The Effect of the “Bush Tax Cuts” on Personal Income

Phoebe Wong

Econ 724 Advanced Econometrics

Fall 2010

Final Paper Presentation

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1. Background on the Bush Tax Cuts

● The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) significantly reduced income, estate, dividends, and capital gains tax rates.

● Highest marginal income tax rate declined from 39.6% in 2000 to currently 35%. The 28, 31 and 36% brackets all fell by 3%, and a 10% bracket was created

● “Sunset Clause”: the Bush tax cuts expires at the end of 2010—should the tax cuts be extended?

● Issues: 1. Huge budget deficit in US: more tax revenue is needed; and 2. Income inequality increased in the past three decades (“the Great Divergence”).

● What were the effects of decrease in marginal tax rate on income distribution and tax revenues?

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1. Background on the Bush Tax Cuts Did the marginal tax rate decrease redistribute income

from the poor to the rich?Highest Quintile (Top 20% earners)

Year

Top Marginal Rate Effective Tax Rate Share of Pretax Income among Total

Population

Share of After-tax Income among Total

Population

1979 70.0% 25.9% 45.5% 42.4%

1981 69.1% 25.9% 46% 43.3%

1983 50.0% 23.6% 47.7% 45.7%

1985 50.0% 23.2% 48.6% 46.7%

1987 38.5% 25.4% 48.9% 46.3%

1989 28.0% 24.8% 49.9% 47.6%

1991 31.0% 25.3% 49% 46.5%

1993 39.6% 27.1% 49.8% 46.8%

1995 39.6% 28.1% 50.2% 46.8%

1997 39.6% 28.3% 52.6% 49.1%

1999 39.6% 28.6% 53.8% 50.2%

2001 38.6% 27.6% 52.3% 48.8%

2003 35.0% 25.7% 52.1% 48.8%

2005 35.0% 26.3% 55.1% 51.6%

Source: Congressional Budget Office.

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2. Measuring the effects of marginal tax changes

● Behavioral response to marginal tax rate used to be captured by the compensated elasticity of labor supply. Individuals adjust the amount of labor supply according to the marginal tax rate, their value on leisure and a composite of consumption goods.

● BUT there are other margins of behavioral responses:

• intensity of work or career choices;

• forms and timing of compensation (fringe benefits or stock options);

• savings and investment decisions;

• tax avoidance (through consulting tax professionals);

• tax evasion

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2. Measuring the effects of marginal tax changes

● The elasticity of taxable income (ETI) can capture not only the hours of work response, but also all other behavioral responses, and therefore more accurately summarizing the marginal efficiency cost of taxation.

● ETI defined as the elasticity of income with respect to the net-of-tax rate:

● 1- τ is the net-of-tax rate; τ is the marginal tax rate.

● z is reported total income or taxable income (depends on what you want to measure).

● e is the percent change in income when the net-of-tax rate increases by 1%.

e=1−

z∗

∂ z∂1−

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3. Econometrics Model

● Auten and Carroll (1999): individual's income determined by four factors that capture the marginal tax rate induced behavioral effects:

1. Individual-specific effect,

2. Time-specific effect,

3. Individual characteristics that do not change over time, but whose relationship to income vary over time,

4. Individuals net-of-tax rate or tax price that varies across both individual and across time,

● Income for the individual in time period t is given by:

I i

I it

X i

1−it

i th

Y it= I tt X i1−it

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3. Econometrics Model

● Individual-specific effects do not vary over time and holds the same relationship with income over time, and is therefore eliminated by first differencing (Hsiao, 1986):

• Δ is the change in variable between period t and t+1

• Time-specific effect controls for factors that affect all individuals in the same way during the period, , represented by the constant term.

• Individual characteristics that do not change over time, but whose relationship to income vary over time, , plus the individuals tax price that varies across both individual and across time, , comprise of the independent variables in this model.

X i

1− it

Y i= X i1−i

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4. Data

● U.S. Census Bureau's Survey of Income and Program Participation (SIPP) 2001-2003 panel.

● Detailed records of earnings, expenditures, assets, and other sociological measures on 36,700 households and 51,598 individuals.

● Samples excluded from the panel:

• Individuals who did not participate in both waves of the survey used to construct the panel.

• Individuals under 21 in 2001: income changes for these individuals most likely reflect the completion of schooling instead of capturing tax-induced behavioral responses.

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5. Dependent Variable

● Two income concepts used to measure elasticity of income: gross income and taxable income.

● Gross income capture individual's total income before deductions/exemptions, useful for analyzing effects of tax changes on reported income and income distribution.

• Difference in the log of the total personal income variable in data set is used to measure gross income change.

