Question

Writing in the Wall Street Journal, Martin Feldstein, an economist at Harvard University, argued that "behavioral responses" of taxpayers to the cuts in marginal tax rates enacted in 1986 resulted in "an enormous rise in the taxes paid, particularly by those who experienced the greatest reductions in marginal tax rates." How is it possible for cuts in marginal tax rates to result in an increase in total taxes collected? What does Feldstein mean by a "behavioral response" to tax cuts?

Short answer

Cuts in marginal tax rates can result in increased total taxes collected as they elicit a 'behavioral response' by encouraging individuals to increase their taxable incomes, for instance, working more or investing more. Despite the lower tax rate, the increased taxable income can lead to a higher total amount of taxes collected.

Step-by-step solution

Understanding Marginal Tax Rate

A marginal tax rate is the rate of tax charged on the last dollar of income earned. This rate changes for different income groups. A lower marginal tax rate will decrease the amount of taxes paid on an additional dollar earned.

Understanding 'Behavioral Response'

A 'Behavioral Response' to a decrease in marginal tax rates refers to the change in taxpayers' behavior due to the tax cut. Taxpayers tend to work, save or invest more when the marginal tax rate is lower as they get to keep more of their income.

Connecting Tax cut and Total Taxes Collected

A reduction in the marginal tax rate can lead to an increase in total taxes collected because it incentivizes individuals to increase their taxable income. The reason is that with lower tax rates they get to keep more of each additional dollar earned. They may work more hours, take on additional jobs, or invest in taxable assets. Therefore, even though the tax on each additional dollar earned (marginal tax rate) is less, the overall taxable income increases, resulting in a rise in total taxes collected.

Key concepts

Behavioral Responses in Economics

Understanding the concept of 'behavioral responses' in economics is crucial when examining the effects of changes in tax policy. When taxpayers experience a reduction in marginal tax rates, their behavior adjusts in various ways. Economists argue that lower tax rates can lead to an increased willingness to engage in economic activities that generate taxable income. This could include working more hours, seeking additional employment, or investing in income-generating assets.

Given that individuals aim to maximize their after-tax income, a lower marginal tax rate reduces the 'penalty' on earning additional income. As a result, taxpayers might be more inclined to undertake extra work or capitalize on investment opportunities, given that the after-tax return on these activities is now greater. This behavioral adaptation to tax rate changes is a fundamental principle within supply-side economics, suggesting that economic behavior can be influenced by tax policy.

Tax Policy and Revenue

The relationship between tax policy and governmental revenue is often not linear, and this is where the concept of elasticity comes into play. Elasticity, in this context, refers to taxpayers' responsiveness to tax rate changes. If a government decides to lower marginal tax rates, it might initially seem that tax revenues would decrease. However, due to behavioral responses, as mentioned earlier, the total taxable income base could expand.

Lower tax rates can stimulate economic growth by providing incentives for increased work and investment, which, in turn, widens the tax base. When the base broadens sufficiently, despite the lower rate, the overall tax revenue might actually increase. This phenomenon, called the Laffer Curve, illustrates that there's an optimal tax rate that maximizes revenue without overburdening taxpayers. Policymakers aim to find a balance where tax rates are neither too high to discourage income generation nor too low to minimize revenue.

Incentives and Taxable Income

Incentives play a pivotal role in shaping taxpayer behavior and, consequently, the amount of taxable income they generate. The concept of marginal tax rates directly ties into how much of an additional dollar earned by an individual actually goes into their pocket. When the marginal tax rate is high, individuals retain less of each additional dollar earned, which may serve as a deterrent to earning more taxable income.

Conversely, with lower marginal tax rates, taxpayers have greater incentives to increase their earnings because they keep a larger portion of their income. This incentive effect can manifest in significant shifts in economic activity, ranging from labor supply changes to investment decisions. This relationship shows that not only do tax rates impact individual decision-making, but they can also influence the economy's overall productivity and efficiency. Therefore, tax policy plays a fundamental role in shaping economic health, both by its direct impact on revenue and by its indirect influence on economic behavior.