Taxpayer Behavior and Government Policy (2003)

Taxpayers respond to government policies. These responses, in turn, can inform government policy design. The increasing fluidity of capital markets calls new attention to the impact and formulation of capital income taxation, in particular to the possible economic benefits of fundamental income tax reforms that would reduce the burdens and distortions imposed on capital income. Much of my recent research has focused on the interrelated topics of measuring agents' responses to capital income taxation, evaluating alternative tax systems, and considering how governments can and do respond to taxpayer behavior. Households, Firms and Capital Income Taxes Capital gains taxes are often cited in relation to potentially large taxpayer responses. Because capital gains taxes are normally due only upon the voluntary sale of assets and can be avoided entirely when appreciated assets are held until a taxpayer's death, there is scope for considerable tax planning, including general avoidance of capital gains taxes and the timing of realized gains to coincide with temporary dips in tax rates. Indeed, the billions of dollars of capital gains realized annually present something of a puzzle, in light of theories suggesting that optimizing taxpayers should be able to avoid realizing net gains and take advantage of their ability- to use a limited annual amount of capital losses to shelter other taxable income. In a joint paper with Leonard E. Burman and Jonathan M. Siegel (1), I considered the capital gains realization behavior of taxpayers over the ten-year period 1985-94, focusing on the extent to which individuals engaged in tax avoidance techniques, notably the realization of capital losses to shield realized capital gains and other income. Our investigation was facilitated by the richness of our data set, which was highly stratified by income and provided information on all capital asset transactions. The results indicated that only about one-tenth of taxpayers exhibited net capital losses in a typical year, a finding consistent with an earlier one by James M. Poterba. (2) We also found, however, that the likelihood of having net capital losses in a given year, and the likelihood of persisting in this state from one year to the next, were both strongly related to wealth and to a constructed measure of taxpayer sophistication, defined by evidence that the taxpayer engaged in short sales or traded in derivatives at least once during the sample period. These findings are consistent with tax avoidance activity being costly and more accessible to those with greater wealth and information. If investors differ in their access to avoidance technology, then we would also expect them to differ in their responses to changes in tax rates. Using the same data set, Siegel and I estimated models of capital gains realization behavior, distinguishing responses to permanent and transitory tax rates changes. (3) Our basic results were consistent with those in earlier studies (4), estimating substantially larger behavioral elasticities to transitory changes than to permanent ones. But we also found strong differences from these basic results when looking exclusively at the taxpayers that our earlier paper had found to be more likely to engage in tax avoidance activity--the rich and sophisticated. For these two groups, responses to permanent tax rates changes were even smaller, and responses to transitory tax rate fluctuations even larger--findings consistent with this group using timing as yet another tax avoidance mechanism and, as a result, facing a lower overall burden of taxation and hence being less sensitive to permanent tax rates changes. Just as challenging to understand as the determinants of capital gains realization and avoidance behavior is the impact of dividend taxation on corporate financial and investment decisions. Through the years, the payment of dividends in the face of a sizable tax penalty, has generated considerable theorizing, with implications regarding the extent to which dividend taxes distort behavior rather than simply being capitalized into the values of corporate shares. …