What Does the Taxable Income Elasticity Say About Dynamic Responses to Tax Changes?

Abstract

The taxable income elasticity is relevant to dynamic scoring because it broadly encompasses many ways taxpayers respond to changes in tax rates. The elasticity includes, for example, changes in labor supply and participation, savings and portfolio allocation, the form of compensation, the timing of income and deductions, and tax evasion and avoidance on the tax base, all subsumed in this one statistic. This one statistic summarizes how the tax base expands or contracts in response to changes in tax rates and, consequently, the extent taxpayer behavior offsets the static revenue loss (gain) of tax rate reductions (increases). In contrast to conventional revenues estimates, which assume that output and other key macroeconomic aggregates remain fixed when considering changes in the tax law, the taxable income elasticity imposes no such constraint. Nevertheless, some macro-dynamic responses, such as investment and savings-related supplyside effects and crowding out, are only partially captured in the taxable income elasticity, and demand effects are generally not reflected at all. Also, the taxable income elasticity generally does not account for shifting between the individual and corporate tax bases and is primarily useful to only evaluate policies that involve changes in tax rates. While large is in the eye of the beholder, the taxable income literature has generally found evidence of at least a modest behavioral response with some of the more recent studies suggesting a taxable income elasticity of about 0.4. This paper uses a 0.4 elasticity to simulate the revenue effect of repealing the recent reduction in the top two tax rates to 35 percent and to motivate a discussion of what the this elasticity can tell us about the dynamic response to changes in tax policy.