NBER WORKING PAPER SERIES THE ELASTICITY OF TAXABLE INCOME: EVIDENCE AND IMPLICATIONS

A central tax policy parameter that has recently received much attention, but about which there is substantial uncertainty, is the overall elasticity of taxable income. We provide new estimates of this elasticity which address identification problems with previous work, by exploiting a long panel of tax returns to study a series of tax reforms throughout the 1980s. This identification strategy also allows us to provide new evidence on both the income effects of tax changes on taxable income, and on variation in the elasticity of taxable income by income group. We find that the overall elasticity of taxable income is approximately 0.4; the elasticity of real income, not including tax preferences, is much lower. We also estimate small income effects on tax changes on reported income, implying that the compensated and uncompensated elasticities of taxable income are very similar. We estimate that this overall elasticity is primarily due to a very elastic response of taxable income for taxpayers who have incomes above $100,000 per year, who have an elasticity of 0.57, while for those with incomes below $100,000 per year the elasticity is less than one-third as large. Moreover, high income taxpayers who itemize are particularly responsive to taxation. We then derive optimal income tax structures using these elasticities. Our estimates suggest that the optimal system for most redistributional preferences consists of a large demogrant that is rapidly taxed away for low income taxpayers, with lower marginal rates at higher income levels. Jon Gruber Emmanuel Saez MIT Department of Economics Department of Economics E52-355 Littauer Center 50 Memorial Drive Harvard University Cambridge, MA 02142-1347 Cambridge, MA 02138 and NBER and NBER gruberj@mit.edu saez@fas.harvard. edu One of the most important features of economic policy-making during the 1980s were a series of tax reforms which dramatically lowered marginal income tax rates in the U.S., particularly for higher income families. The top marginal income tax rate at the federal level fell from 70% in 1980 to 28% by 1988, as the income tax schedule was reduced from fteen brackets to four. There were parallel changes in state income tax systems over this decade as well; New York, for example, moved from a system in 1980 with 13 brackets and a top marginal rate of 14% to one in 1989 with 5 brackets and a top marginal rate of 7.875%. The intellectual weight behind this dramatic reduction in marginal tax rates was the logic of supply side economics. A number of in uential articles, such as Hausman (1981) and Boskin (1978), argued that behaviors such as labor supply and savings were very elastic with respect to their prices, and as a result lower tax rates could generate important increases in economic activity. A large body of subsequent literature, however, suggested that these behavioral elasticities were actually rather modest (Slemrod, 1990). While this subsequent literature may not be a driving factor, it is noticeable that the 1990s have seen a reversal of the tax reductions of the 1980s, with marginal rates rising to 39.6% at the top today. Over the past few years, however, a new literature has emerged which has pointed out that these standard behavioral responses are only one component of what drives taxable income; other responses such as the form of compensation, unmeasured e ort, and compliance also ultimately determine taxable income income, and these may be more elastic with respect to taxation. Feldstein (1995) in particular observed that it is the overall elasticity of taxable income which is relevant for assessing the implications of tax changes for revenue raising. His seminal article found that this elasticity was very high for the Tax Reform Act of 1986 (TRA86), in excess of one for his central estimates. This striking conclusion has generated a substantial body of work on this central parameter. Unfortunately, this subsequent work has generated a wide range of estimated elasticities, ranging from Feldstein's estimate at the high end to close to zero at the low end. This extreme variation re ects a variety of di erences between the approaches in these papers, along dimensions such as the de nition of income (ranging from broad Haig-Simons type de nitions to narrower taxable income de nitions), the samples used (ranging from just focusing on high income taxpayers to using a full range of incomes),