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Tax Avoidance and the Deadweight Loss of the Income Tax

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  • Martin Feldstein

Abstract

The traditional method of analyzing the distorting effects of the income tax greatly underestimates its total deadweight loss as well as the incremental deadweight loss of an increase in income tax rates. Deadweight losses are substantially greater than these conventional estimates because the traditional framework ignores the effect of higher income tax rates on tax avoidance through changes in the form of compensation (e.g., employer paid health insurance) and through changes in the patterns of consumption (e.g., owner occupied housing). The deadweight loss due to the increased use of exclusions and deductions is easily calculated. Because the relative prices of leisure, excludable income, and deductible consumption are fixed, all of these can be treated as a single Hicksian composite good. The compensated change in taxable income induced by changes in tax rates therefore provides all of the information that is needed to evaluate the deadweight loss of the income tax. These estimates using TAXSIM calibrated to 1994 imply that the deadweight loss per dollar of revenue of using the income tax rather than a lump sum tax is more than twelve times as large as Harberger's classic estimate. A marginal increase in tax revenue achieved by a proportional rise in all personal income tax rates involves a deadweight loss of nearly two dollars per incremental dollar of revenue. Repealing the 1993 increase in tax rates for high income taxpayers would reduce the deadweight loss of the tax system by $24 billion while actually increasing tax revenue.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5055.

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Date of creation: Mar 1995
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Publication status: Published as "The Income Tax and Charitable Contributions: Part I - Aggregate and Distributional Effects," National Tax Journal, Vol. 28, no. 1 (1975): pp. 81-100.
Handle: RePEc:nbr:nberwo:5055

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  1. Daniel Feenberg & Jonathan Skinner, 1989. "Sources of IRA Saving," NBER Working Papers 2845, National Bureau of Economic Research, Inc.
    • Daniel Feenberg & Jonathan Skinner, 1989. "Sources of IRA Saving," NBER Chapters, in: Tax Policy and the Economy, Volume 3, pages 25-46 National Bureau of Economic Research, Inc.
  2. James M. Poterba & Steven F. Venti & David A. Wise, 1992. "401(k) Plans and Tax-Deferred Saving," NBER Working Papers 4181, National Bureau of Economic Research, Inc.
  3. Jerry A. Hausman, 1983. "Taxes and Labor Supply," NBER Working Papers 1102, National Bureau of Economic Research, Inc.
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  5. Gale, W.G. & Scholz, J.K., 1990. "Iras And Household Savings," Working papers 9009, Wisconsin Madison - Social Systems.
  6. Martin Feldstein, 1978. "The Welfare Cost of Capital Income Taxation," NBER Chapters, in: Research in Taxation, pages 29-51 National Bureau of Economic Research, Inc.
  7. Joel Slemrod, 1998. "A General Model of the Behavioral Response to Taxation," NBER Working Papers 6582, National Bureau of Economic Research, Inc.
  8. James M. Poterba & Steven F. Venti & David A. Wise, 1993. "Do 401(k) Contributions Crowd Out Other Persoanl Saving?," NBER Working Papers 4391, National Bureau of Economic Research, Inc.
  9. B. Douglas Bernheim & John Karl Scholz, 1993. "Private Saving and Public Policy," NBER Chapters, in: Tax Policy and the Economy, Volume 7, pages 73-110 National Bureau of Economic Research, Inc.
  10. Stuart, Charles E, 1984. "Welfare Costs per Dollar of Additional Tax Revenue in the United States," American Economic Review, American Economic Association, vol. 74(3), pages 352-62, June.
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  12. Alan J. Auerbach, 1982. "The Theory of Excess Burden and Optimal Taxation," NBER Working Papers 1025, National Bureau of Economic Research, Inc.
  13. Venti, Steven F & Wise, David A, 1990. "Have IRAs Increased U.S. Saving? Evidence from Consumer Expenditure Surveys," The Quarterly Journal of Economics, MIT Press, vol. 105(3), pages 661-98, August.
  14. Sandmo, Agnar, 1985. "The effects of taxation on savings and risk taking," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 1, chapter 5, pages 265-311 Elsevier.
  15. Eric M. Engen & William G. Gale & John Karl Scholz, 1994. "Do Saving Incentives Work?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 25(1), pages 85-180.
  16. Arnold Harberger, 1964. "Taxation, Resource Allocation, and Welfare," NBER Chapters, in: The Role of Direct and Indirect Taxes in the Federal Reserve System, pages 25-80 National Bureau of Economic Research, Inc.
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  1. Does it Matter Where the Laffer Curve Bends?
    by Megan McArdle in Megan McArdle on 2010-08-12 18:47:54
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