom?”
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 3 / 101
Credit to Heathcote Storesletten Violante (QJE, forthcoming) for the quote.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 4 / 101
Tax Cuts and Jobs Act
Source: Tax Policy Center.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 5 / 101
Tax Cuts and Jobs Act
Source: Tax Policy Center.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 6 / 101
Current top income tax policy debate
Mr. Johnson had become the first Senate Republican to saypublicly that he could not vote for the Senate’s version of the taxbill. During the phone call on Wednesday afternoon, Mr. Ryan,who had campaigned heavily for Mr. Johnson in 2016, posed anessential question, according to the senator: “What are yougoing to need?”
Source: NYTimes.
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Current top income tax policy debate
What Mr. Johnson needs, he said in an interview from Wisconsinon Friday, is for the bill to treat more favorably small businessesand other so-called pass-through entities – businesses whoseprofits are distributed to their owners and taxed at rates forindividuals. Such entities, including Mr. Johnson’s family-runplastics manufacturing business, account for more than half ofthe nation’s business income, and the senator says the tax billwould give an unfair advantage to larger corporations.
“I just have in my heart a real affinity for these owner-operatedpass-throughs,” he said. “We need to make American businessescompetitive – they’re not right now. But in making businessescompetitive, we can’t leave behind the pass-throughs.”
Source: NYTimes.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 8 / 101
Rising Top 1% income shares
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%Pr
e-Ta
x In
com
e Sh
are
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Year
Dividends Other capital incomeBusiness income Salaries
Source: Smith, Yagan, Zidar, Zwick (2017).
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 9 / 101
Outline
1 Motivation
2 PolicyFederal US income tax policyState and local tax deductionMortgage interest deductionPass-throughs, taxes, and inequalityRecent top income tax reforms
3 TheoryLabor supply theoryOptimal labor income tax progressivity
4 EvidenceEmpirical estimation of e and identification issuesEvidence from Zidar (2017) “Tax cuts for whom?”
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 10 / 101
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 laborand capital income sources) = called Adjusted Gross Income (AGI)
Main exclusions: fringe benefits (health insurance, pensioncontributions), imputed rent of homeowners, unrealized capital gains
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 11 / 101
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) mortgageinterest payments, (c) charitable giving, various small other items
About 10% of AGI lost through itemized deductions, called taxexpenditures
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 12 / 101
Federal US Income tax deductions
Source: Tax Policy Center.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 13 / 101
Federal US Income tax deductions
0 10 20 30 40Share (%) of National Total
$200K+
[$100K, $200K)
[$75K, 100K)
[$50K, $75K)
[$25K, $50K)
[$0, $25K)
Returns AGIItemized Deductions
Source: Zidar’s calculations of IRS SOI 2013 data
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 14 / 101
Federal US Income tax brackets
Tax T (z) is piecewise linear and continuous function of taxableincome z with constant marginal tax rates (MTR) T ′(z) by brackets
In 2013-2016, 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 doubletaxation of corporate profits]
Tax rates change frequently over time. Top MTRs have declineddrastically since 1960s (as in many OECD countries)
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 15 / 101
Federal US Income tax schedule
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 16 / 101
Federal US Income marginal tax schedule
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 17 / 101
Federal US top income tax rate
Source: Saez.Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 18 / 101
Federal US Income tax deductions
Source: Tax Policy Center.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 19 / 101
State and Local Tax Deduction
