Is the Taxable Income Elasticity Sufficient to Calculate Deadweight Loss? The Implications of Evasion and Avoidance

Since Feldstein (1999), the most widely used method of calculating the excess burden of income taxation is to estimate the e¤ect of tax rates on reported taxable income. Feldstein’s taxable income formula for deadweight loss implicitly assumes that the marginal social cost of evasion and avoidance equals the tax rate. This paper argues that this condition is likely to be violated in practice for two reasons. First, some of the costs of evasion and avoidance are transfers to other agents in the economy rather than real resource costs. Second, some individuals overestimate the costs of evasion and avoidance. I show that, in such situations, excess burden depends on a weighted average of the taxable income and total earned income elasticities, with the weight determined by the resource cost of sheltering income from taxation. This generalized formula implies that the e¢ ciency cost of taxing high income individuals is not necessarily large despite evidence that their reported incomes are highly sensitive to marginal tax rates. Keywords: excess burden, tax evasion, optimal taxation E-mail: [email protected]. I have bene…ted from discussions with Alan Auerbach, Peter Diamond, Caroline Hoxby, John Friedman, David Gamage, Roger Gordon, Louis Kaplow, Adam Looney, Wojtek Kopczuk, Emmanuel Saez, Joel Slemrod, Shlomo Yitzhaki, and Philippe Wingender. Gregory Bruich provided outstanding research assistance. Funding from the Hoover Institution is gratefully acknowledged. In an in‡uential pair of papers, Martin S. Feldstein (1995, 1999) showed that the excess burden of income taxation can be calculated by estimating the e¤ect of taxation on reported taxable income – the “taxable income elasticity.” Feldstein’s taxable income approach has since become the central focus of the literature on taxation and labor supply because of its elegance and practicality. The approach is elegant because one does not have to account for the various channels through which taxation might a¤ect behavior (e.g. hours, e¤ort, training) to measure e¢ ciency costs. It is practical because tax records containing data on reported taxable income are widely available. The empirical literature on the taxable income elasticity has generally found that elasticities are large (0.5 to 1.5) for individuals in the top percentile of the income distribution, and relatively small (0 to 0.3) for the rest of the income distribution (see e.g., Lawrence B. Lindsey 1987, Joel B. Slemrod 1998, Jonathan Gruber and Emmanuel Saez 2002, Saez 2004). This …nding has led some to suggest that reducing top marginal tax rates would generate substantial e¢ ciency gains.1 The taxable income reported by high income individuals is very sensitive to the tax rate partly because of tax avoidance and evasion (Slemrod 1992, 1995).2 For example, individuals make charitable contributions to reduce their taxable income or use unmonitored o¤shore accounts to under-report income. Does the e¢ ciency cost of taxation depend on whether the taxable income elasticity is driven by avoidance and evasion rather than changes in labor supply? Existing studies (e.g. Feldstein 1999, Slemrod and Shlomo Yitzhaki 2002, Saez 2004) suggest that the answer is no, as long as there are no changes in tax revenue from other tax bases. For example, Slemrod and Yitzhaki remark that “Feldstein’s (1999) claim about the central importance of the elasticity of taxable income generalizes to avoidance and evasion.” The intuition underlying this conclusion is straightforward: an optimizing agent equates the marginal cost of sheltering $1 of income from taxation with the net marginal cost of reducing earnings by $1, so the reason that reported taxable income falls does not matter for e¢ ciency calculations. This paper reevaluates the taxable income elasticity as a measure of deadweight loss in the presence of evasion and avoidance (“sheltering”behaviors).3 Feldstein’s formula implicitly requires that the marginal social cost of sheltering $1 of income equals the tax rate (the bene…t of sheltering Academic examples include Gruber and Saez (2002) and Feldstein (2006). The Joint Economic Committee (2001) has argued in favor of lowering top rates based on the taxable income evidence. See Austan Goolsbee (1999) for a critique of the empirical literature on taxable income. 2 Income shifting can also occur intertemporally. When tax changes are anticipated, individuals appear to retime income substantially (Goolsbee 2000). I abstract from such intertemporal e¤ects, focusing on the question of how to measure e¢ ciency costs using estimates of the long-run e¤ect of taxes on behavior. The distinction between illegal evasion and legal avoidance is not critical for the analysis in this paper, so I use the term “sheltering”as a general description of all evasion and avoidance behaviors.