PERSONAL TAXATION AND BEHAVIOR

Chapter 18

Labor Supply

Hours of leisure per week

Inco

me

per w

eek

0 T

time endowment

D|Slope| = w

F

G

Leisure Worki

ii

iiiE1

Income

18-2

Effects of Taxation

Hours of leisure per week

Inco

me

per w

eek

0 T

D|Slope| = w

F

G

ii

iiiE1

i

I

E2|Slope| = (1-t)w

H

G’

Hours of work before tax

Hours of work after

tax

18-3

Effects of Taxation

Hours of leisure per week

Inco

me

per w

eek

0 T

D

F

G

ii

iiiE1

i

J

E3

H

K

Hours of work before tax

Hours of work after

tax

18-4

Effects of Taxation

Hours of leisure per week

Inco

me

per w

eek

0 T

D

F

NE1

P

E4

Hours of work before tax

|Slope| = w

|Slope| = (1-t1)w|Slope| = (1-t2)w

|Slope| = (1-t2)w

(1-t1)$5,000

(1-t1)$5,000 + (1-t2$5,000

18-5

Empirical Findings

• Eissa [2001] – For males aged 20-60, the effect of changes in the

net wage on hours worked is small and often statistically insignificant• Elasticity of approximately 0.05

– For married females, the hours of work and labor force participation decisions are quite sensitive to changes in the net wage, although it has gotten smaller over time. • Elasticity of approximately 0.40

18-6

Some Caveats

• Demand-side considerations• Individual versus group effects• Other dimensions of labor supply: Human

Capital• The compensation package• The expenditure side

18-7

Taxes and Human Capital Accumulation

• Human capital• Investing in human capital

– B – C > 0– (1 – t)B – (1 – t)C = (1 – t)(B – C>) 0– Income versus substitution effects

• Shortcomings of model– Returns uncertain– Explicit costs– Other taxes– Progressive taxes

18-8

Labor Supply and Tax Revenues

Hours per week

Wag

e ra

te p

er h

our

SL

w

L0

(1-t1)w

L1

db

a c

(1-t2)we

f

L2

k

(1-t3)wh i

L3

j

(1-tA)w

LA18-9

Tax Rates versus Tax Revenue– Laffer Curve

Tax rate

Tax

reve

nue

t1 t2 tA t318-10

Debate Over the Laffer Curve

• The Laffer curve and the elasticity of labor supply

• Where on the Laffer curve is the economy operating?

• Other ways tax rates can affect tax revenues• Determining the optimal tax rate• Is maximizing tax revenue a valid goal?

18-11

Saving and the Life-Cycle Model

Present consumption (c0)

Futu

re c

onsu

mpti

on c

1

Endowment point

I0

I1

M

N

ІSlopeІ = 1 + r

E1

c0*

c1*

iii

iii

Saving

18-12

Deductible Interest Payments and Taxable Interest Receipts

Present consumption (c0)

Futu

re c

onsu

mpti

on c

1

I0

I1

M

N

After-tax budget lineІSlopeІ = 1 + (1-t)r

E1

c0*

c1*

Saving before tax

Q

P

A

c0t

c1t

Savingaftertax

18-13

Deductible Interest Payments and Taxable Interest Receipts

Present consumption (c0)

Futu

re c

onsu

mpti

on c

1

I0

I1

M

N

After-tax budget lineІSlopeІ = 1 + (1-t)r

E1

c0*

c1*

Saving before tax

Q

P

A

c0t

c1t

Savingaftertax

18-14

Nondeductible Interest Payments and Taxable Interest Receipts

Present consumption (c0)

Futu

re c

onsu

mpti

on c

1

I0

I1

M

N

After-tax budget lineІSlopeІ = 1 + (1-t)r

c1*

Q

P

A

c1t

18-15

Some Additional Considerations

• Real net rate of return• Many assets• Private saving versus social saving• Validity of life-cycle model• Empirical evidence: effect of taxation on saving

– Problems using the regression approach• Specification issues• Measurement issues

– Joint Committee on Taxation [2005]

18-16

Tax-Preferred Savings Accounts

• Types of tax-preferred savings accounts and how they work

• Are contributions to these accounts new saving?

• Administrative details and effect on saving: insights from Behavioral Economics

18-17

Taxes and the Capital Shortage

• Taxes and investment• Taxes and excess burden• Closed versus open economy

18-18

Housing Decisions

• Effects of the income tax on housing decisions– Rnet = R – I + ΔV

• Implicit rent not taxed• Deductibility of mortgage interest and

property tax payments• The decision to rent or buy

18-19

Proposals for Change

• Critique of subsidy for owner-occupied housing– Are there significant positive externalities?– Impact on distribution of income – Incentive to take on risky mortgages, contributing to the

housing and financial crisis of 2008-2009• Political feasibility of taxing imputed rent• Reform proposals

– Elimination of deduction for property tax and mortgage interest

– Placing an upper-limit on deductions– Convert mortgage interest deduction into a credit

18-20

Portfolio Composition

• Tobin’s model of portfolio composition• Impact of proportional tax with full loss offset

– Impact on return– Impact on risk

• Empirical evidence

18-21

A Note on Politics and Elasticities

• Ambiguity about effect of taxation on behavior• Importance of elasticities• “Convenient” beliefs about elasticities

18-22

Chapter 18 Summary

• The U.S. personal income tax affects several economic decisions including labor supply, housing consumption, saving, and human capital investment

• Research into these affects are among the most contentious of all areas of public policies

18-23