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Effects of taxes on economic behavior.

Article Excerpt
INTRODUCTION

I am pleased to be part of this National Tax Journal forum celebrating the 100th anniversary of the National Tax Association and grateful for the invitation to discuss the effects of taxes on economic behavior, a subject that has been central in my research since my paper some forty years ago on the effects of tax rules on corporate dividends (Feldstein, 1967). Over the years, my tax research has focused primarily on the ways that taxes affect household behavior and on the welfare implications of those changes, and that will be the focus of this paper.

The effect of taxes on economic behavior is important for three distinct reasons. First, the behavioral response of taxpayers affects the revenue consequences of changes in tax rates and tax rules. Second, the effects on economic efficiency or deadweight loss depend on taxpayers' compensated behavioral responses, i.e., on the behavioral effects excluding pure income effects. And, third, behavior is important for understanding the short-run macroeconomic consequences of tax changes on aggregate demand and employment.

I have long been an advocate of reforming the revenue estimation process to reflect explicitly the impact of taxes on behavior and the implications of that behavior for tax revenue (e.g., Feldstein, 1997). I am pleased, therefore, that in recent years the revenue estimators of the Treasury and the Congress have been taking behavior into account more fully in their revenue estimates, going beyond the traditional so-called "static estimates" that assume that taxes have no effect on taxpayer behavior. But the very limited nature of the behavior that is taken into account means that official analyses of tax rate increases still overstate the resulting revenue gain while official analyses of tax rate reductions overstate the resulting revenue losses. Therefore these revenue estimates bias the political decision process to favor tax rate increases over tax cuts. Although much can be done to improve these calculations, I am encouraged by the willingness of the revenue estimators to improve their earlier methods and by their participation in the annual meeting of the National Bureau of Economic Research (NBER) group that focuses on these revenue estimation issues. I will return later in this paper to the issue of improving revenue estimates.

Unfortunately, there is no reason to be pleased about the analysis in policy discussions of the efficiency effects of tax changes. Explicit estimates of the welfare consequences of proposed tax changes are completely absent in the Congressional and White House discussions of tax policy. Although policymakers understand that higher taxes hurt the economy by distorting behavior--reducing work effort, saving, and risk-taking--there is no attempt to quantify these adverse effects or translate them into reductions in economic efficiency. My own experience is that the concept of the deadweight loss of a tax increase, i.e., the amount that individuals would have to be paid to make them as well off as they would be without the proposed tax change, is much easier to teach in a classroom than to convey in a Congressional hearing. And yet any sensible policy analysis of alternative tax structures should involve comparing the revenue, deadweight loss, and distributional consequences of the alternative tax options. Later in this paper I will illustrate this with an example from the current debate about raising payroll tax revenue to fund future Social Security benefits. I will also comment on two common conceptual errors that economists make in assessing the deadweight losses of tax changes.

The short-run macroeconomic consequences of tax changes depend on how the Federal Reserve (Fed) changes monetary policy in response to the tax change. If a tax change produces a fiscal stimulus that exceeds what the Fed believes to be prudent, it will neutralize it by raising interest rates. Alternatively, a fiscal stimulus may simply substitute for an easier monetary policy that the Fed would otherwise implement. As a general rule, it would seem best to assume that a change in fiscal stimulus would be offset by the induced change in monetary policy. One exception would occur when interest rates are so low that the Fed cannot lower rates any further. In such a liquidity trap, a fiscal stimulus would raise aggregate demand. A second exception would occur when financial market conditions or the availability of bank capital make it difficult for the Fed to stimulate economic activity. In this case, the Fed would welcome a fiscal stimulus and would not seek to offset it. Because of these exceptions to the general rule, the possible fiscal stimulus effect of a tax change must be considered on a case-by-case basis to assess the likely reaction of the Federal Reserve to...

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