In a recent post, Patrick Honohan raised the issue of what a sustainable tax system would look like, and in a follow up to that post, discussed whether a goal of keeping low income workers out of the tax net implied, with the current tax revenue requirement, tax rates on other earners that were so high as to have serious disincentive effects. In the ensuing discussion, John McHale suggested that I was being too sanguine about the incentive effects at the top of the distribution and helpfully pointed me towards a literature that I wasn’t familiar with, on the tax rate elasticity of taxable income, and particularly to a paper by Gruber and Saez (J.Pub.Econ., 2002), which finds an average elasticity of 0.4, with higher elasticities for high earners.
There are two reasons why we should be worried if income elasticities for this group are so high. First, a pragmatic one: it suggests that revenue will rise relatively little if we increase tax rates on this group. Second, a more worrying one: this group contains the job creators; if they’re discouraged from taking the risks and reduce their labour market effort, then there are far bigger knock-on effects in jobs that would have been created with lower tax rates, but now won’t be. The latter concern dominates much of the discussion on this matter – see, for example, Greg Connor’s comment here.
And so, an elasticity of 0.4 would indeed have to cause a rethink on my part. So I went off to read the paper.
The paper is fascinating. It does indeed find an elasticity of taxable income to marginal tax rates of 0.4, with an even higher elasticity of 0.57 for high earners. (Note to explain the counter-intuitive sign: this is actually an elasticity wrt the net-of-tax rate, i.e. if the marginal rate goes up by 1%, so that the net-of-tax rate goes down by 1%, this causes a 40% decrease in income). But the elasticity of ‘broad’ income – income before tax exemptions are taken out – is much lower; it is 0.12 on average, and 0.17 for high earners. The bulk of the difference between these two elasticities is due to changes in what the authors call ‘itemization behaviour’ – in other words, tax avoidance. This point is reinforced by several other analyses in the paper.
One of the two policy conclusions drawn is that
“[t]he large elasticities that we observe are driven by ‘holes’ in the tax base that allow taxpayers, particularly at higher income levels, to reduce their tax burdens. With a broader tax base we would distort behavior less and could therefore raise revenues more efficiently.”
[The second is that concern about the distorting impact of high implicit tax rates in the $10k-$50k income range due to changes in effort (hours) “…may be overblown”, and that attention should instead be paid to incentives that reward participation rather than marginal increments to hours worked.]
So the paper’s message is (i) that the effect on (potentially job-creating) effort by high fliers of increasing tax rates is not zero, but is not high and (ii) that getting rid of tax write-offs should be a priority, particularly if marginal rates on high earners are to be raised.