Economic Effects of Taxation: Some Stylized Facts

1. Economic Effects of Taxation: Some Stylized Facts Jon Bakija Department of Economics Williams College jbakija@williams.edu

2. Government has both benefits and costs • Benefits • Some show up in GDP. Example: • Government fixes a market failure (e.g., imperfect information in credit markets) that otherwise would prevent people from making productive investments in education • Some (mostly) do not. Some examples: • Protection from risk through social insurance • Improving social welfare by helping needy • A cleaner environment • Costs • When taxes are related to ability-to-pay, this inevitably reduces the incentive to earn income, which has a cost • Example: • A person is deciding whether to do some extra work that would earn $100. • The forgone leisure is worth $80 to the person. • In the absence of taxes, person chooses to do the work, gets net benefit of $20. • With a 30% income tax, the work is not done, the person loses $20 net benefit, and government gets no revenue from it. • Conclusion: cost of tax is larger than the revenue raised by the government (in this example, by $20). • The evidence discussed in this presentation tells us something about the costs of taxation, and possibly about some of the benefits that show up in GDP. • But it leaves out the benefits that don’t show up in GDP, so it is not itself decisive, just one ingredient we’d need to help make the decision

7. Econometric cross-country evidence on taxes and growth is mixed • The graphs above suggest no effect of overall level of taxes on growth • The final one does suggest a small negative effect, but not statistically significant • Problems: reverse causality, omitted variable bias, and “bad control” • Increased income increases demand for government (“Wagner’s law”) • Recessions cause tax revenues to decline relative to GDP automatically (e.g., people fall into lower tax brackets). • Governments often enact tax cuts at bottom of recession. Subsequent recovery results from response to Keynesian stimulus which only applies when economy is below capacity, the effects of central bank policy, etc. Doesn’t tell us anything about long-run effects of having a big government, since different issues are involved. • And of course, many other factors influence growth. • The “bad control” problem: controlling for a variable that is partly an outcome of the causal effect you are trying to estimate can bias your estimates. • Example: spending more on civil service and education may help reduce corruption, which in turn improves growth. In that case, controlling for corruption may absorb some of the positive effects of government on growth, biasing the estimated effect of size of government (as measured by tax / GDP) towards negative. • Slemrod (1995) critiques the literature

8. Econometric cross-country evidence on taxes and growth is mixed • Bergh and Henreksen (2011) survey the recent literature. • They conclude that for rich countries, increasing taxes by 10% of GDP reduces annual growth rate by 0.5%-point to 1%-point. • But estimates are very sensitive to reasonable changes in set of control variables, which can produce an estimate of zero effect of taxes on growth (e.g., Bergh and Karlssson 2009) • Their preferred method, which leads to their main conclusion above, estimates lots of regressions with different small subsets of control variables, and constructs an average estimate weighted by R-squared (overall forecasting accuracy) of each regression. • But this does not really solve the reverse causality, omitted variable bias, and “bad control” problems discussed on previous page. • They concede that they have not really established causality with any confidence. • They also concede that Scandinavian countries have clearly achieved high growth with high taxes, and try to understand why. • Well-designed policy, good institutions? • Culture and trust?

9. Effects of taxes on hours worked • Much prior research suggests hours worked are not responsive enough to incentives to affect aggregate labor income very much • See, e.g., See Alesina, Glaeser, and Sacerdote (2005) • Example: Moffitt & Wilhelm (2000): hours worked by rich did not go up when 1986 tax reform cut top rate from 50% to 28%. • Those arguing taxes have a big impact on labor supply point to cross-country evidence.

12. Taxes and Hours Worked: Discussion • The graphs imply: • A 10% increase in tax rate (e.g., from 30% to 33%) would reduce hours worked by 1.7%. • It would need to reduce hours worked by 10% to put us on the wrong side of the Laffer curve, so this implies we’re nowhere close to that. • At recent U.S. levels of taxation and hours worked, the graphs imply that a 10% increase in after-tax wage is associated with about a 4% increase in hours worked. • Blomquist and Simula (2010) calculate that this would imply that the economic cost of rasing an additional $1 of revenue from an uniform across-the-board tax rate increase in the U.S. would be about $1.44. • But many other factors could explain this relationship • Unions pushing for mandatory vacations and shorter work weeks in Europe for reasons unrelated to taxes • Other government policies such as unemployment insurance, pensions • “Income effects” of technology (higher wages and incomes -> people choose more leisure) • See Alesina, Glaeser, and Sacerdote (2005) • Ohanian, Raffo, and Rogerson (2007) find an effect about twice as large • But that is driven by time series variation common to all countries (not larger declines in hours for countries with larger tax increases). • They do not control for time fixed effects (so they are not doing a “difference-in-differences” comparison) • Maybe biased due to common technological change across countries leading to common income effects?

13. Figure 7 – Do rising top income shares imply progressive taxes on the highest incomes are especially harmful to the economy? Source: reproduced directly from Saez, Slemrod, and Giertz (2012). Income excludes capital gains.

14. Figure 8 -- Outside the top 1%, there was a much smaller change in income despite tax cuts Source: reproduced directly from Saez, Slemrod, and Giertz (2012). Income excludes capital gains.

15. Figure 9 -- Larger cuts in top tax rate are associated with larger increases in top income shares across countries Source: reproduced directly from Piketty, Saez, and Stantcheva (2011). Income excludes capital gains.

