1
Chapter 16 – Personal
Taxation and Behavior
Public Economics
2
Introduction
? A key policy question is how do households
respond to the incentives presented in the U.S,
tax code?
? We will examine:
– Labor supply
– Saving
– Housing
– Portfolio Composition
3
Labor Supply:
Theoretical Considerations
? Recall from previous discussions of the
welfare system,that a labor supply
problem has the following elements:
– Time Endowment (T)
– Budget constraint,with a price of leisure of
$w
– Preferences
4
Labor Supply:
Theoretical Considerations
? Figure 16.1 shows a typical labor supply
framework.
? Person chooses FT of work in this
example,and attains utility on
indifference curve ii.
Figure 16.1
6
Labor Supply:
Theoretical Considerations
? How do taxes affect the work decision?
? In Figure 16.2,tax reduces wage rate
– From $w to $(1-t)w,because person only
cares about part of wage he gets to keep
– Tax reduces the opportunity cost of another
hour of leisure
? Budget constraint rotates from TD to TH.
Figure 16.2
8
Labor Supply:
Theoretical Considerations
? Based on the specific indifference curves
in Figure 16.2,we can conclude the
following:
– The person is worse off after the tax,that is,
utility is lower
– In this case,the person reduces hours of
work from FT to IT.
9
Labor Supply:
Theoretical Considerations
? Is it always the case that the person will
reduce hours of work when a tax is
imposed (or increased)?
? No,Figure 16.3 shows a case where
hours of work increases from FT to JT
(and the person is still worse off relative
to no taxes).
Figure 16.3
11
Labor Supply:
Theoretical Considerations
? Increasing (or decreasing) taxes changes the
after-tax wage rate,Changing the wage rate
has two effects:
– Substitution effect – leisure is relatively less costly
after the effective wage is cut,so a person substitutes
toward leisure and away from work (↑ leisure).
– Income effect – The person feels poorer after the
effective wage cut,and if leisure is a normal good,
the person consumes less of it (↓ leisure).
12
Labor Supply:
Theoretical Considerations
? Progressive taxes
– Consider three tax rates
– t1 for income under L
– t2 for income between L and M
– t3 for income greater than M
? The effective wage rate (and the slope of the
budget constraint) changes as hours of work
increases.
13
Labor Supply:
Theoretical Considerations
? Figure 16.4 depicts this situation
? Budget constraint is now TLMN.
? In this figure,person maximizes utility at E4.
? One common theoretical prediction that arises
from kinked budget constraints is that many
people should locate at the kink points.
Figure 16.4
15
Labor Supply:
Empirical Findings
? Theory suggest labor supply should
depend on:
– After-tax wage
– Preferences (factors like age,gender,marital
status,and children)
? Econometricians have estimated
regression equations relating hours of
work to these variables.
16
Labor Supply:
Empirical Findings
? For,prime-age” males (ages 20 to 60),effect of
changes in the net wage on hours of work is
small.
– Elasticity of 0.05,meaning that a 10% increase in the
wage increase hours of work by ?%.
? Elasticities for women vary widely,but married
women seem quite sensitive to changes in the
net wage.
17
Labor Supply:
Some Caveats
? Demand-side considerations
– Large influx of workers could lower
equilibrium wage or change consumption
patterns
? Individual versus group effects
– Effects of tax policy could have ambiguous
effects; some may increase work and other
may decrease work.
18
Labor Supply:
Some Caveats
? Other dimensions of labor supply
– Hours of work the usual metric
– Human capital investment
? Proportional income tax could lead to no
change in investment because both the
benefits (increased wages) and costs
(forgone current earnings) are taxed.
19
Labor Supply:
Some Caveats
? Compensation package
– Fringe benefits not taxed
? Expenditure side
– How tax revenue is spent (e.g.,national
parks versus child care facilities) could affect
work effort
20
Labor Supply:
Labor Supply and Tax Revenues
? How do tax collections vary with the tax
rate?
? Consider the supply curve,SL,in Figure
16.5.
? Shows optimal work effort for each after-
tax wage – in this case,the substitution
effect dominates.
Figure 16.5
22
Labor Supply:
Labor Supply and Tax Revenues
? At wage w,work L0,and no tax revenue is
collected.
? At wage (1-t1)w,work L1,and collect t1L1 in tax
revenue.
? At wage (1-t2)w,work L2,and collect t2L2 in tax
revenue.
? As tax rate gets very high,total tax revenue will
eventually fall (to zero).
23
Labor Supply:
Labor Supply and Tax Revenues
? Figure 16.6 maps out the relationship between
tax rates and tax revenue.
? Obviously,if taxes exceed tA,could increase tax
revenue by cutting tax rates.
