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Economic News, Data and Analysis

Feldstein on taxes, etc.

In a September interview, Marty Feldstein says tax cuts do not pay for themselves. And says, when talking about the Tax Reform Panel’s report: “Flat taxes are a wonderful dream, but not a practical policy.”

Federal Reserve Bank of Minneapolis – The Region – Interview with Martin Feldstein – September 2006
Now much of my own work over the years has been about taxes and about the response of households and businesses to taxes in various ways. And in particular if you look at the household response to marginal tax rates, the typical professional economist’s view and also that of most tax policy officials is that people don’t seem to respond very much. If you look at the relationship between labor force participation and tax rates, or working hours and tax rates, there’s not much there. There is for married women, who have more discretion, but for single women, or men between 25 and 60, there’s virtually no response of labor force participation.
I’ve argued that that’s really looking in the wrong place. The measure of labor supply that matters is not just hours. The relevant labor supply includes human capital formation, choice of occupation, willingness to take risk, entrepreneurship and so on. All of these affect income and tax revenue.
What’s more, taxes cause a further distortion that causes a “deadweight loss,” that is, an economic inefficiency. Taxes change the way people choose to be compensated. I get compensated in fringe benefits rather than taxable cash because I have the choice between 65 cents of spendable cash or a dollar of fringe benefits. That choice of fringe benefits that are worth less than a dollar for every dollar that they cost to produce implies economic waste. It shows up as lower taxable income. A reduction in taxable income, whether it occurs because I work less or because I take my compensation in this other form, creates the same kind of inefficiency.
Economic analysis shows that if you want a single measure of the inefficiencies created by the tax on labor income, you can just look at taxable labor income. You don’t have to distinguish whether a higher tax rate reduces taxable income because I work fewer hours or I bring less human capital to the table or I get compensated in the form of fringe benefits and nice working conditions.
Therefore, we should look at the data on how taxable income relates to marginal tax rates. I looked at the experience before and after the 1986 tax cut, because that was a very big, bold one. The Treasury provided data that allowed one to track individual taxpayers over time. So you could look at an individual a few years before the 1986 Tax Reform Act and at that same individual a few years later. And that comparison suggested quite a large response: Taxable income responded with an elasticity of about 1, meaning that a 10 percent increase in the after-tax share that an individual got to keep, say, going from 60 percent to 66 percent, would increase their taxable income by 10 percent. So those are big numbers.
Think about an across-the-board tax cut. Let’s say you cut all tax rates by 10 percent, so that the 25 percent rate goes to 22 1/2 percent, 15 percent rate goes to 13 1/2 percent, and so on. That raises taxable incomes. The revenue cost of that tax cut is only about two-thirds of the so-called static result that you’d get if you didn’t take behavior into account. So both in terms of thinking about the economic efficiency, which is very hard to explain to the lay public—I’ve been bending my sword trying—and also in terms of tax revenue, these are very large effects.
Of course, cutting the 15 percent rate to 13 1/2 percent has a much smaller proportional effect on the net-of-tax share than doing it at higher rates. So if this were not a change across the board but a change in the top rate of the sort that we had in ’86, that would be an even bigger behavioral impact.


Filed under: Economics

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