16. If the cross-country relationship between tax cuts and top income shares shown above were entirely driven by real economic responses (e.g., working harder): • The economic cost of raising $1 more tax revenue from a top-bracket taxpayer would $1.55 • The peak of the Laffer curve would be at a top tax rate of 57%

17. But there are other possible explanations for rising top income shares • Skill-biased technical change • Globalization • “Superstar” theory • Executive compensation issues • Pay (e.g. stock options) tied to booming financial market asset prices • Shifting of income from corporate to personal tax base • Changes in tax avoidance and evasion • Costly, but can be addressed by tax reform and enforcement • To the extent these other factors contribute, the previous slide overestimates the unavoidable costs of progressive taxation

18. High top marginal tax rates have not been associated with lower growth in U.S.

19. Figure 12 -- Top marginal tax rates and economic growth are uncorrelated across countries Source: reproduced directly from Piketty, Saez, and Stantcheva (2011). Income excludes capital gains.

20. Jobs of top earners suggest importance of non-tax explanations Source: Bakija, Cole, and Heim (2012).

21. Income growth of top earners differed greatly by occupation, yet all faced similar tax cuts Source: Bakija, Cole, and Heim (2012).

22. References Alesina, Alberto, Edward Glaeser, and Bruce Sacerdote. 2005. “Work and Leisure In The U.S. and Europe: Why So Different?” NBER Macroeconomics Annual, Vol. 20 Issue 1. (Link to freely accessible working paper version: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=706982). Bakija, Jon, Adam Cole, and Brad Heim. 2012. “Jobs and Income Growth of Top Earners and the Causes of Changing Income Inequality: Evidence from U.S. Tax Return Data” Working Paper, Williams Colllege (http://web.williams.edu/Economics/wp/BakijaColeHeimJobsIncomeGrowthTopEarners.pdf). Bergh, Andreas, and Magnus Henrekson. 2011. “Government Size and Growth: A Survey and Interpretation of the Evidence.” Journal of Economic Surveys. Vol. 25, No. 5, pp. 872-897. (Link to freely accessible working paper version: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1734206). Bergh, Andreas, and Martin Karlsson. 2009. “Government Size and Growth: Accounting for Economic Freedom and Globalization.” Public Choice, Vol. 142. (Link to freely accessible working paper version: http://www.andreasbergh.se/download/PubCh09_Revised_final.pdf) Blomquist, Soren, and Laurent Simula. 2010. “Marginal Deadweight Loss When the Income Tax is Nonlinear.” Working paper (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1610090) Conference Board. 2010. “Total Economy Database, Output, Labor, and Labor Productivity Country Details, 1950-2009.” (http://www.conference-board.org/economics/database.cfm). Diamond, Peter, and Emmanuel Saez. 2011. “The Case for a Progressive Tax: From Basic Research to Policy Recommendations.” Journal of Economic Perspectives. Vol 25, No. 4 (pp. 165-190). (http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.25.4.165) McDaniel, Cara. 2009. “Average tax rates on consumption, investment, labor, and capital in the OECD 1950-2003.” Updated through 2008 on 10/18/2009. (http://www.caramcdaniel.com/tax-files/mcdaniel_tax_update.xls?attredirects=0).

23. References Moffitt, Robert and Mark Wilhelm. 2000. “Taxation and the Labor Supply Decisions of the Affluent." In Does Atlas Shrug? The Economic Consequences of Taxing the Rich, Joel Slemrod, ed., New York: Russell Sage Foundation and Harvard University Press ,pp. 193-234. (Link to freely accessible working paper version: http://www.nber.org/papers/w6621). Nickell, Stephen, Luca Nunziata. 2001. “Labour Market Institutions Database.” September 21. (http://cep.lse.ac.uk/pubs/download/data0502.zip). OECD (Organization for Economic Cooperation and Development). 2012. iLibrary Statistics (http://www.oecd-ilibrary.org/statistics). Ohanian, Lee, Andrea Raffo, and Richard Rogerson. 2007. “Work and Taxes: Allocation of Time in OECD Countries.” Federal Reserve Bank of Kansas City Economic Review. Third Quarter. (http://www.kc.frb.org/publicat/econrev/PDF/3q07raffo.pdf) Piketty, Thomas, Saez, Emanuel. 2011. “Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities.” NBER Working Paper No. 17616. (Link to freely available working paper version: http://elsa.berkeley.edu/~saez/piketty-saez-stantchevaNBER11thirdelasticity.pdf) Saez, Emmanuel, Joel Slemrod, and Seth Giertz. 2012. “The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review.” Journal of Economic Literature. Vol. 50, No. 1, pp. 3-50. (Link to freely available working paper version: http://elsa.berkeley.edu/~saez/saez-slemrod-giertzJEL12.pdf) Slemrod, Joel, and Jon Bakija. 2008. Taxing Ourselves: a Citizen’s Guide to the Debate over Taxes. 4th edition. MIT Press. Slemrod, Joel. 1995. "What Do Cross-Country Studies Teach Us About Government Involvement, Prosperity, and Economic Growth?" Brookings Papers on Economic Activity, No. 2. (Freely available at: http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/1995_2_bpea_papers/1995b_bpea_slemrod_gale_easterly.pdf)