Research by Dr Sarah Burns and Professor James Ziliak provides new evidence that how personal incomes respond to changes in tax policy is much larger than suggested by prior estimates.

Their study, which is published in the March 2017 issue of the Economic Journal, shows that for each 10% reduction in marginal tax rates, gross (before-tax) incomes increase by 4% and taxable incomes (gross incomes less deductions) by 5.5%. This is an effect size that is twice as large as the average estimate found in previous work.

The authors note that understanding how income responds to marginal tax rates – what”s known as ”the elasticity of taxable income” (ETI) – has become a focal outcome for research and policy work on the optimal design of the income tax and transfer system.

Under certain assumptions and in conjunction with estimates of how unevenly incomes are distributed at the top of the income scale, the ETI can inform policy on the magnitude of the tax rate that maximises revenues among high earners. All else being equal, the larger the ETI, the smaller is the tax rate needed to maximise revenues.

This follows because a larger ETI implies that taxpayers are more sensitive to changes in tax rates. In other words, if they are faced with a higher tax rate, some may cut back on hours of work in the labour force and still others may seek new tax shelters.

Typical estimates of the ETI place that top marginal tax rate at nearly 75%, whereas the estimates in the new study imply a top rate 25% lower at 55%. In other words, prior estimates suggest top marginal tax rates much higher than is optimal in light of these new findings.

Identifying whether changes in tax rates causally change incomes is a methodological challenge that has confronted the economics profession for decades. The problem is that in a graduated marginal tax rate system where tax rates increase with incomes (such as that found in the UK or the United States), the tax rate facing the individual is determined by their income.

This means that the tax rate facing an individual can change for reasons unrelated to changes in tax policy. For example, if a taxpayer receives a promotion from their employer, their inflation-adjusted income next year may increase enough to place them in a higher tax bracket, even though the tax brackets themselves were unchanged (adjusted for inflation).

This makes it necessary for researchers to find an independent, exogenous source of tax changes to infer a causal pathway from taxes to incomes. Some studies have attempted to use legislated tax reforms over time as the primary source of independent information to identify the causal channel, as does the new study.

But what the new research shows is that the typical method employed does not remove all the potential bias compared with the authors” alternative approach. This results in previous estimates of the ETI that are too low.

”Identifying the Elasticity of Taxable Income” by Sarah K. Burns and James P. Ziliak is published in the March 2017 issue of the Economic Journal. Sarah Burns is at the Institute for Defense Analyses. James Ziliak is Director of the Center for Poverty Research at the University of Kentucky.

James Ziliak

+1-859-257-6902 | jziliak@uky.edu