The Relationship between Tax Rates and Tax Revenue.
Since the mid-1970s, there has been discussion regarding the relationship between high marginal tax rates and tax revenues. According to the Laffer Curve, there is a tax rate at which tax revenues are maximized. This curve implies that at low marginal tax rates, tax revenues are an increasing function of tax rates, while at high marginal rates, tax revenues are a decreasing function of tax rates. It is assumed that, at high marginal rates, this inverse relationship occurs because high tax rates may stifle economic activity and reduce the supply of labor. This theory has been the underpinning for many tax reduction proposals and policies.
Regarding research on the relationship between tax rates and tax revenue, most studies have examined the impact of tax rates on tax revenue by looking at labor supply elasticity (Feldstein, Journal of Political Economy, 1995; Macurdy et al., Journal of Human Resources, 1990; Lindsey, Journal of Public Economics, 1987). If labor supply is elastic in response to a change in tax rates, then income may decline when tax rates increase. Macurdy et al. (1990) found that tax rates had minimal effect on labor supply, while both Lindsey (1987) and Feldstein (1995) found that labor supply was very elastic. Other studies examined the elasticity of taxable income with respect to marginal tax rates (Saez, Journal of Economic Literature, 2012; Giertz, Southern Economic Journal, 2010; Chetty, American Economic Journal: Economic Policy, 2009; Kopczuk, Journal of Public Economics, 2005). Most found that taxable income was inelastic with respect to changes in tax rates.
In the present study, the relationship between individual income tax revenue and various income tax policies are examined. Although there has been much discussion on the impact of high marginal tax rates on tax revenues, there has been little analysis of the role that the lowest tax rates have on tax revenues. In addition, there has been limited examination of the role that tax brackets have on tax revenues.
In order to determine the relationship between tax rates and tax revenue for the individual income tax, the following equation was estimated: Tax/GDP = [[beta].sub.0] + [[beta].sub.1] highest tax rate+ [[beta].sub.2] lowest tax rate+ [[beta].sub.3] lowest bracket + [[beta].sub.4] highest bracket + [[beta].sub.5] unemployment rate + [[beta].sub.6] trend. Tax/GDP denotes individual income tax revenues as a percentage of gross domestic product (GDP). Highest tax rate is the highest marginal tax rate. Lowest tax rate is the lowest marginal tax rate. Highest bracket is the lower income bound of the highest tax bracket. Lowest bracket is the higher income bound of the lowest tax bracket. The unemployment rate is a proxy for overall economic trends.
A first-order autoregressive procedure was used in order to correct for serial correlation. Annual data for the period 1946-2016 was used. Tax data were obtained from the Internal Revenue Service. Unemployment data was obtained from the Bureau of Labor Statistics. All dollar values were deflated using Consumer Price Index Urban (CPI-U), base year 1982-1984.
Results indicate that the lowest tax rate is positively related to tax revenues while the highest tax bracket (lower income limit) is negatively related to tax revenues. These results suggest that for every one percentage point increase in the lowest tax rate, tax revenue as a percentage of GDP increases by 0.276 percentage points. For every $100,000 reduction in the lower income bound of the highest tax bracket, tax revenue as a percentage of GDP increases by 0.12 percentage points. The highest marginal tax rate had no statistically significant effects on income tax revenues. The unemployment rate was negatively related to Tax/GDP (for every one percentage point increase in the unemployment rate, Tax/GDP fell by 0.132 percentage points. The trend variable suggests that tax revenue increased over time. The [R.sup.2] for the regression was 0.515.
These results are reasonable in the following regard. All taxpayers pay the lowest rate. Hence, any increase in that rate results in an increase in tax revenues. However, very few taxpayers Eire subject to the highest marginal tax rate. Hence, a change in that rate should not significantly affect tax revenues, especially if taxpayers' labor supply elasticity is less than one. An increase in the highest marginal tax rate may also cause high-income taxpayers to reduce their taxable income by an amount that would offset their increased tax liability. A more efficient way to increase tax revenues would be to increase the number of taxpayers who are subject to the highest marginal tax rate.
One reason typically given for reducing marginal tax rates is because these rates may hurt small business owners. Due to high marginal tax rates, business owners may be dissuaded from hiring more employees or making capital improvements. However, business income represents only 3% of total income reported on all tax returns. Hence, the impact of lowering marginal tax rates on business activity should be minimal at best. A more concerning impact of tax policy on economic growth may be the frequent changes in tax rates that create uncertainty among business owners, thus discouraging investment and expansion.
In conclusion, increasing the lowest marginal tax rate and reducing the lower income bound of the highest tax bracket increases individual income tax revenues as a percentage of GDP. Increasing the highest marginal tax rate has no statistically significant effects on tax revenues. The present study, however, does not analyze other changes in tax policy, such as lowering tax rates for certain types of income or the adoption of new tax credits. Given that changes in tax rates are typically accompanied by other changes in the tax code, the analysis used in the present study may not adequately capture all possible determinants of tax revenues.
Published online: 29 December 2017
Mark Gius  (ID)
 Department of Economics, Quinnipiac University, Hamden, CT 06518, USA
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|Publication:||Atlantic Economic Journal|
|Date:||Mar 1, 2018|
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