Innovation and the Long-Run Elasticity of Total Taxable Income

[Author Affiliation]Benjamin Russo, Economics Department, Belk College of Business, The University of North Carolina at Charlotte, 9201 University City Boulevard, Charlotte, NC 28223, USA; brusso@uncc.edu[Acknowledgment]This paper has benefited greatly from comments made by Hwan Lin, Jennifer Troyer, and participants in seminars at Davidson College, the University of Iowa, the University of North Carolina at Charlotte, and sessions at annual meetings of the Southern Economic Association and the Western Economic Association International. Two anonymous referees provided very detailed and helpful suggestions. I remain responsible for any errors.1. IntroductionThe elasticity of taxable income with respect to the income tax determines revenue responses to changes in the tax rate and influences the welfare effects of the tax. As a result, measurement of this elasticity is a continuing focus of research on tax policy.1 Most empirical estimates of taxable income elasticities are based on short-run analyses. However, long-run fiscal policy effects may differ from short-run effects in sign as well as in size.2 The sign reversals arise from long-run general equilibrium relationships. The empirical literature has often cited the desirability for long-run measurement.3 However, in this regard nearly no work has been reported. This paper derives long-run general equilibrium elasticities of taxable income with respect to income taxes and discusses policy implications.Before the advent of the concept "taxable income elasticity" economists often estimated labor supply and saving elasticities in an attempt to quantify the behavioral and efficiency effects of taxes. Many empirical estimates indicate labor supply and saving responses to after-tax wage rates and interest rates may be relatively small.4 However, Lindsey (1987) argues that the important behavioral responses to tax rates include more than just changes in labor supply. For example, a change in the tax rate may lead to changes in capital gains realizations and itemized deductions. Feldstein (1995) argues that the behavioral responses to taxes also include changes in portfolio investment in the short run and changes in the location of work and types of jobs in the long run.5 These authors suggest that changes in taxable income reflect behavioral responses to taxes more reliably than does labor supply, and they develop the concept of the elasticity of taxable income to quantify such changes.The literature on empirical estimation of taxable income elasticities has generated many important insights into behavioral responses to income taxes. Nevertheless, factors exist that could cause empirical estimates to overstate or understate true tax responsiveness. For example, some tax avoidance schemes can cause shifts in the timing of economic decisions without affecting real economic activity (Slemrod 1996). In this case, empirical estimates of taxable income elasticities could overstate tax responsiveness. In addition, if long-run general equilibrium relationships are not captured by empirical data, empirical estimates could understate tax responsiveness. To see this, note that in general equilibrium initial tax responses in one market can be reinforced by responses elsewhere. Suppose, for example, that a change in tax rates increases labor supply and saving, initially, by small amounts. Over time, larger saving increases the capital stock and, therefore, the marginal product of labor. Higher wages, in turn, could stimulate labor supply. Transactions and adjustment costs, as well as uncertainty, could cause these inter-relationships to take a long time to develop, so it may be difficult to capture them in standard empirical analyses and in event studies in particular.In this paper, I attempt to avoid some of the difficult issues raised by Slemrod (1996) and, at the same time, capture long-run general equilibrium relationships that seem likely to affect tax responsiveness. …