Tax Policy and the Economy

Many, if not most, baby boomers appear at risk of suffering a major decline in their living standard in retirement. With federal and state government finances far too encumbered to significantly raise Social Security, Medicare, and Medicaid benefits, boomers must look to their own devices to rescue their retirements, namely, working harder and longer. However, the incentive of boomers to earn more is significantly limited by a plethora of explicit federal and state taxes and implicit taxes arising from the loss of federal and state benefits as one earns more. Of particular concern is Medicaid and Social Security’s complex earnings test and clawback of disability benefits. This study measures the work disincentives confronting those age 50 to 79 from the entire array of explicit and implicit fiscal work disincentives. Specifically, the paper runs older respondents in the Federal Reserve’s 2013 Survey of Consumer Finances through The Fiscal Analyzer—a software tool designed, in part, to calculate remaining lifetime marginal net tax rates.

We find that working longer, say an extra five years, can raise older workers’ sustainable living standards. But the impact is far smaller than suggested in the literature, in large part because of high net taxation of labor earnings. We also find that many baby boomers now face or will face high and, in very many cases, extremely high work disincentives arising from the hodgepodge design of our fiscal system. A third finding is that the marginal net tax rate associated with a significant increase in earnings, say $20,000 per year, arising from taking a full-time or part-time job (which could be a second job) can, for many elderly, be dramatically higher than that associated with earning a relatively small, say $1,000 per year, extra amount of money. This is due to the various income thresholds in our fiscal system. We also examine the elimination of all transfer program asset and income testing. This dramatically lowers marginal net tax rates facing the poor. Another key finding is the enormous dispersion in effective marginal remaining lifetime net tax rates facing seemingly identical households, that is, households with the same age and resource level. Finally, we find that traditional, current-year (i.e., static) marginal tax calculations relating this year’s extra taxes to this year’s extra income are woefully off target when it comes to properly measuring the elderly’s disincentives to work.

Our findings suggest that Uncle Sam is, indeed, inducing the elderly to retire.

We present new calculations of cumulative marginal tax rates (MTRs) facing low-income families participating in multiple welfare programs over the period 1997–2007, the period after 1996 welfare reform but before the program expansions of the Great Recession. Our calculations are for nondisabled, nonelderly families who pay federal and state income taxes and the payroll tax but receive benefits from up to four different transfer programs—Medicaid, food stamps, subsidized housing, and Temporary Assistance for Needy Families. The results show enormous variation in MTRs across families who participate in different combinations of welfare programs, who have different family structures, and who have earnings in different ranges. For families who participate in either no or fewer than two welfare programs, which constitutes the large majority of low-income families, MTRs are either negative or positive but modest in magnitude. But families participating in two or more programs, while still facing negative or modest positive rates at low earnings, usually face considerably higher MTRs at higher earnings ranges, often up to 80% and even occasionally over 100%. While the fraction of families in this category is not large, they constitute about one-fifth of single-parent families.

This paper provides preliminary evidence on behavioral responses to taxation around the 2013 tax increase that raised top marginal tax rates on capital income by about 9.5 points and on labor income by about 6.5 points. Using published tabulated tax statistics from the Statistics of Income division of the IRS, we find that reported top 1% incomes were significantly higher in 2012 than in 2013, implying a large short-run elasticity of reported income with respect to the net-of-tax rate in excess of one. This large short-run elasticity is due to income retiming for tax avoidance purposes and is particularly high for realized capital gains and dividends, and highest at the very top of the income distribution. However, comparing 2011 and 2015 top incomes uncovers only a small medium-term response to the tax increase as top income shares resumed their upward trend after 2013. Overall, we estimate that at most 20% of the projected tax revenue increase from the 2013 tax reform is lost through behavioral responses. This implies that the 2013 tax increase was an efficient way to raise revenue.

In theory, the US tax system aims to attribute and tax all business income to individuals, but the tax treatment of this income varies. Pass-through income is taxed when earned, capital gains income is taxed when realized, dividends when distributed, and other forms of business income may escape taxation entirely. Business owners have control over the timing and character of their income: they can often choose, for example, between reporting business income or deducting it as wages or fringe benefits. And laws change, changing the incentive and ability to shift income between the individual and corporate sectors.

We integrate a wide variety of tax data to document the large long-run changes in the structure of business income and business taxation in the United States. These changes include the degree to which business incomes are taxed on a realization versus an accrual basis, the extent to which taxation is deferred, and the share of business income that is ultimately subject to taxation. We highlight the evolving relevance of retained earnings in the changing corporate sector and its relationship to equity values and unrealized capital gains. We also document the evolution of individual income components—profits of pass-through entities, dividends, and capital gains (both taxable gains and those escaping taxation through step-up). As a result of these changes, business incomes are increasingly taxed through personal income taxes instead of a combination of corporate and personal taxes. In particular, this implies that observability of business incomes on personal income tax returns has improved over time, a fact that has implications for measuring and understanding the income distribution.

A recent wave of literature, partly motivated by presidential campaign tax reform plans, analyzes tax expenditure limitation proposals. These reforms are often advanced not only, or even primarily, because they reduce distortions caused by favoritism for some types of expenditures over others. Largely they are urged for a number of other reasons: on distributive grounds, because the resulting broader base enables lower marginal tax rates and hence less distortion of labor effort and other margins, and to raise revenue without requiring higher marginal tax rates. It is generally recognized that the particular results on these dimensions are heavily dependent on what sorts of rate adjustments are used to return the proceeds to taxpayers. Often, revenue neutrality is assumed. This essay advances a complementary, distribution-neutral perspective on the analysis of tax expenditure limitations. Distribution-neutral implementation provides an illuminating benchmark against which to understand prior analysts’ large number of results and, more importantly, clarifies the analysis, particularly of the distribution-distortion trade-off. The central lessons contradict the common belief that one can have less distortion of labor supply through lower marginal tax rates while also maintaining or enhancing progressivity.