PERSONAL TAXATION AND BEHAVIOR Chapter 18

Labor Supply D Income per week |Slope| = w E1 G iii ii Income i Leisure Work Hours of leisure per week F T time endowment

Effects of Taxation D Income per week |Slope| = w H E1 G iii ii |Slope| = (1-t)w Hours of work after tax E2 G’ i F I T Hours of leisure per week Hours of work before tax

Effects of Taxation D Income per week H E1 G iii E3 Hours of work after tax K ii i J F T Hours of leisure per week Hours of work before tax

Effects of Taxation D Income per week |Slope| = w |Slope| = (1-t2)w E1 (1-t1)$5,000 + (1-t2$5,000 (1-t1)$5,000 |Slope| = (1-t2)w |Slope| = (1-t1)w P F T Hours of leisure per week Hours of work before tax

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

Some Caveats Demand-side considerations Individual versus group effects Other dimensions of labor supply: Human Capital The compensation package The expenditure side

Taxes and Human Capital Accumulation 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

Labor Supply and Tax Revenues Wage rate per hour SL j a k c w b (1-t1)w d e (1-t2)w f (1-tA)w i h (1-t3)w L3 LA L2 L1 L0 Hours per week

Tax Rates versus Tax Revenue– Laffer Curve

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?

Saving and the Life-Cycle Model Future consumption c1 c1* E1 iii ii i I1 Endowment point ІSlopeІ = 1 + r Saving M c0* I0 Present consumption (c0)

Deductible Interest Payments and Taxable Interest Receipts Future consumption c1 c1* E1 P c1t After-tax budget line ІSlopeІ = 1 + (1-t)r I1 A Saving after tax Q M c0* c0t I0 Present consumption (c0) Saving before tax

Deductible Interest Payments and Taxable Interest Receipts Future consumption c1 c1* E1 P c1t After-tax budget line ІSlopeІ = 1 + (1-t)r I1 A Saving after tax Q M c0t c0* I0 Present consumption (c0) Saving before tax

Nondeductible Interest Payments and Taxable Interest Receipts Future consumption c1 c1* P c1t After-tax budget line ІSlopeІ = 1 + (1-t)r I1 A Q M I0 Present consumption (c0)

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]

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

Taxes and the Capital Shortage Taxes and investment Taxes and excess burden Closed versus open economy

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

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

Portfolio Composition Tobin’s model of portfolio composition Impact of proportional tax with full loss offset Impact on return Impact on risk Empirical evidence

A Note on Politics and Elasticities Ambiguity about effect of taxation on behavior Importance of elasticities “Convenient” beliefs about elasticities

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