Marginal Tax Rates and Income: New Time Series Evidence

Using new narrative measures of exogenous variation in marginal tax rates associated with postwar tax reforms in the US, this study estimates short run elasticities of taxable income of around 1.2 based on time series from 1946 to 2012. Elasticities are larger in the top 1% of the income distribution but are also positive and statistically significant for other income groups. Previous time series studies of tax returns data have found little evidence for income responses to taxes outside the top of the income distribution. The different results in this study arise because of additional efforts to account for dynamics, expectations and especially the endogeneity of tax policy decisions. Marginal rate cuts lead to increases in real GDP and declines in unemployment. This study also presents evidence that the responses are to marginal rather than average tax rates. Counterfactual tax cuts targeting the top 1% alone have positive effects on economic activity and incomes outside of the top 1% but increase inequality in pre-tax incomes. The data and methodology in this study do not permit any conclusions about the impact of tax rate changes targeting lower income taxpayers alone.