? The contentions that tax rates exceeded tA were
popularly known as being on the wrong side of
the Laffer curve and were an important tenet in
supply-side economics.
Figure 16.6
25
Labor Supply:
Labor Supply and Tax Revenues
? Several points deserve mention:
– Shape of Laffer curve depends on elasticity
of hours with respect to after-tax wage
– Although not likely in practice,Figure 16.6
suggests lower tax rates can lead to higher
collections
– Empirical question
– Not only hours of work,but taxable income.
26
Saving
? Life-cycle model says that individual’s
consumption and saving decisions during
a year are the result of a process that
considers their lifetime economic
circumstances.
27
Saving
? Consider a model with the following
features:
– Two periods (t=0 or 1)
? Working life and retirement
– Two income flows (I0 and I1).
? Earnings and pension income
– Preferences over consumption (C0 and C1)
? Consumption in present and future
28
Saving
? Figure 16.7 incorporates this detail into
an intertemporal budget constraint.
? Endowment point is the point where
person’s per-period consumption
matches their per-period income.
? With perfect capital markets,can save or
borrow at interest rate r,Gives budget
constraint MN.
Figure 16.7
30
Saving
? This figure makes clear that person can
borrow against future pension wealth,or
save current earnings for future.
– These are simply movements along the
budget constraint MN.
? If current consumption is less than I0,the
person is saving,otherwise he is
borrowing.
31
Saving
? Figure 16.8 imposes some indifference
curves on the budget constraint.
? Given these preferences,the person
chooses point E1,in which he is saving I0-
C0 for retirement.
? Capital markets allow this person to attain
higher utility than at the endowment point.
Figure 16.8
33
Saving
? How would taxes affect saving?
? We consider two cases:
– Case I,Interest earnings are taxable,and
interest payments are deductible
– Case II,Interest earnings are taxable,and
interest payments are not deductible
34
Saving
? Case I,Interest earnings are taxable,and
interest payments are deductible
? With a proportional tax t,the rate of return falls
from r to (1-t)r.
– With any change in r,can always consume
endowment point (I0,I1).
– Budget constraint rotates around this point,with the
absolute value of the slope decreasing.
35
Saving
? In Figure 16.9,new budget constraint is
PQ.
? As illustrated,cannot choose point E1,but
instead choose point Et.
– In this example,saving decreases.
Figure 16.9
37
Saving
? This is not the only possibility,however.
? In Figure 16.10,new budget constraint is still PQ.
? In this case,saving increases.
? Ambiguity arises because,on the one hand,taxing interest
reduces the opportunity cost of present consumption
(substitution effect),On the other hand,taxing interest
makes it more difficult to achieve any future consumption
goal (income effect).
Figure 16.10
39
Saving
? Case II,Interest earnings are taxable,
and interest payments are not deductible
– Can still consume endowment point (I0,I1).
– Saving is still penalized (as in the previous
two figures),but borrowing is not rewarded.
– Kinked budget constraint PAM.
Figure 16.11
41
Housing Decisions
? Tax code favors housing consumption in
several ways.
? Suppose a homeowner decides to rent out his
house
– Receives net rental payments of R (net of operating
expenses)
– Mortgage interest payments MI (business expense)
– House may increase in value ΔV.
42
Housing Decisions
? Net income as a landlord is therefore:
– Rnet=R-MI+ΔV
? An owner-occupier receives an imputed
rent R (the benefit of living in the house),
still pays maintenance expenses and
mortgage interest,and receives capital
gains.
43
Housing Decisions
? Thus,the owner occupier receives the
same income flow as the landlord,and
under the Haig-Simons principle,should
pay the same tax.
? Under U.S,tax law,the implicit rent R is
untaxed for homeowners,and the capital
gain ΔV is usually untaxed too.
44
Housing Decisions
? Implicit subsidy increases demand for
housing,with elasticities around -1.0.
45
Portfolio Composition
? Taxes not only affect the decision to save,
but asset allocation.
? Do high taxes discourage investors from
taking risks?
– Why take a chance on a risky investment if
your gains are going to be grabbed by the
tax collector?
46
Portfolio Composition
? Tobin (1958) models individuals as
making investments based on two
characteristics:
– Expected return
– Risk
? Investors like higher returns and lower
risk.
47
Portfolio Composition
? Two assets:
– One is perfectly safe,but zero rate of return
– Other is risky,on average has positive return
– Can hold any combination of two assets
? Levy a proportional tax,and assume full
loss offset – individuals can deduct all
losses from taxable income.
48
Portfolio Composition
? Risky investment now has a lower return
(makes asset less attractive),but also
less risk (makes asset more attractive).
? Result is therefore ambiguous.
