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The Agenda

NRO’s domestic-policy blog, by Reihan Salam.

Arpit Gupta on Tax Increases and Behavioral Responses



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My friend and colleague Arpit Gupta has written a lucid primer on how to think about the elasticity of taxable income and the marginal excess burden of taxation, and how our understanding of both can and should guide our approach to tax policy:

 

Higher tax rates induce a variety of behavioral responses. People may choose to work fewer hours, take jobs that offer less pay, or drop out of the workforce entirely. Over the long run, people may avoid making investments that boost income in the future, such as pursuing more education, because the return on this investment is lower (in the form of reduced after-tax income). These tax responses all lower economic efficiency. Alternatively, individuals may restructure their declared income to lower their tax liability — for example, by engaging in economic activities that generate more deductions. While these actions may not necessarily lower economic output, they lower the revenue governments receive from higher taxation.

While economists largely agree that higher taxes have some impact on both economic efficiency and declared income, the quantitative impact can be difficult to gauge. In calculating this effect, economists emphasize the importance of one parameter: the elasticity of taxable income (ETI). This parameter measures the extent to which individuals adjust their taxable income in response to a rise in their marginal tax rates. It is an attractive instrument because it allows an analysis of the impacts of taxation without needing to specify the particular pathways by which taxation impacts individual behavior.

Arpit then goes on to survey a number of papers estimating the elasticity of taxable income for high-earners. Though the estimates vary considerably, all re fairly high. I was particularly struck by the Saez-Gruber estimate of ETI for high-earners who itemize deductions. Refreshingly, Arpit doesn’t end his discussion with a laundry list of proposals. But read it if you want to have a better understanding of the tax debate. (And if you’re reading this, you probably do.)



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