Taxes Matter II

Taxes Matter II

August 21, 2006 Posted by J. Scott Moody - No Comments

A new Harvard Study shows that taxes substantially affect taxpayer behavior.


We all know that taxpayer’s respond to tax incentive/disincentives. For example, they may buy a larger house than they may “need” because they can deduct the mortgage interest from their income taxes. Since the behavior is tax-induced, it harms the economy. Rather than buying a larger house, the taxpayer could have invested in Google instead.
“Deadweight loss” is a term used by economists to describe the economic inefficiencies created by taxation—such as when taxpayers reduce work and/or consumption or shift income to avoid taxation. In other words, the very process of transferring resources from the private to the government sector results in a permanent loss of potential economic output. For example, Dr. Martin Feldstein, President and CEO of the National Bureau of Economic Research, estimated that the 1993 Federal income tax increase resulted in a deadweight loss of $2 for every $1 raised in taxes.
However, estimating the deadweight loss is subject to degree in which taxpayer’s change their behavior. If, in fact, taxpayer’s do not buy larger houses because the mortgage interest is deductible; then the deadweight loss is small and vice-versa. Economists refer to this as the “tax elasticity.” The example given above is an example of a “low tax elasticity.”
As such, Dr. Feldstein’s critics focused in on his tax elastcities claiming that they were too high and thus he was overstating the deadweight loss. This new Harvard study finds that Dr. Feldstein is closer to revealing the truth than his critics. To summarize their conclusions:
“Understanding how individuals shift labor supply and income over time in response to wage and tax rate changes is crucial for numerous economic questions. Estimates of intertemporal labor supply elasticities and taxable income elasticities have important implications for life cycle labor supply, aggregate employment fluctuations and business cycles, efficiency costs of taxation, and the design of optimal tax and transfer systems. …We focus primarily on tax rate changes arising from the loss of a dependent exemption. Using the SIPP, we estimate a significant elasticity of family labor income of 0.75 for families with base year earnings between $35,000 and $85,000. Our estimates using the tax panel data are almost identical. These estimates are at the high end of the range found in previous work. This may be because studies examining unanticipated changes tend to confound substitution and income effects, which would result in downward biased estimates. …Most of our estimates of taxable income elasticities are unfortunately imprecise as a result of data limitations. In theory, however, our estimates of labor income elasticities from the SIPP data should be lower bounds on the true elasticities of taxable income. The high-end estimates then imply substantial behavioral responses to taxation.”
A “substantial behavioral reponse to taxation,” also means substantial deadweight losses to the economy. For policmakers this means that raising taxes hurts the economy by more than just the revenue raised–up to $2 for every $1 raised–and that cutting taxes helps the economy by more than the reduced revenue.