Major tax reform proposals, such as the Tax Reform Act of 1986, the2005 President’s Advisory Panel on Federal Tax Reform, and TaxCuts and Job Acts 2017, often propose eliminating or reducing thestate and local tax deduction (SALT), which is one of the largest taxexpenditures in the U.S. tax code and was deemed by PresidentReagan “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 incomethat is subject to federal income tax.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 20 / 101
State and Local Tax Deduction2015 data from Tax Policy Center
0 50 100State and local tax deduction (billions)
WyomingSouth Dakota
AlaskaNorth Dakota
VermontWest Virginia
MontanaDelaware
New MexicoMississippi
IdahoNevada
MaineHawaii
Rhode IslandNew Hampshire
District of ColumbiaArkansasNebraskaLouisianaAlabama
TennesseeOklahoma
KansasUtahIowa
KentuckySouth Carolina
ArizonaIndiana
MissouriWashington
ColoradoOregon
WisconsinMichigan
MinnesotaNorth Carolina
GeorgiaConnecticut
OhioFloridaVirginia
MarylandMassachusetts
PennsylvaniaTexasIllinois
New JerseyNew YorkCalifornia
Source: TPC 2015 dataGraduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 21 / 101
State and Local Tax Deduction2015 data from Tax Policy Center
0 5 10 15 20Share of Total (%)
WashingtonColorado
OregonWisconsin
North CarolinaMinnesota
MichiganGeorgia
ConnecticutOhio
FloridaVirginia
MarylandMassachusetts
PennsylvaniaTexasIllinois
New JerseyNew YorkCalifornia
SALT Share Fed Income Tax Share
Source: TPC 2015 dataGraduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 22 / 101
State and Local Tax Deduction2015 data from Tax Policy Center
0 5,000 10,000 15,000 20,000Average State and local tax deduction
AlaskaTennessee
AlabamaNevada
South DakotaMississippi
WyomingLouisiana
North DakotaNew Mexico
FloridaWashington
ArizonaTexas
OklahomaUtah
IndianaSouth Carolina
IdahoColoradoArkansas
GeorgiaDelawareMontana
KansasWest Virginia
North CarolinaMichiganMissouri
HawaiiKentucky
New HampshireIowaOhio
NebraskaPennsylvania
VirginiaMaine
WisconsinVermont
Rhode IslandIllinois
OregonMaryland
MinnesotaMassachusetts
District of ColumbiaNew Jersey
CaliforniaConnecticut
New York
Source: TPC 2015 dataGraduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 23 / 101
State and Local Tax Deduction2015 data from Tax Policy Center
0 2 4 6 8 10SALT as % of AGI
AlaskaSouth Dakota
WyomingNorth Dakota
TennesseeNevadaFloridaTexas
LouisianaAlabama
WashingtonNew Mexico
MississippiWest Virginia
OklahomaIndianaArizona
ArkansasKansas
ColoradoMichigan
South CarolinaNew Hampshire
MissouriIdaho
DelawareUtahOhio
North CarolinaMontana
HawaiiKentucky
PennsylvaniaNebraska
IowaGeorgia
IllinoisVirginia
MaineVermont
WisconsinMinnesota
Rhode IslandMassachusetts
District of ColumbiaOregon
MarylandCalifornia
ConnecticutNew Jersey
New York
Source: TPC 2015 dataGraduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 24 / 101
State and Local Tax Deduction2015 data from Tax Policy Center
0 10 20 30 40 50Share of returns in state with deduction (%)
WyomingWest Virginia
VermontSouth DakotaNorth Dakota
MontanaDistrict of Columbia
DelawareAlaska
Rhode IslandNew Mexico
New HampshireNebraska
MaineIdaho
HawaiiNevada
MississippiKansas
ArkansasUtah
OklahomaIowa
LouisianaKentuckyAlabama
TennesseeSouth Carolina
OregonMissouriIndiana
ConnecticutArizona
WisconsinMinnesotaColorado
WashingtonNorth Carolina
MichiganMassachusetts
MarylandVirginia
OhioGeorgia
PennsylvaniaNew Jersey
IllinoisFloridaTexas
New YorkCalifornia
Source: TPC 2015 dataGraduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 25 / 101
Mortgage interest deduction (MID)
People who itemize their deductions can deduct interest payments onthe first $1 million of outstanding mortgage loan principal for aprimary or secondary home and on the interest for up to $100,000 ofhome equity debt.
Dollars: 7 percent of the benefits go the middle 20 percent ofhouseholds, compared to roughly three-quarters that go to the topquintile.
Participation: 17 percent of those in the middle quintile take thededuction, compared to about 70 percent in the top quintile.
Source: Tax policy center.http://www.taxpolicycenter.org/taxvox/gutting-mortgage-interest-deduction
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 26 / 101
Mortgage interest deduction (MID)
Source: Tax Policy Center.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 27 / 101
Mortgage interest deduction (MID)
Source: Tax Policy Center.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 28 / 101
Recent top income tax reforms
Source: Saez (TPE, 2017).
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 29 / 101
Recent top income tax reforms
Source: Saez (TPE, 2017).
