6. How Do Taxes Affect Income

As this analysis has shown, the empirical literature provides little evidence that high-income taxpayers significantly change their economic behaviour in response to changes in marginal effective tax rates in the areas discussed. This lack of evidence undermines claims that relatively modest increases in the marginal tax rate will have a significant negative impact on the economy. A simple glance at the historical documents reinforces this conclusion. The marginal tax rate is the amount of additional tax paid for each additional dollar earned as income. The average tax rate is the total tax paid divided by the total income earned. A marginal tax rate of 10% means that 10 cents of every dollar earned would be considered a tax. However, unlike the federal government, which provides a prime rate, most states tax capital gains at the same rate as regular income. Connecticut, Hawaii, Massachusetts and Oregon levy special tax rates on capital gains income. Ultimately, pre-tax income inequality has increased since the 1970s, despite an increase in government transfer payments.

Because high-income earners pay higher average tax rates than others, federal taxes reduce inequality. But the mitigating effect of taxes today is about the same as before 1980. For example, after-tax income inequality has increased about as much as pre-tax inequality. Taxes have not exacerbated rising income inequality, but have done little to offset them. Feldstein and Wrobel (1998) examined whether state and local governments can effectively redistribute revenues through taxes and transfers. Their findings largely support the economic theory that, in the long run (under conditions of perfect mobility), a person`s pre-tax salary adjusts to make the person`s real after-tax income equal in all jurisdictions. This leveling occurs when individuals find that after-tax income is higher in another jurisdiction and are moved to areas where real net income is more favorable. The conditions for perfect mobility do not exist – although mobility has increased dramatically after the pandemic – but Feldstein and Wrobel find real effects that essentially correspond to a stylized theory. In addition, a large difference between capital gains tax rates and tax rates on other types of income promotes tax avoidance. It redirects capital towards relatively unproductive investments in which taxpayers would not invest, but for the tax advantage.

It also promotes sophisticated systems to convert ordinary income into capital gains in order to obtain the tax advantage. To the extent that increasing capital gains tax rates reduces the difference and discourages such tax hedging behaviour, it can increase economic efficiency. That`s what Leonard Burman, former director of the Urban-Brookings Tax Policy Center, said in his commentary on the 2003 capital gains tax cut: Increasing revenues by broadening the tax base can indeed improve the effectiveness of tax legislation. And because cleaner tax legislation offers fewer opportunities to evade tax, broadening the tax base can reduce the economic costs of tax increases, which are also necessary to ensure the sustainability of public finances. So how should policymakers evaluate proposed taxes when data on tax changes rarely reflect the predictions of conventional analysis? The answer, as Greg Leiserson, former director of tax policy for fair growth, writes, “If U.S. tax reform leads to fair growth, a pay-as-you-go table will show it.” 25 An income analysis explains how much money is collected or lost, and a distribution analysis explains who pays or benefits from the tax. Many complex calculations and assumptions underpin the creation of income and distribution tables, but when done right, they provide the most important information policymakers need to know about how tax changes affect the populations they care about. In addition, allegations that approximately half of business income “passed on” (i.e., income that businesses pass on to their owners who pay taxes on those profits) is taxed at the two highest tax rates[49] are also misleading.

These claims are based on an extremely broad definition of “business” that treats any taxfiler with business income as a business owner. Under this definition, professors who are occasionally paid to give a speech or give advice on the side, lawyers and accountants whose firms are organized in partnerships, and business leaders who are paid to serve on the boards of other companies are treated as small business owners. A Recent Treasury [48] These include small business owners who report zero gross adjusted income (GII) or negative adjusted gross income. The Consolidated Revenue Fund definition of a “small business owner” includes tax filers who report net asset income from small businesses equal to at least 25% of the taxpayer`s GDI. “Small businesses” are identified as intermediary businesses that meet certain criteria for the types and amounts of reported income and deductions claimed (these criteria are designed to exclude applicants who are not engaged in “commercial” activities) and that have both income and deductions of less than $10 million. Matthew Knittel, Susan Nelson, Jason DeBacker, John Kitchen, James Pearce and Richard Prisinzano, Office of Tax Analysis, Department of the Treasury. “Methodology for identifying small businesses and their owners”, technical paper of 4 August 2011. Cloyne (2013) built on the work of Romer and Romer (2010) by analysing the narrative assessment of legal tax changes in the UK between 1955 and 2009.

Like Romer and Romer, Cloyne controlled endogenous tax changes and included only exogenous tax changes in his analysis—those that were not correlated with changes in interest rates and macroeconomic output. The most important finding of the author`s research is that, on average, a tax cut of 1 percentage point relative to GDP increases GDP by 0.6% in the quarter following the tax change and by 2.5% after about three years. The study found that an exogenous tax increase of 1% of GDP after three years (12 quarters) led to an estimated 3% drop in GDP. Much of the decline in GDP was attributed to lower personal consumption expenditure and private domestic investment. The authors found that while taxes are increased by 1% of GDP, personal consumption expenditure and private domestic investment have been steadily declining for about two years.