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Income and Behavioural Responses at the Top of the Income Distribution…
Income and Behavioural Responses at the Top of the Income Distribution
Elasticity of Taxable Income (ETI)
Measure that captures the
full
dimension of behavioural responses
Empirical quantity
Key for determining the efficiency cost of taxing top earnings + optimal top tax rates
Channels of Taxable Income Response:
Labour Income: Hours worked, participation, migration, effort on the job, training, education
Capital income: Savings, portfolio choice
Tax avoidance: Legal shifting of income into untaxed or lower-taxed form
Tax evasion: Illegal under-reporting of income
Dependent on the nature of the tax system (e.g. broader tax base + strong enforcement can lead to a
lower
ETI)
Top Income Share Analysis
Background in US:
At the end of WW2, top MTR was extremely high (94% in 1944-1955) and kicked it only at high incomes. Since then, MTR has fallen considerably to the 35% it is currently
Changes in the top MTR provides quasi-experimental variations that allows us to evaluate ETI among top-income earners
We evaluate responses by considering the
change in top income share
around the reform
Definitions:
Top income share
= Total taxable income in the top percentiles of the distribution/share of total taxable income in the population
Taxable income
= Reported before-tax income entering the calculation of tax liability
Insights
Observations
Top percentile share started to increase in 1981, when top MTR started to decline
Sharp jump in top percentile share from 1986-1988 corresponds to the sharp drop in top MTR enacted by TRA86
Top-percentile share continues to increase in the 1990s, despite increases in top MTR
Income share for the 90-99th percentile is very smooth, and displays no correlation with the MTR for this group
Conclusion:
ETI may be strongly heterogenous across reforms/time periods. Alternatively, there could be many different confounders/factors muddying the results/conclusions here
Brewer-Saez-Shepard (2010), Kleven and Schultz (2014)
Methodology
Top Income Share Analaysis
Identifying assumption:
Absent the tax change, top income share would have remained constant
DiD
approach using whole population as a control group
ETI = change in ln(top income share)/change in ln(1-t)
Full Variation over Time
Identifying assumption:
Absent any tax changes, top income share would have remained constant or moved in a way that is uncorrelated with the top MTR.
Threat to identification:
If the top income share is trending for non-tax reasons in a way that is correlated with the tax reform changes, this will bias the ETI estimate
Regression analysis: ln(top income share) = ETI*ln(1-t) + v
Trending Inequality
Regression analysis: ln(top income share) = ETI*ln(1-t) + at + bt^2 + ct^3 + v
Identifying assumption:
Any non-tax changes in the top income share correlated with the tax reforms are fully captured by the 3rd order polynomial time trend controls
Threat to identification:
We cannot be sure how to fully control for inequality trends, and sufficienly rich time trend controls will soak up all the identifying variation
Potential Bias:
If inequality increases for
non-tax reasons
, ETI estimate will be biased upwards. Other non-tax reasons include:
Non-tax policies favouring the rich
Skill-biased technical progress
Globalisation
Superstar markets
Changing social norms
We controlled for time trends and explored control groups very close to the top in order to rectify this, but we cannot be sure which specification adequately controls for a trending distribution.
TRA86 Behavioural Response
Changes in personal taxable income could be driven by
income shifting
between corporate/personal tax bases
ETI estimate based on personal income data would then overstate the revenue and efficiency implications of behaioural responses
Main Finding
Pre-86, breakdown of income had very few S-corps, but S-corps are becoming increasingly more dominant.
This is because while regular corporations are subject to double taxation (i.e. pay taxes both at the corporate and then at the individual income level), S-corps are exempt from paying taxes at the corporate level :
Insights:
Top income share remains flat in the 1960 and well into the 1970s despite substantial tax cuts
About 1/3 of the surge in taxable income around TRA86 was driven by S-corporation income, which suggests shifting from C-corp to S-corp
Partnership income rises dramatically after TRA86 as partnership loss tax shelters are closed
Dramatic shit in the composition of top income from dividends to wage and S-corp (showing the shift from rentiers to working rich)
Dramatic secular growth in top wage income since the early 1970s, with short-term spikes around 1988 ad 1992 due to timing effects
Laffer Curve
A
marginal change dt
leads to
Mechanical
revenue effect dM
Behavioural
revenue effect dB
High-income Laffer rate, t*, is dR = dM + dB = 0
Laffer rate represents an
upper bound on optimal top marginal tax rate.
It would not be wise to increase tax rates beyond the Laffer rate.
By formula,
t* = 1/(1+ETI x alpha)
Alpha = z/(z-z-bar) = average income/(average income above cut-off)
Alpha functions as a
pareto parameter
. Empirically, alpha appears to be rather fixed.
Implication for ETI
ETI is
not
a structural parameter. It depends on avoidance and evasion, which depends on the tax and enforcement system
If MTR > Laffer rate, you should i) reduce the MTR; b) reduce the ETI
Optimal policy depends on the social costs and benefits of either policy
Govt should have a
favoured range of ETI estimates
rather than just one estimate