Tax Reform 1986 and Marginal Welfare Changes for Labor

Abstract

During the 1980s in the United States, before-tax income shifted away from the poor and toward the upper income groups. Changing the distribution of tax burdens or after-tax income is one way to redress a growing imbalance in before-tax income. Pechman [14], Feldstein [6], and Wallace et al. [17] have all shown that the Tax Reform Act of 1986 (TRA86) increased the progressivity of the combined personal and corporate income taxes, an achievement not accomplished in the last two decades of income tax reform [14]. Tax reform can also increase or decrease the welfare of individuals in an economy through its effect on the allocation of labor supply resources. TRA86 reduced the highest marginal income tax rates from 50 percent to 28 percent for high income persons and removed some lower-income persons from the tax roles. Such large marginal tax rate changes introduce significant potential for increased economic efficiency in labor supply and for welfare gains for the rich and poor alike. These changes should be part of the benefit analysis of tax reform. Indeed, Hausman and Poterba [10] report welfare cost changes that result from TRA86 for the average male and female. Their estimates, however, do not account for welfare cost changes throughout the income distribution. In addition to our use of microdata to estimate the marginal welfare cost of tax reform, we use more precise measures of marginal tax rates than other researchers. In this paper, we use Browning's partial equilibrium framework to examine the influence of the reduction in marginal tax rates from TRA86 on the distribution of welfare gains from labor supply reallocation for males by population decile and for females by population decile and by marital status. The empirical results illustrate how the tax reform affected low-income female household heads, where poverty is so heavily concentrated, as well as other household heads and spouses. The results indicate that TRA86 reduced welfare costs in the economy, but these welfare