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 30 / 101
Outline
1 Motivation
2 PolicyFederal US income tax policyState and local tax deductionMortgage interest deductionPass-throughs, taxes, and inequalityRecent top income tax reforms
3 TheoryLabor supply theoryOptimal labor income tax progressivity
4 EvidenceEmpirical estimation of e and identification issuesEvidence from Zidar (2017) “Tax cuts for whom?”
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 31 / 101
Progressive tax distorts consumption-leisure choices
A key question: how much do hours of work (H2 vs H1) increase when taxschedule becomes flatter?
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 32 / 101
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
Demand function
Source: Card.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 34 / 101
Expenditure function
Source: Card.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 35 / 101
Indirect utility function
Source: Card.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 36 / 101
Slutsky decomposition
Source: Card.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 37 / 101
Using the expenditure function: setup
Source: Card.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 38 / 101
Static labor supply: direct approach
The maximized value function (i.e., the indirect utility function) is:
v(p,w , y) = maxx ,h
u(x ,T − h) s.t. px = wh + y (1)
where
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 wageThe budget constraint is px = wh + y or rearranging px + wh = wT + ySource: Card.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 39 / 101
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
Static labor supply: indirect expenditure function approachto solve for hc(p,w , u)
Source: Card.
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Static labor supply: slutsky equation
Source: Card.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 42 / 101
Income effect w ∂h∂y and the budget constraint
From the budget constraint
px = wh + y (2)
p∂x
∂y= w
∂h
∂y+ 1 (3)
−(1− p∂x
∂y︸︷︷︸mpe
) = w∂h
∂y(4)
where
mpe is marginal increase in total spending on goods and services ifnon-labor income goes up by 1 dollar
1−mpe is marginal increase in total spending on leisure whennon-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
Slutsky equation
ε = εC + w0 ∂h
∂y(5)
where the classic benchmarks for US male workers are:
ε ∈ [−.1, .2]
εc ≈ .1 to .3
1−mpe ≈ .1 to .2
Source: Card.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 44 / 101
Application of expenditure function: DWL
Source: Card.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 45 / 101
How progressive should labor income tax be?
What is the optimal degree of tax progressivity when households economicoutcomes are determined by their initial ability, partially insurable wageshocks, taste for work, and human capital investment?
Argument in favor of progressivity: missing markets
Social insurance of privately-uninsurable lifecycle shocksRedistribution with respect to unequal initial conditions
Argument against progressivity: distortions
Labor supplyHuman 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
An answer from Heathcote Storesletten Violante
Source: Heathcote Storesletten Violante (QJE, forthcoming)Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 47 / 101
Saez and Diamond JEP 2011
Source: Saez and Diamond (JEP, 2011).
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 48 / 101
Saez and Diamond JEP 2011
Source: Saez and Diamond (JEP, 2011).Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 49 / 101
Saez and Diamond JEP 2011
Source: Saez and Diamond (JEP, 2011).Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 50 / 101
Saez and Diamond JEP 2011
Source: Saez and Diamond (JEP, 2011).
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 51 / 101
Saez and Diamond JEP 2011
Source: Saez and Diamond (JEP, 2011).
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 52 / 101
Outline
1 Motivation
2 PolicyFederal US income tax policyState and local tax deductionMortgage interest deductionPass-throughs, taxes, and inequalityRecent top income tax reforms
3 TheoryLabor supply theoryOptimal labor income tax progressivity
4 EvidenceEmpirical estimation of e and identification issuesEvidence from Zidar (2017) “Tax cuts for whom?”
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 53 / 101
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 zitafter they know z0
it exactly
In year t, i individual reports income zit and faces τit = T ′(zit).Reported income zit = z0
it(1− τit)e , where e is ETI and z0it is income
reported when τit = 0 (i.e., potential income)
We can estimate e using
log zit = e log(1− τit) + log z0it
The last equation cannot be identified using OLS if τ is correlatedwith income z0
it , so need to instrument τit
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 54 / 101
Share AnalysisEstimating 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 t0 and t1 are pre- and post-reform years
e =log st1 − log st0
log(1− τs,t1)− log(1− τs,t0)
st : share of income accruing to the top 1% earners in t
τs,t : income-weighted avg marginal tax rate faced by taxpayers in thisincome group in t
Identification assumption: Absent the tax change, the share wouldhave remained constant from year t0 to t1 (on average)
Using full time series: estimate a time-series regression of the form
log st = e log(1− τs,t) + εt
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 55 / 101
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
Use a share analysis
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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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
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
Shifting
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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Shifting
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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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
A control group?
