Tax Reform and Automatic Stabilization

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.