PERSONAL TAXATION AND BEHAVIOR Chapter 18

Labor Supply Hours of leisure per week Income per week 0T time endowment D |Slope| = w F G Leisure Work i ii iii E1E1 Income 18-2

Effects of Taxation Hours of leisure per week Income per week 0T D |Slope| = w F G ii iii E1E1 i I E2E2 |Slope| = (1-t)w H G’ Hours of work before tax Hours of work after tax 18-3

Effects of Taxation Hours of leisure per week Income per week 0 T D F G ii iii E1E1 i J E3E3 H K Hours of work before tax Hours of work after tax 18-4

Effects of Taxation Hours of leisure per week Income per week 0T D F N E1E1 P E4E4 Hours of work before tax |Slope| = w |Slope| = (1-t 1 )w |Slope| = (1-t 2 )w (1-t 1 )$5,000 (1-t 1 )$5,000 + (1-t 2 $5,

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

Some Caveats Demand-side considerations Individual versus group effects Other dimensions of labor supply: Human Capital The compensation package The expenditure side 18-7

Taxes and Human Capital Accumulation Human capital 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 18-8

Labor Supply and Tax Revenues Hours per week Wage rate per hour SLSL w L0L0 (1-t 1 )w L1L1 d b ac (1-t 2 )w e f L2L2 k (1-t 3 )w h i L3L3 j (1-t A )w LALA 18-9

Tax Rates versus Tax Revenue– Laffer Curve Tax rate Tax revenue t1t1 t2t2 tAtA t3t

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? 18-11

Saving and the Life-Cycle Model Present consumption (c 0 ) Future consumption c 1 Endowment point I0I0 I1I1 M N ІSlopeІ = 1 + r E1E1 c0*c0* c1*c1* i ii iii Saving 18-12

Deductible Interest Payments and Taxable Interest Receipts Present consumption (c 0 ) Future consumption c 1 I0I0 I1I1 M N After-tax budget line ІSlopeІ = 1 + (1-t)r E1E1 c0*c0* c1*c1* Saving before tax Q P A c0tc0t c1tc1t Saving after tax 18-13

Deductible Interest Payments and Taxable Interest Receipts Present consumption (c 0) Future consumption c 1 I0I0 I1I1 M N After-tax budget line ІSlopeІ = 1 + (1-t)r E1E1 c0*c0* c1*c1* Saving before tax Q P A c0tc0t c1tc1t Saving after tax 18-14

Nondeductible Interest Payments and Taxable Interest Receipts Present consumption (c 0) Future consumption c 1 I0I0 I1I1 M N After-tax budget line ІSlopeІ = 1 + (1-t)r c1*c1* Q P A c1tc1t 18-15

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] 18-16

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 18-17

Taxes and the Capital Shortage Taxes and investment Taxes and excess burden Closed versus open economy 18-18

Housing Decisions Effects of the income tax on housing decisions – R net = R – I + ΔV Implicit rent not taxed Deductibility of mortgage interest and property tax payments The decision to rent or buy 18-19

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 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 18-20

Portfolio Composition Tobin’s model of portfolio composition Impact of proportional tax with full loss offset – Impact on return – Impact on risk Empirical evidence 18-21

A Note on Politics and Elasticities Ambiguity about effect of taxation on behavior Importance of elasticities “Convenient” beliefs about elasticities 18-22

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 18-23