The Elasticity of Taxable Income with respect to Marginal Tax Rates : A Critical Review

1. M1 PPD – 02.11.2010 Marianne Tenand The Elasticity of Taxable Income with respect to Marginal Tax Rates : A Critical Review E. Saez J. B. Slemrod S. H. Giertz NBER 15012, 2009

2. Why do we want to capture this elasticity? * Fiscal policy applications : • Deriving the optimal size of the public sector • Quantifying efficiency costs of a form of taxation • Deriving the optimal tax rate(s) [t* = 1/ (1+ε) for PIT] • Make an empirical evaluation of the Equity/Efficiency Trade-Off in income taxation * Trade-off : results from the impossibility to tax an intrinsic characteristic of individuals => Behavorial reactions => deadweight loss for society (a priori)

3. Capturing labor supply elasticity : the quest for the Graal • Empirical studies and strategies to find ε • The 1st attempts : questionnaires (Fields and Stanbury, 1969, on lawyers) • Guaranteed Income experiments (USA, Canada) • Taxpayers drain (participation constraint – for richer and poorer taxpayers => the elasticity of labor supply of these groups is probably higher than medium-classes’ elasticities) • Other econometrics studies. • Conclusion : small ec and small η => small ε => little efficiency costs of taxing income…? • NOT SO FAST! Troubling evidence that taxpayers react to tax changes! And in many other ways that just through the number of hours worked.

4. The revolution of the ETI approach • In reality : income subject to the PIT is not simply equal to w.L => more relevant concept: reported income, denoted z - Z includes nbr of hours worked, effort, other forms of income, investment in formation, propensity to report income (evasion), to use tax optimization schemes, etc. - Takes implicitly account of other, unobservable characteristics of income and tax system • Model : Max u(c,z) where c = (1-τ)z + E • Gives an individual « reported income » supply function z = z(1-τ, E) where E is an income not subject to taxation • No income effect (two channels : E and w). Then : ETI = (1-τ)/z . dz/d(1-τ)

5. ETI : empirical strategies • Focus : the upper end of income distribution • Let z+ be the reported income threshold above which taxpayers face a marginal tax rate of τ • Let zm the average income reported by taxpayers in this top bracket. zm = zm (1-τ) • The aggregate ETI in the top bracket is e = (1-τ)/zm . dzm /d(1-τ) = average of individual elasticities weighted by individual income. Then : reported income zi,t = z0i,t .(1 –τi,t )e individual i, time t. Where z0i,t is the potential income ( reported if τi,t = 0) - Important assumptions : no income effects/ short-term and long-term –responses are identical/ constant e over time / perfect information

6. Identifications issues Log zi,t = e. log (1 - τi,t ) + log z0i,t * OLS : endogeneity problem since log z0i,t(the unobservable), is (positively) correlated with τi,t • Solution : find instruments correlated with τi,t but uncorrelated with potential reported income z0i,t * Instruments at our reach : changes in tax rates provoked by tax reforms (natural experiments) or unlesgislated changes. * Where/ when ? USA (mainly) and other developed countries ; exploiting the major tax shifts experienced since the 1970s.

11. Sensitivity to the specific reform and to the choice of the years Different elasticities for differing groups? Endogeneity ? Time-serie identification at risk Upward bias

14. Not sensitive to the choice of the base group Lacks controls (parallel trends violated) Mean reversion = upward bias with a rate increase (even larger for 49% C-group ; and when lag increases) Pb of identification More satisfactory estimates ; even if…

15. Conclusions : • share analysis and cross-section analysis seem more robust to estimate the ETI • But panel analysis may be really performing in specific circumstances (ex: 1993) « The most reliable long-run estimates range from 0.12 to 0.4, suggesting that the US marginal top rate is far from the top of the Laffer curve, but greater that one would calculate if the sole behavorial response was labor supply. Estimates for other [developed] countries are, for the most part, in this range. » • The fear - expressed in the 1980s with the Conservative revolution- that in most developed countries marginal tax rates were sub-optimally high, was exaggerated… - But nonetheless, several issues still need to be tackled…

16. Further issues (and work for you!) The studies are still unsatisfactory under certain aspects : • short term vs long term responses • small changes vs large changes in tax rate (question of the perfect information of taxpayer and of transaction costs) • tax base shifting (application : welfare analysis and change in the revenue-maximizing tax rate). The authors call for examining closely the “anatomy of response [to tax]”, to distinguish between the many effects incorporated in z. • Constance of elasticities across time? Across countries? (hypothesis of Kopczuck that e is not a structural parameter, but a function of the income base) => In matter of empirical studies on behavioral reaction to taxation, much is still to be done!

17. References and remarks More to be found in this article • A bunch of empirical studies (developed countries, other than the USA) are reviewed in the article • Interesting explanations about fiscal externalities and their consequences on effective efficiency costs (particularly on tax base shifting : to set optimal tax rates, you must take into account the various existing taxes and their inter-relations) • In Annexes, details about US databases and tax reforms. Other texts • Fields, DB and W.T. Standbury. 1971. Income Taxes and Incentives to work : some additional empirical evidence, AER • Kopczuk, Wojciech.2005. Tax Bases, Tax Rates and the Elasticity of Reported Income.Journal of Public Economics • Saez, Emmanuel. 2001. Using Elasticities to Derive Optimal Income Tax Rates. Review of Economic Studies, 68: 205-229. • Several works of Joel Slemrod, Martin Feldstein, Peter Diamond and James Mirrless.