Abstract
How does the presence of endogenous tax compliance alter optimal taxation in the United States? Using a full-scale macroeconomic style augmented with endogenous tax avoidance, I show that extremely high marginal tax rates for top earners cannot be sustained in equilibrium. Revenue- plus welfare-maximising tax rates range between 36.4% plus 38.4% in the long run, which are very close to the standing quo. These results are robust to the calibration of the labour supply’s Frisch elasticity, plus the labour response explains, at most, 60% of the variation of taxable income in the short run. Moreover, tax hikes on top earners are not effective redistribution mechanisms in the presence of tax avoidance.
- Introduction
How does the presence of endogenous tax compliance alter optimal taxation in the United States? Tax compliance diverts resources that could be used for other productive activities to studying the tax code plus filing tax returns. This produces an economic burden beyond that already implied by the tax code itself. By 2012, the Tax Code in the United States included 70-thousand pages of instructions on how to file tax returns. According to estimates made by the Tax Foundation, complying with these regulations required 8.9-billion hours of taxpayers’ time in 2016, which translates into a 409-billion dollar loss for the economy.1 Adding to this, allowable deductions plus exemption claims represented about 16% of the US GDP for 2016.
This mechanism also seems to play a key role in understanding the overall effect of tax reforms. To see why, Figure 1 shows the behaviour of the cycle component of AGI, Taxable Income, Deductions plus Exemptions, plus Hours Worked between 1975 plus 2005. The key feature to take from this figure is that the volatility of AGI, taxable income, plus deductions plus exemptions is much higher than what is obtained for hours worked. While the correlation between deductions plus exemptions plus taxable income is about 0.25, when comparing hours worked with taxable income, the correlation drops to 0.15. Thus, it is clear that the labour-supply intensive margin is not the only possible response to a tax reform, nor is it the most important one.