High marginal tax rates also encourage increased tax deductions for things like mortgage expenses and greater write-offs for business expenses like travel and entertainment. When marginal tax rates come down, such deductions are reduced and individuals spend more of their money on the things they really prefer. Relatively small changes in the form of compensation and in tax deductions and business expenses can have a big impact on taxable income and tax revenue. And that excludes the revenue that is not collected because individuals choose nicer working conditions and other untaxed forms of compensation that are not counted in the governments analysis. The high marginal tax rates that distort behavior in these ways are not just an issue for high-income households.
Statistical studies show that reducing marginal tax rates raises taxable income substantially.
These studies are based on large samples of anonymous tax returns provided by the Treasury Department that follow individual taxpayers before and after the tax reforms of the past two decades. All of these estimates suggest that the Bush tax reform would substantially raise taxable incomes, significantly cutting the costs of the reform. To estimate the total effect of the taxpayer responses to the Bush tax plan, Daniel Feenberg and I have used the National Bureau of Economic Research Taxsim model, a computerized accounting calculator that applies alternative tax rates to a sample of more than 100,000 anonymous individual tax returns. Although the Bush plan involves a gradual phase-in of tax rate reductions, we focus on the effect when all of the tax rate reductions have occurred. We do not try to forecast specific future years but analyze the effect for a single year at the year 2000 level of incomes.