NCPA - National Center for Policy Analysis

Marginal Tax Rates Affect Behavior

August 9, 1996

Variations in tax levels affect how taxpayers make decisions and act, according to economic researchers. Higher rates induce them to substitute fringe benefits and nicer working conditions for taxable cash, as well as choose more leisure time and less demanding work.

To illustrate, consider the case of a married couple with $50,000 in taxable income and the impact of Bob Dole's proposed 15 percent across-the-board cut in rates.

  • Each additional dollar of taxable earnings now takes 28 cents more in federal personal income taxes, 15 cents more in employer-employee payroll taxes, and about 5 cents more in state income taxes -- adding up to a marginal tax rate of 48 percent.
  • So each extra dollar of taxable earnings only adds 52 cents of spendable income.
  • As a result, taxpayers will choose -- and companies will spend each additional $1 of compensation for -- fringe benefits and nicer working conditions, rather than taxable income, down to the point where the employee values the benefit at less than 52 cents.
  • Similarly, offered $100 for extra work, the employee will turn the offer down if working means giving up leisure which he values for as little as $52.

Now consider the impact of Dole's tax reduction on that same couple -- reducing their marginal federal tax rate from 28 percent to about 24 percent.

  • An extra dollar of taxable earnings would therefore mean 56 cents of spendable cash instead of the current 52 cents.
  • There would be less incentive to substitute low-valued fringe benefits and leisure for spendable income.
  • Although an 8 percent increase seems small, economists say that its effect would be substantial.

A study of a large sample of tax returns following the 1986 tax rate cuts verifies this effect. Assume that the $50,000 couple elected to increase its taxable income by just 4 percent due to incentives from the tax cut -- to $52,000.

  • The $2,000 of extra consumption and tax revenue would otherwise have been fringe benefits and leisure valued at about 52 cents per dollar, or $1,040.
  • The $960 difference measures the reduction in waste that results from the 15 percent rate cut.
  • If the couple's income remained unchanged after the cut, they would pay $1,340 less in tax -- a revenue loss as analyzed in a "static" manner.
  • But under a "dynamic" analysis -- taking into account a probable net increase in taxable income of about $1,500, plus other factors -- the revenue loss is only $755.
  • The "feedback" effect of increased taxable earnings cuts the loss of income tax revenue in this case by 44 percent.

While the effect is similar for high-income taxpayers, they would be even more responsive to tax rate changes. It is estimated that a couple with $300,000 of taxable income would respond to the 15 percent rate cut by willingly increasing their taxable income enough to pay $10,240 more in taxes -- because the goods and services they can buy with the extra net cash exceeds the value of the foregone leisure and fringe benefits.

Source: Martin Feldstein (Harvard), "A Case for Cutting Marginal Rates," Wall Street Journal, August 9, 1996.


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