The Elasticity of Taxable Income during the 1990s: New Estimates and Sensitivity Analyses

[Author Affiliation]Seth H Giertz, , , , sgiertz2@unl.edu[Acknowledgment]The author wishes to thank David Weiner, Ed Harris, Bob Dennis, Doug Hamilton, Tom Woodward, Emmanuel Saez, Chris Bollinger, and three anonymous referees for their comments and assistance.1. IntroductionEconomists have long recognized that taxation creates economic inefficiency by distorting relative prices, often between leisure and all other goods in the economy. Even a broad-based income tax can have substantial efficiency costs, so long as leisure remains untaxed. Harberger (1964) uses this as motivation for comparing the efficiency implications of direct versus indirect taxation. In so doing, he shows how labor supply elasticities can be used to measure the efficiency implications of income taxation.1 Harberger's analysis had a profound influence on public and labor economists, spurring increased research into labor supply elasticities, which were seen as proxies for the efficiency costs from taxation.More than two decades after Harberger, economists began to emphasize the variety of other margins over which taxes can distort behavior, in addition to hours worked. These economists noted that these other behavioral responses may too have important implications for efficiency. An important building block in the evolution of this literature was set forth by Slemrod (1990), who presented a hierarchy of behavioral responses to taxation. Slemrod divided behavior into three categories based on their responsiveness to taxes. His least responsive category, real responses , includes individuals changing consumption and work patterns and businesses altering investment and production decisions. Second, in order of responsiveness is circumvention , which includes both illegally (evasion) and legally (avoidance) bypassing the tax system.2 In the case of evasion, income is concealed from tax authorities--or factors that offset tax liabilities, such as expenses and deductions, are inflated (beyond what is legally permitted). In the case of avoidance, income is shifted in order to receive more favorable tax treatment. Diverting income into a tax-deferred retirement account is an example of avoidance.3 Included in circumvention is the expenditure (of time and money) necessary to avoid or evade taxation. Third on the hierarchy--and the most responsive--is the timing of income receipt , which includes "pulling" the receipt of income into the previous year or "pushing" it into the next in order to take advantage of more favorable tax treatment (while not altering real behavior).4 Slemrod further recognizes that the type of behavioral response could have implications for both tax revenue and tax incidence--and in some cases efficiency.Predating Slemrod's insights, Lindsey (1987) produced elasticity estimates for taxable income--although what Lindsey termed taxable income more closely approximates adjusted gross income (AGI)--instead of labor supply.5 Lindsey's estimated elasticities were much larger than the labor supply literature would have suggested. Lindsey emphasized the revenue implications of the elasticity of taxable income (ETI) but not its efficiency implications.Building on Slemrod and Lindsey, Feldstein (1995) produced ETI estimates but went much further than Lindsey in describing the behaviors that could affect taxable income. He argued that many of these behaviors were not captured by labor supply elasticities. Furthermore, Feldstein posited that (income) taxation creates economic inefficiency not only by distorting the relative price between labor and leisure but more broadly by distorting the relative price between goods or activities that are taxed and those that are not taxed since leisure is not the only untaxed activity. For example, in response to taxes, not only work hours but also work effort might change. …