49
Recap of the Personal Taxation
and Behavior
? Labor Supply
? Saving
? Housing
? Portfolio Composition
Chapter 16 – Personal
Taxation and Behavior
Public Economics
2
Introduction
? A key policy question is how do households
respond to the incentives presented in the U.S,
tax code?
? We will examine:
– Labor supply
– Saving
– Housing
– Portfolio Composition
3
Labor Supply:
Theoretical Considerations
? Recall from previous discussions of the
welfare system,that a labor supply
problem has the following elements:
– Time Endowment (T)
– Budget constraint,with a price of leisure of
$w
– Preferences
4
Labor Supply:
Theoretical Considerations
? Figure 16.1 shows a typical labor supply
framework.
? Person chooses FT of work in this
example,and attains utility on
indifference curve ii.
Figure 16.1
6
Labor Supply:
Theoretical Considerations
? How do taxes affect the work decision?
? In Figure 16.2,tax reduces wage rate
– From $w to $(1-t)w,because person only
cares about part of wage he gets to keep
– Tax reduces the opportunity cost of another
hour of leisure
? Budget constraint rotates from TD to TH.
Figure 16.2
8
Labor Supply:
Theoretical Considerations
? Based on the specific indifference curves
in Figure 16.2,we can conclude the
following:
– The person is worse off after the tax,that is,
utility is lower
– In this case,the person reduces hours of
work from FT to IT.
9
Labor Supply:
Theoretical Considerations
? Is it always the case that the person will
reduce hours of work when a tax is
imposed (or increased)?
? No,Figure 16.3 shows a case where
hours of work increases from FT to JT
(and the person is still worse off relative
to no taxes).
Figure 16.3
11
Labor Supply:
Theoretical Considerations
? Increasing (or decreasing) taxes changes the
after-tax wage rate,Changing the wage rate
has two effects:
– Substitution effect – leisure is relatively less costly
after the effective wage is cut,so a person substitutes
toward leisure and away from work (↑ leisure).
– Income effect – The person feels poorer after the
effective wage cut,and if leisure is a normal good,
the person consumes less of it (↓ leisure).
12
Labor Supply:
Theoretical Considerations
? Progressive taxes
– Consider three tax rates
– t1 for income under L
– t2 for income between L and M
– t3 for income greater than M
? The effective wage rate (and the slope of the
budget constraint) changes as hours of work
increases.
13
Labor Supply:
Theoretical Considerations
? Figure 16.4 depicts this situation
? Budget constraint is now TLMN.
? In this figure,person maximizes utility at E4.
? One common theoretical prediction that arises
from kinked budget constraints is that many
people should locate at the kink points.
Figure 16.4
15
Labor Supply:
Empirical Findings
? Theory suggest labor supply should
depend on:
– After-tax wage
– Preferences (factors like age,gender,marital
status,and children)
? Econometricians have estimated
regression equations relating hours of
work to these variables.
16
Labor Supply:
Empirical Findings
? For,prime-age” males (ages 20 to 60),effect of
changes in the net wage on hours of work is
small.
– Elasticity of 0.05,meaning that a 10% increase in the
wage increase hours of work by ?%.
? Elasticities for women vary widely,but married
women seem quite sensitive to changes in the
net wage.
17
Labor Supply:
Some Caveats
? Demand-side considerations
– Large influx of workers could lower
equilibrium wage or change consumption
patterns
? Individual versus group effects
– Effects of tax policy could have ambiguous
effects; some may increase work and other
may decrease work.
18
Labor Supply:
Some Caveats
? Other dimensions of labor supply
– Hours of work the usual metric
– Human capital investment
? Proportional income tax could lead to no
change in investment because both the
benefits (increased wages) and costs
(forgone current earnings) are taxed.
19
Labor Supply:
Some Caveats
? Compensation package
– Fringe benefits not taxed
? Expenditure side
– How tax revenue is spent (e.g.,national
parks versus child care facilities) could affect
work effort
20
Labor Supply:
Labor Supply and Tax Revenues
? How do tax collections vary with the tax
rate?
? Consider the supply curve,SL,in Figure
16.5.
? Shows optimal work effort for each after-
tax wage – in this case,the substitution
effect dominates.
Figure 16.5
22
Labor Supply:
Labor Supply and Tax Revenues
? At wage w,work L0,and no tax revenue is
collected.
? At wage (1-t1)w,work L1,and collect t1L1 in tax
revenue.
? At wage (1-t2)w,work L2,and collect t2L2 in tax
revenue.
? As tax rate gets very high,total tax revenue will
eventually fall (to zero).
23
Labor Supply:
Labor Supply and Tax Revenues
? Figure 16.6 maps out the relationship between
tax rates and tax revenue.
? Obviously,if taxes exceed tA,could increase tax
revenue by cutting tax rates.
