Changes in Income Concentration: Taxes or Macroeconomic Conditions?

I. INTRODUCTION The effects of tax policy at various points in the income distribution have received increased attention from politicians and researchers in recent years. Both major presidential candidates in the 2000 election proposed tax cuts that involved dramatically different distributional effects. Former Vice President Al Gore's plan included targeted tax cuts for the middle class; President George W Bush's plan provided a tax cut to all taxpayers regardless of their income. President Bush has been criticized for this plan, as it gives the largest tax break (at least in dollar value terms) to those at the upper end of the income distribution. What has only recently been discussed, however, is the fact that the ultra-rich pay a much larger than proportionate share of federal income taxes. Feenberg and Poterba (2000) report that the top 0.5% of taxpayers with the largest income tax bills paid nearly one-fourth of all income taxes in 1995, a share that has increased dramatically since the early 1960s. The Joint Committee on Taxation (2001) reports that the top 1% of the income distribution will be responsible for nearly 36% of total individual income tax liability in 2001. In response to critics of his plan, President Bush's supporters have noted publicly that even though rich taxpayers would receive larger tax cuts in dollar value terms, they would contribute an even larger share of total income tax collections after his reform. Although there is little controversy over the importance of ultra-rich taxpayers to the tax system, researchers have not reached a clear consensus as to how they react to changes in tax rates. President Bush's supporters imply that wealthy taxpayers respond to tax rate cuts by reporting more adjusted gross income (AGI), either by working more and earning more money, by reaping the benefits of a more prosperous economy, by shifting earnings into lower-tax years, or by reducing noncompliance, among other possibilities. It is not clear which (if any) of these explanations is most relevant. No consensus has arisen, primarily because this largely empirical question has not received significant attention in the literature. Our research is a direct extension of the recent literature on the responsiveness of reported AGI to changes in top federal income and capital gains tax rates. We address these issues in a time-series econometric framework, first by using more recent data to reexamine earlier time-series results and second by departing from earlier research and implementing a vector autore-gression (VAR) technique. Results indicate that tax rate changes are responsible for much of the cyclical movements in the share of AGI that is reported by the top 0.5% of the AGI distribution but that macroeconomic conditions are at least as important. Our baseline results show that a 10% cut in the top federal marginal income tax rate would increase the top AGI share by only 2.7% to 3.1%, and a similar cut in the top capital gains tax rate would increase it by 4% to 5%. Section II of the article discusses the motivation for our research and describes previous findings. We continue in section III with a description of our data and empirical methods, and present time-series regression results in section IV Section V includes simulations from those regressions. We discuss an alternative estimation strategy based on VAR techniques in section VI, and section VII concludes. II. BACKGROUND AND LITERATURE REVIEW Initiating the most recent wave of research on this topic, Feenberg and Poterba (1993) examine data from 1951 to 1990and reveal a substantial increase in the share of AGI that is reported on very high income tax returns. They conclude that this is at least partly a result of tax code changes and not a result of increased capital gains. Furthermore, they note that it is impossible to determine how much of the increase in reported income is due to different avoidance behavior, to changes in behavior (labor supply), or to changes in returns to the factors (labor and capital) that high-income taxpayers own. …