NCPA - National Center for Policy Analysis

As Taxes Rise, Deductions Grow

August 30, 1999

Supply-siders insist that taxable income shrinks as marginal tax rates increase. Supporting their claim is the fact that boosts in tax rates legislated in 1993 raised far less revenue than forecast by the static models that allowed for no behavioral responses by taxpayers. The 1993 hike raised only about one- third of the static tax revenue gains.

If supply-side reasoning is correct, then taxable income should be lower in high tax states, everything else equal, and higher in low tax states. Auburn University economist James Long finds that the 1991 data on federal individual tax returns strongly support this relationship. State marginal rates varied widely in 1991, ranging from 0 to 12 percent. Because of confidentiality, high-income returns -- those over $200,000 adjusted gross income -- could not be included in the study.

  • The data show that a 10 percent increase in the marginal tax rate in high brackets (say, from 40 percent to 44 percent) reduces taxable income by about 4 percent, with half that percentage response -- about 2 percent -- by low-income payers.
  • More than 80 percent of the shrinkage in the tax base is produced because taxpayers shift their spending toward tax deductible categories like mortgage interest payments and IRA contributions.
  • The interest deduction on home mortgage payments increases demand for owner-occupied housing, especially in high tax states, and the result is higher housing prices there.

Overall, however, tax responsiveness in the 1990s is less than earlier because the 1986 income tax reform lowered incentives and opportunities for tax avoidance.

Source: James E. Long, "The Impact of Marginal Tax Rates on Taxable Income: Evidence from State Income Tax Differentials," Southern Economic Journal, April 1999.


Browse more articles on Tax and Spending Issues