Friday, September 22, 2006

Elasticity and Tax Cuts

Back during the early 1980's, an argument was advanced that cutting taxes will increase the amount of workers, increase work effort and have no impact on the budget deficit (since the increase in labor raises tax revenue even though tax rates have actually declined. In theory this is certainly possible. For instance, if I tax you 0% obviously the governmnet will take in no revenuw. However, if I tax 100% of your income the government is likely to collect close to zero revenue as well because you have no incentive to work. Since you don't work, there is no revenue to collect. Some argued, therefore, that decreasing tax rates would boost work effort enough to pay for the entire tax cut.

This obviously did not work out as the deficits in the 1980's and early 1990's attest to. But it does highlight the issue of elasticity. The reality was that the labor supply elasticity was low (increasing income only increased work and effors by less than one). Some on the other side have argued that this suggests taxes could actually be increased so that the benefits exceed the costs (since the elasticity is less than 1 this is certainly possible).

However, merely looking at labor elasticity by itself really does not tell you whether raising taxes (and in the current environment that would mean tilt the tax code much more heavily towards the rich) is a good idea. Martin Feldstein---Harvard Professor, former CEA under Reagan and the head of NBER---explains why.

And in particular if you look at the household response to marginal tax rates, the typical professional economist's view and also that of most tax policy officials is that people don't seem to respond very much. If you look at the relationship between labor force participation and tax rates, or working hours and tax rates, there's not much there. There is for married women, who have more discretion, but for single women, or men between 25 ...

I've argued that that's really looking in the wrong place. The measure of labor supply that matters is not just hours. The relevant labor supply includes human capital formation, choice of occupation, willingness to take risk, entrepreneurship and so on. All of these affect income and tax revenue.

....Therefore, we should look at the data on how taxable income relates to marginal tax rates. I looked at the experience before and after the 1986 tax cut, because that was a very big, bold one. The Treasury provided data that allowed one to track individual taxpayers over time. So you could look at an individual a few years before the 1986 Tax Reform Act and at that same individual a few years later. And that comparison suggested quite a large response: Taxable income responded with an elasticity of about 1, meaning that a 10 percent increase in the after-tax share that an individual got to keep, say, going from 60 percent to 66 percent, would increase their taxable income by 10 percent. So those are big numbers.