? The contentions that tax rates exceeded tA were
popularly known as being on the wrong side of
the Laffer curve and were an important tenet in
supply-side economics.
Figure 16.6
25
Labor Supply:
Labor Supply and Tax Revenues
? Several points deserve mention:
– Shape of Laffer curve depends on elasticity
of hours with respect to after-tax wage
– Although not likely in practice,Figure 16.6
suggests lower tax rates can lead to higher
collections
– Empirical question
– Not only hours of work,but taxable income.
26
Saving
? Life-cycle model says that individual’s
consumption and saving decisions during
a year are the result of a process that
considers their lifetime economic
circumstances.
27
Saving
? Consider a model with the following
features:
– Two periods (t=0 or 1)
? Working life and retirement
– Two income flows (I0 and I1).
? Earnings and pension income
– Preferences over consumption (C0 and C1)
? Consumption in present and future
28
Saving
? Figure 16.7 incorporates this detail into
an intertemporal budget constraint.
? Endowment point is the point where
person’s per-period consumption
matches their per-period income.
? With perfect capital markets,can save or
borrow at interest rate r,Gives budget
constraint MN.
Figure 16.7
30
Saving
? This figure makes clear that person can
borrow against future pension wealth,or
save current earnings for future.
– These are simply movements along the
budget constraint MN.
? If current consumption is less than I0,the
person is saving,otherwise he is
borrowing.
31
Saving
? Figure 16.8 imposes some indifference
curves on the budget constraint.
? Given these preferences,the person
chooses point E1,in which he is saving I0-
C0 for retirement.
? Capital markets allow this person to attain
higher utility than at the endowment point.
Figure 16.8
33
Saving
? How would taxes affect saving?
? We consider two cases:
– Case I,Interest earnings are taxable,and
interest payments are deductible
– Case II,Interest earnings are taxable,and
interest payments are not deductible
34
Saving
? Case I,Interest earnings are taxable,and
interest payments are deductible
? With a proportional tax t,the rate of return falls
from r to (1-t)r.
– With any change in r,can always consume
endowment point (I0,I1).
– Budget constraint rotates around this point,with the
absolute value of the slope decreasing.
35
Saving
? In Figure 16.9,new budget constraint is
PQ.
? As illustrated,cannot choose point E1,but
instead choose point Et.
– In this example,saving decreases.
Figure 16.9
37
Saving
? This is not the only possibility,however.
? In Figure 16.10,new budget constraint is still PQ.
? In this case,saving increases.
? Ambiguity arises because,on the one hand,taxing interest
reduces the opportunity cost of present consumption
(substitution effect),On the other hand,taxing interest
makes it more difficult to achieve any future consumption
goal (income effect).
Figure 16.10
39
Saving
? Case II,Interest earnings are taxable,
and interest payments are not deductible
– Can still consume endowment point (I0,I1).
– Saving is still penalized (as in the previous
two figures),but borrowing is not rewarded.
– Kinked budget constraint PAM.
Figure 16.11
41
Housing Decisions
? Tax code favors housing consumption in
several ways.
? Suppose a homeowner decides to rent out his
house
– Receives net rental payments of R (net of operating
expenses)
– Mortgage interest payments MI (business expense)
– House may increase in value ΔV.
42
Housing Decisions
? Net income as a landlord is therefore:
– Rnet=R-MI+ΔV
? An owner-occupier receives an imputed
rent R (the benefit of living in the house),
still pays maintenance expenses and
mortgage interest,and receives capital
gains.
43
Housing Decisions
? Thus,the owner occupier receives the
same income flow as the landlord,and
under the Haig-Simons principle,should
pay the same tax.
? Under U.S,tax law,the implicit rent R is
untaxed for homeowners,and the capital
gain ΔV is usually untaxed too.
44
Housing Decisions
? Implicit subsidy increases demand for
housing,with elasticities around -1.0.
45
Portfolio Composition
? Taxes not only affect the decision to save,
but asset allocation.
? Do high taxes discourage investors from
taking risks?
– Why take a chance on a risky investment if
your gains are going to be grabbed by the
tax collector?
46
Portfolio Composition
? Tobin (1958) models individuals as
making investments based on two
characteristics:
– Expected return
– Risk
? Investors like higher returns and lower
risk.
47
Portfolio Composition
? Two assets:
– One is perfectly safe,but zero rate of return
– Other is risky,on average has positive return
– Can hold any combination of two assets
? Levy a proportional tax,and assume full
loss offset – individuals can deduct all
losses from taxable income.
48
Portfolio Composition
? Risky investment now has a lower return
(makes asset less attractive),but also
less risk (makes asset more attractive).
? Result is therefore ambiguous.
49
Recap of the Personal Taxation
and Behavior
? Labor Supply
? Saving
? Housing
? Portfolio Composition
