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Tax Reform and Automatic Stabilization

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Author Info
Thomas J. Kniesner
James P. Ziliak

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Abstract

A fundamental property of a progressive income tax is that it provides implicit insurance against shocks to income by dampening the variability of disposable income and consumption. The Economic Recovery Act of 1981 (ERTA) and the Tax Reform Act of 1986 (TRA86) greatly reduced the number of marginal tax brackets and the maximum marginal rate, which limits the stabilizing effect of the tax system on household consumption when pre-tax income fluctuates. We examine the effect of the federal income tax reforms of the 1980s on the associated degree of automatic stabilization of consumption. The empirical framework derives from the consumption insurance literature where the ideal outcome is spatially equal changes in households' marginal utilities of consumption. Because evidence for U.S. households rejects complete consumption insurance, we begin with a model of partial consumption insurance, which we use to identify how the degree of partial insurance has changed since ERTA and TRA86. Our data come from interview years 1980-1991 in the Panel Study of Income Dynamics. We find that in certain cases the tax reforms of the 1980s actually increased the automatic stabilization inherent in a progressive income tax (especially when the Social Security payroll tax and the Earned INcome Tax Credit are included). Overall, though, ERTA and TRA86 reduced consumption stability by about 50 percent. More recent tax reforms, most notably increased EITC generosity, have restored or enhance consumption insurance.

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Paper provided by Northwestern University/University of Chicago Joint Center for Poverty Research in its series JCPR Working Papers with number 165.

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Date of creation: 24 Mar 2000
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Handle: RePEc:wop:jopovw:165

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  1. Morissette, René & Ostrovsky, Yuri, 2008. "How Do Families and Unattached Individuals Respond to Layoffs? Evidence from Canada," Analytical Studies Branch Research Paper Series 2008304e, Statistics Canada, Analytical Studies Branch. [Downloadable!]
  2. Ivan Vidangos, 2009. "Household welfare, precautionary saving, and social insurance under multiple sources of risk," Finance and Economics Discussion Series 2009-14, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  3. Yang, Juan & Mitchell, Paul D. & Gray, Michael & Steffey, Kevin, 2007. "Unbalanced Nested Component Error Model and the Value of Soil Insecticide and Bt Corn for Controlling Western Corn Rootworm," Staff Paper Series 510, University of Wisconsin, Agricultural and Applied Economics. [Downloadable!]
  4. Morissette, René & Ostrovsky, Yuri, 2005. "The Instability of Family Earnings and Family Income in Canada, 1986 to 1991 and 1996 to 2001," Analytical Studies Branch Research Paper Series 2005265e, Statistics Canada, Analytical Studies Branch. [Downloadable!]
  5. Reagan Baughman & Stacy Dickert-Conlin, 2009. "The earned income tax credit and fertility," Journal of Population Economics, Springer, vol. 22(3), pages 537-563, July. [Downloadable!] (restricted)
  6. Torben Andersen, 2005. "Is there a Role for an Active Fiscal Stabilization Policy?," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  7. Morissette, René & Ostrovsky, Yuri, 2008. "Comment les familles et les personnes seules réagissent-elles aux licenciements? Un éclairage canadien," Direction des études analytiques : documents de recherche 2008304f, Statistics Canada, Direction des études analytiques. [Downloadable!]
  8. Julie L. Hotchkiss & Robert E. Moore, 2007. "Assessing the welfare impact of the 2001 tax reform on dual-earner families," Working Paper 2007-27, Federal Reserve Bank of Atlanta. [Downloadable!]
  9. Alan Auerbach, 2002. "Is There a Role for Discretionary Fiscal Policy?," NBER Working Papers 9306, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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