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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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
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
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
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
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
Income composition
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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Income composition
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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Income composition
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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Income composition
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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Income composition
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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Income composition
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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Income composition
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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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
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
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
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
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
Which trend?
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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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
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
Implied elasticity depends on trend
Source: Saez (TPE, 2017) “Taxing the Rich More: Evidence from the 2013 Tax Increase”
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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
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
Medium-term elasticity estimates
These estimates have implications for top rate
τ∗ =1
1 + ae
When a = 1.5,
If e = .25, then τ∗ = .73
If e = .5, then τ∗ = .57
If e = 1, then τ∗ = .40
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 87 / 101
Summary of empirical evidence of ETI
e Estimation
Feldstein (1995) 1-3 Tabulated diff-in-diff, OLS. The differencein the % change in taxable income between T and C
is divided by the difference in the % change in theaverage net-of-tax-rate between T and C .
Auten and Carroll (1999) 0.55 2SLS, regress change in log AGI between 1985 and 1989against change in log net-of-tax rate. Instrument for change
in net-of-tax rate by inflating adjusted 1985 incomes by the CPI to1989 levels and then applying 1989 law to these incomes.
Moffitt and Wilhelm (2000) 0.35-0.97 Moffitt and Wilhelm calculate e using Feldstein’s (1995)approach, which yields e rom 1.76 to 1.99, and a 2SLS regressionapproach, 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 rateof 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.1.06 (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) 0.12-0.30, depending Methods of Gruber and Saez (2002) to larger panel data sets of tax returnson years included from 1979 to 2001. Results vary if using taxable vs. broad income.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 88 / 101
Explaining empirical findings
No reason to expect a universal parameter:
Kopczuk (2002) argues that the ETI is a function of preferences andthe breadth of the tax base and tax enforcement)
Giertz (2007): elasticity w.r.t. taxable income varies much more bydecade than the elasticity w.r.t. broad income → changing rules fordeductions 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 ETIestimates upward when top tax rates fall and downward when they rise
Models fail to capture important types of income shifting, such as theshifting between the corporate and individual income tax base
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 89 / 101
A classic debate
There are two ideas of government. There are those who believethat if you just legislate to make the well-to-do prosperous, thattheir prosperity will leak through on those below. TheDemocratic idea has been that if you legislate to make themasses prosperous their prosperity will find its way up andthrough every class that rests upon it.
—William Jennings Bryan (July, 1896)
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 90 / 101
Two views
Consequences of changing tax policy for different groups are fiercelydebated
1 Tax changes for high income earners “trickle down” and are the mosteffective way to affect prosperity
Higher marginal tax rates for top-income taxpayers lead to largedistortions in labor supply, investment, and hiring, so tax cuts fortop-income taxpayers most effectively increase aggregate economicactivity.
2 Others contend the opposite
Lower-income groups have higher marginal propensities to consumeand disincentives to work from means-tested benefits, so tax cuts forlower-income groups generate sizable consumption and labor supplyresponses, and thereby, more overall activity
Source: Zidar (2017)
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 91 / 101
Research Question
Question:
Do tax changes for high-income earners “trickle down?”
Would these effects be larger if the tax changes were less targeted atthe top?