● Taxable income captures adjustment to income and itemized deduction due to tax changes, useful for analyzing overall behavioral response of individuals.

• The exact taxable income (as filed on tax return) is not available in data set, a taxable income proxy is constructed.

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5. Dependent Variable

● Taxable income is determined by adding together income from all sources, then subtracting allowable adjustments, exemptions and deductions according to individual's filing status.

● Individual's filing status and deductions used are not available in the data set.

● The proxy is constructed based on these assumptions:

• All unmarried individuals file as single with no dependent, with one personal exemption and standard deduction;

• All married individuals file jointly with their spouse, with children under 18 claimed as dependents, two exemptions and two earners standard deduction.

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6. Independent Variables● Individual's tax price (1 – τ) is measured by the federal marginal

tax rate proxy.

● Marginal tax rate is determined by taxable income, filing status, and the schedule of statutory tax rates of the respective year. The proxy is constructed by the same assumptions.

● Comparison of tax bracket statistics from IRS and the marginal tax rate proxy:

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6. Independent Variables● Reverse Causality: Individual's tax price is endogenous to the

reported income, e.g. as taxable income increases, marginal tax rate may also increase despite tax rate decrease under the Bush Tax Cuts.

● Instrumental Variable (IV) needed: it has to be correlated to the endogenous regressor and not to the error term.

● Compare the reported income after the tax change to the income that would have been reported had the tax change not taken place.

● Instrument constructed by computing the individual's tax price under 2003's tax law using 2001's income inflated to 2003's level (synthetic tax price)

● IV is the difference in log of individual's synthetic tax price under 2003's tax law and their actual 2001 tax price.

● As such, the IV eliminates the effect of income changes on the change in tax price and reflects only the exogenous statutory change in tax.

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6. Other Independent Variables● Initial 2001 income used to control for reversion-to-mean

effects

● Individual characteristics with relationship to income that have changed over time:

• Level of wealth reflect the ability to alter labor arrangement in response to tax changes. Capital income used as proxy.

• The effects of age, number of children, marital status on income also change over time.

• Geographic regions: difference in income growth among different regions during the period of study.

• Business ownership and recipient of non-salary income increase the opportunity to alter reported income

• Owners of financial investment instruments may experience different income growth rate based on the return to financial investments during that period.

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7. Summary Statistics of Variables

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8. Validity Issues● Validity of the Instrumental Variable depends on:

• At least one of the regressors is in fact endogenous. Test of exogeneity through C test returns a p-value of 0, overwhelmingly rejecting the null hypothesis of exogeneity.

• Instrument has to be uncorrelated with error term. Overidentifying retrictions through J test could be used if the model is overidentified. But there are only one instrument and one endogenous regressor, J test cannot be performed and choice of instrument can only be assessed by logical reasoning.

• Instrumental variable has to be sufficiently correlated with the endogenous regressor. Test by first stage regressions returns extremely high F statistics (above 2500), suggesting a very strong instrument.

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8. More Validity Issues● Both taxable income and tax prices (the two estimations

used to estimate tax price elasticity) are constructed by proxy.

● Tax price proxy was checked against IRS statistics and is pretty close to the true value. Tax brackets encompass large ranges of taxable income, less vulnerable to biases.

● Taxable income is very sensitive to filing status, amount of exemptions and deductions one claims. The approximation is severely limited by the information available in the date set.

● The gross income dependent variable should yield results that are more reliable than the taxable income dependent variable.

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9. Results from Gross Income model

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9. Results from Gross Income model● Estimated tax-price elasticity without non-tax factor is 1.23,

with 0.16 standard error, comparable to the results by Auten and Carroll (1.19), and Lindsey and Feldstein (1.0)

● Coefficient for level of wealth is positive and significant: income grew more rapidly for wealthy individuals.

● Coefficient is positive for age and negative for age squared: income growth increase with age, but at a decreasing rate.

● North East and West Coast experienced more rapid income growth than rest of the country.

● Individuals who own stocks, bonds or mutual funds experienced greater income growth than those who don't.

● Coefficient of business owner is not significantly different from zero.

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10. Conclusion● Tax price elasticity coefficient falls by more than 50% to

0.52 when non-tax factors are taken into account.

● Both tax rate reduction and non-tax factors determined income growth during that period.

● Failing to control for non tax factors might have led to upward bias on tax price elasticity in previous studies.

● Gross income tax price elasticity has not changed much between 1990 and 2003.

● Taxable income results yield tax price elasticity of 1.096, with all non-tax factors included.

● Revenue maximizing tax rate:

● But taxable income results are higher than expected, and should be interpreted with caution.

=11e

≈47.7percent