Wednesday, January 8, 2014

A History of Behavioral Responses to Tax and Transfer Policies

The most fundamental insight required to understand tax and transfer policy is simple: financial incentives affect behavior. That is a point on which basically all thinking people can and do agree, but the agreement stops there. The way and degree to which tax and transfer programs affect behavior is hotly debated and highly relevant given the current debate on the future direction of policy.

It's important to note how important it is that we get an accurate picture of how powerful these effects are. Back in the 1960s and 1970s, our tax and transfer system reflected an academic consensus that vastly underestimated behavioral responses to taxation. Indeed, prior to 1980, we had a tax system with a top tax rate of 70% and welfare system (prior to reform in the 1990s) embedded with truly awful incentives. Since incentives were thought to be small, the effects of these perverse incentives were thought to be small and thus did not play a large enough role in the policy discussion

This underestimation of incentives was not a matter of bad research or baseless assumptions. Instead, it was a matter of incomplete research that was simply not able to capture anywhere near the full behavioral responses to taxation. For instance, the literature looked for relationships between changes in tax rates and hours worked and found none.

By the time the late 1970s came around, new researchers that weren't as ideologically committed to defending the welfare state and progressive tax system were upending previously held assumptions. Eventually, these intellectuals would be proven right and would gain in influence. The late 1970s saw both economic stagnation and a degree of cultural decay. For instance, the share of children born out of wedlock had been rising since 1960. By the late 1970s, this was having real cultural consequences. Welfare rolls were exploding at the same time as dependency was on the rise for a large share of the population. Behavioral responses to government policy were not entirely to blame for these trends of the era, but they certainly played a large role.

The increased recognition of these realities led to significant anger among the middle and working class. These were families that, in an increasingly weak economy with high inflation, were paying ever higher tax rates. Instead of paying for programs that may benefit these workers, tax dollars were flowing, at least in part, to an increasing group of dependents who no longer saw reason to work due to incentives (as well as bureaucrats). These middle and working class families were right to be angry. But, they were wrong to direct their anger at the welfare recipients, who were merely responding rationally to incentives. Instead, the anger should have been directed at a government that overtaxed productive behavior and traditional families while subsidizing non employment and irresponsible behavior.

Charles Murray, in Losing Ground, found that bad incentives made many anti poverty programs self defeating. Martin Feldstein looked at responses to taxes and noted that there are many ways that people might respond to taxes. He created a new measure known as elasticity of taxable income. Instead of trying to find relationships between tax rates and potential areas that behavioral responses might be found, Feldstein looked at total taxable income which would capture all behavioral responses. He found much larger responses than previous research (especially among upper income taxpayers). Arthur Laffer even began arguing that tax rates had become so high that it was possible that some taxes could actually be reduced and still increase revenue (due to behavioral responses).

For a number of reasons, policy began taking incentives into account more. In the 1980s, the top marginal tax rate on business income and certain kinds of capital income fell dramatically from 70% to 28%. There were reductions in taxes on other types on income that were smaller but still quite significant. In the 1990s, in order to tackle the problem of perverse incentives in the welfare system, welfare reform was ultimately passed and signed.

Of course, these policies were part of a larger neoliberal policy revolution that included rollbacks in the regulatory state, a increasingly stable monetary policy, public spending restraint, and free trade. Academic research and practical experience was increasingly suggest the superiority of markets to statism in general. The fact that incentives were found to be much more powerful in many more ways than originally thought was part of this research and experience.

For the most part, these reforms were successful. Welfare rolls were reduced while a booming economy offered increased jobs and opportunities. Resources that had been used on tax avoidance in the past were redirected to more productive uses because lower tax rates made tax avoidance less profitable. Due to behavioral responses, the revenue losses for some of the tax rates cuts were small if there was a reduction in revenue at all.

Later research on ETI would later find that the behavioral responses found in previous literature were almost entirely due to wealthy individuals taking more pains to avoid taxes when tax rates are higher and that income derived from capital and business is much more sensitive to taxation than wage income. The implication here was that the most economically efficient tax reductions were also the least politically popular: reduction in tax rates on wealthy investors and business owners.

Indeed, the political realities surrounding policy have been the biggest constraint on policy that would do a significant amount to correct bad incentives inherent to our tax and transfer system. Welfare reform was only possible when regular, working people saw their own tax bills rise at the same time that dependency on welfare was rising. That stoked the anger necessary to reform the system. Again, some of the anger that should have been aimed entirely at bad government policy was aimed at the recipients of public aid, but there was still a push for reform that ultimately succeeded.

The increasing awareness of behavioral responses in public policy didn't just result in lower taxes and a smaller state. There were also policies that attempted to replace parts of the welfare state with programs that did not create the same bad incentives. The earned income tax credit (EITC) was created in the 1970s and has been expanded numerous times. This is basically an anti poverty program that encourages employment instead of discouraging employment, proving that fighting material poverty and encouraging employment do not necessarily need to be conflicting goals.

The EITC should be seen as a model for the type of program that should be replacing the current programs in the welfare state, as it both fights poverty by both offering material cash benefits to the impoverished and encouraging the kind of behavior required to truly escape poverty.

The early 2000s saw new research that upended previous assumptions about the behavioral responses to public policy. Nobel prize winner Edward Prescott challenged the idea that taxes had little impact on labor supply. Basically, he theorized that previous work looking at the relationship did not take into account all the channels that taxes could effect labor supply.

Prescott compared hours worked in the G-7 countries in the 1970s and 1990s. He found that, in the 1970s, when tax rates were similar in these countries, hours worked were also similar. In the 1990s, when tax rates diverged, countries with lower tax rates also had higher hours worked. This was later backed up by further research (look here).

Public policy in the 2000s showed some awareness of these realities. George W Bush successfully pushed through two major tax reductions. These tax reductions were not ideal if the goal was to encourage productive behavior (or reduce discouragement of productive behavior) because the tax rate cuts were small (although the total cost of the tax cuts were large due to tax cuts that did not cut rates) and not permanent. Still, there were some reductions in marginal tax rates.

Bush also tried to move towards private accounts is social security which would have helped mitigate the work disincentives inherent to entirely government run retirement systems, but that effort proved to be politically futile. Despite some positive efforts, the Bush administration did not do much to incorporate realities about behavioral responses into public policy.

If the Bush administrations efforts were weak, the Obama administration has been flat out counter productive. The ACA does a lot to discourage employment by creating huge implicit marginal tax rates. Indeed, the effects of the means tested subsidies and Medicaid expansion on incentives basically undo much of the good welfare reform did. At the same time, the ACA raises tax rates on investment income and business income at the top which also further discourages productive behavior.

Despite the fact that there has been no evidence that incentive effects are smaller than previous thought, it seems that many of the new policy makers in the post Bush world believe this nonetheless. It took 30 years of gradual policy changes to even make a small dent in the perverse incentives that were created by 50 years of bad policy.

It's only taken the current administration a few years to undo a good deal of the positive reforms. Even worse, there is no empirical basis for the return of high tax rates and bad incentives in anti poverty programs.

There is a way forward, which I'll cover in a follow up post in the near future.
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