Variation in income tax policy in the U.S. can help us answer thesequestions and inform this debate
Source: Zidar (2017)
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Tax changes for each income percentile
Source: Zidar (2017)
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Zidar (2017)
Quantifies the importance of the distribution of tax changes for theiroverall impact on economic activity
New data using tax returns from NBER TAXSIM
New variation from federal tax shocks × variation in incomedistribution across states
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Federal tax changes by income group
Source: Zidar (2017)
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Geographic variation in top income shares
Source: Zidar (2017)
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 96 / 101
Findings
1 The positive relationship between tax cuts and employment growth islargely 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, prioreconomic conditions
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 97 / 101
State: employment to populaiton
Source: Zidar (2017)Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 98 / 101
State: employment
Source: Zidar (2017)Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 99 / 101
State: real wage increase ⇒ LS response
Source: Zidar (2017)
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 100 / 101
State: consumption effects ⇒ demand response
Source: Zidar (2017)
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 101 / 101
Basic model of top income taxation
Top-income individual solves
maxc,l
u(c , l) s.t. c = wl(1− τ) + E
c : disposable incomel : labor supply measured in hours of workw : the exogenous wage rateτ is the top marginal tax rateE is non-taxable endowment/virtual income
Issue: w might depend on individual effort, tax rates andopportunities for evasion ⇒ reported taxable income might differfrom wl
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 103 / 101
Feldstein (1999): Using reported income
Feldstein (1999): Individual problem is
maxc,z(l)
u(c , z(l)) s.t. c = z(l)(1− τ) + E
z : reported taxable income s.t. ∂u/∂z < 0τ : top marginal tax rate for earners with income above z̄
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 104 / 101
Elasticity of taxable income (ETI) in basic framework
Individual ETI e is
ei =1− τzi
∂zi∂(1− τ)
Aggregate ETI is the weighted average of individual ETI
e =1− τzm
∂zm
∂(1− τ)
zm: average reported taxable income across N individuals in the topbrackete captures not only the hours of work response, but also all otherbehavioral responses to marginal tax rates
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 105 / 101
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 highertax rate, absent behavioral response
dM ≡ N(zm − z̄)dτ > 0
2 Behavioral response B: changes in reported income due to greaterincentive to evade and lower incentive to generate income
dB ≡ −Nezm τ
1− τdτ < 0
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 106 / 101
Impact of tax change on total revenue in basic framework
Total change in revenue R is the sum of the mechanical andbehavioral effects:
dR = dM + dB
= N(zm − z̄)
[1− e
zm
zm − z̄
τ
1− τ
]dτ
Define a = zm
zm−z̄ to measure the “thinness” of the top tail of theincome distribution. Rewrite the above equation as
dR = dM
[1− τ
1− τea
]⇒ The fraction of tax revenue lost through behavioral responses is afunction increasing in τ , e and a
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 107 / 101
Measuring efficiency costs (abstracted from distributionalconsiderations)
Marginal excess burden (MEB):“for each extra dollar of taxesraised, the government imposes an extra cost equal to MEB > 0 ontaxpayers
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 5 108 / 101
Revenue maximizing τ in basic framework
Revenue maximizing τ∗ is the rate when dR = dM + dB = 0:
τ∗ =1
1 + ae
Using e = 0.25 and a = 1.5, τ∗ = 72.7% >> 42.5% when combiningall taxes
In the basic model e is a sufficient statistic to estimate the efficiencycosts of taxation
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 109 / 101
Deviation from basic framework: income shifting
Reduction in reported incomes is due in part to a shift away from taxableindividual income toward other forms of taxable income
Assume a fraction s < 1 of taxable income disappears from the taxbase 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 = −Nezm τ
1− τdτ + Nezm
st
1− τdτ
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 110 / 101
Deviation from basic framework: income shifting
Total revenue change dR is
dR = dM
[1− τ − st
1− τea
]MEB is
MEBs =(τ − st)ea
1− τ − (τ − st)ea
Revenue maximizing tax rate τ∗ is
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 5 111 / 101
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 incomeclassification to tax rates on different bases
Timing responses: if individuals and firms expect tax changes, theyhave incentives to accelerate or slow taxable income realizationsbefore the tax change takes place. Similarly, if current vs. futureincome taxes change, individuals have an incentive to change theirbehavior
Short vs long run responses may differ due to adjustment costs. LRresponses are particularly important for understanding savings andcapital accumulation
Tax evasion: elasticity of reported vs. actual income may differ
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 112 / 101
Deviation from basic framework: classic externalities
Suppose a fraction s of taxable income response to a tax rate increasedτ is due to higher expenditures on activities that create anexternality
Externality has social marginal value of exactly t dollars per dollar ofadditional expenditure
Behavioral effect is the same as when income shifts
dB = −Nezm τ
1− τdτ + Nezm
st
1− τdτ
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 113 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 114 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 115 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 116 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 117 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 118 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 119 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 120 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 121 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 122 / 101
Labor Supply Theory
Source: Saez.
Graduate Public Finance (Econ 523) Taxing Top Earners Lecture 5 123 / 101