The Elasticity of Taxable Income : Influences on Economic Efficiency and Tax Revenues, and Implications for Tax Policy

This chapter focuses on important developments in ETI research, both empirical and theoretical, over the first decade of the twenty-first century and relates them to important tax issues that the United States will face over the next few years. Next, the chapter examines the two most important Bush tax cuts, the Economic Growth Tax Relief and Reconciliation Act of 2001 (EGTRRA) and the Jobs Growth Tax Relief and Reconciliation Act of 2003 (JGTRRA), which are set to expire after 2010, unless additional legislation is enacted. The analysis is repeated for a range of ETI estimates to show how allowing the individual income tax rate cuts to expire might affect economic efficiency and tax revenues. Based on 2005 data, returning individual income tax rates to their 2001 levels would raise revenues by $98.6 billion dollars assuming no behavioral responses. At an elasticity of taxable income (ETI) of 0.2, $15.6 billion of this mechanical increase ($12.2 billion from the federal income tax and $3.4 billion from payroll and state taxes) would be lost due to reductions in taxable income. At an ETI of 0.8, $62.4 billion of the mechanical revenue gain ($48.8 billion from the federal income tax and $13.6 billion from payroll and state taxes) would be lost. The DWL per dollar of additional revenue from the federal income tax is also highly sensitive to the ETI, ranging from $0.18 at an ETI of 0.2 to $1.25 at an ETI of 0.8. When offsets to revenue from payroll and state taxes are taken into account, the range is from $0.19 to $1.72. Laffer curves and rates are also presented in the chapter under the range of ETI assumptions, with special attention focused on the top tax bracket. Again, estimates are quite sensitive to the ETI. At an ETI of 0.2, the estimated Laffer tax rate for the top tax bracket is 78 percent; at an ETI of 1, the estimated Laffer rate is just 41 percent-or slightly higher than the current effective marginal tax rate for this group