The impact of marginal tax rates on taxable income: evidence from state income tax differentials.

Summary

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The connection between marginal tax rates and taxable income was investigated with a large cross section of income tax returns filed by persons who face various marginal tax rates because of state income tax differentials. Experimental findings showed that a rise in the marginal tax rate decreases taxable income primarily because taxpayers claim bigger deductions. High-income individuals are more sensitive to tax rate changes than lower-income persons.

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The impact of marginal tax rates on taxable income: evidence from state income tax differentials.

1. Introduction

The relationship of taxable income to the marginal tax rate has important implications for both the revenue consequences of tax policy and the deadweight loss of the income tax.(1) Not surprisingly, then, Feldstein's (1995b) analysis of the 1986 tax reform, in which he concluded that taxable income is highly responsive to changes in the marginal tax rate, has been closely examined and subjected to certain criticisms, which are summarized in Slemrod (1995b), Auten and Carroll (1995), and Goolsbee (1998). Two common criticisms of Feldstein's net-of-tax rate (i.e., one minus the tax rate) elasticity, which averaged either 1.26 or 2.10 depending on how taxable income was measured, were (i) that his panel data contained too few high-income taxpayers (e.g., there were only 57 individuals in the 49 or 50% tax bracket in 1985) and (ii) that his analysis was incomplete because it excluded nontax determinants of taxable income.

Auten and Carroll (1995) addressed these and other criticisms in their reexamination of Feldstein's findings. Their estimate of a "taxes only" and a multivariable model of taxable income using a substantially larger data set (containing 4387 taxpayers in the top two brackets) yielded taxable income elasticities smaller than (in some instances less than half as large as) those reported by Feldstein. The methodological approach of the Feldstein and comparable longitudinal studies, in which changes over time in taxable income of different groups are compared to the changes in the tax rates of the groups, has also been criticized. Goolsbee (1998) argues that it rests on a questionable assumption, namely, that lower-income individuals are a valid control group for higher-income individuals. If high-income individuals have incomes that trend upward at a relatively faster rate or are more likely to be in forms whose timing can be shifted in the short run, then Goolsbee believes that the Feldstein net-of-tax rate elasticities may be substantially overstated, perhaps by 75% or more.

In light of criticisms of existing studies, additional research on the impact of tax rate changes on taxable income is warranted, and a study that uses an alternative approach to measure the tax or net-of-tax rate elasticity may yield independent evidence on this important issue. In this article, the relationship between taxable income and the mar...

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