«OPTIMAL TAXATION OF TOP LABOR INCOMES: A TALE OF THREE ELASTICITIES Thomas Piketty Emmanuel Saez Stefanie Stantcheva Working Paper 17616 ...»
NBER WORKING PAPER SERIES
OPTIMAL TAXATION OF TOP LABOR INCOMES:
A TALE OF THREE ELASTICITIES
Working Paper 17616
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue Cambridge, MA 02138 November 2011 We thank co-editor Karl Scholz, Marco Bassetto, Wojciech Kopczuk, Laszlo Sandor, Florian Scheuer, Joel Slemrod, two anonymous referees, and numerous seminar participants for useful discussions and comments. Rolf Aaberge, Markus Jantti, Brian Nolan, Esben Schultz, and Floris Zoutman helped us gather international top marginal tax rate data. We are very thankful to Miguel Ferreira for sharing the international CEO data from Fernandes, Ferreira, Matos, and Murphy (2013) with us. We acknowledge ˝nancial support from the Center for Equitable Growth at UC Berkeley and the MacArthur foundation.
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© 2011 by Thomas Piketty, Emmanuel Saez, and Stefanie Stantcheva. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.
Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities Thomas Piketty, Emmanuel Saez, and Stefanie Stantcheva NBER Working Paper No. 17616 November 2011, Revised March 2013 JEL No. H21
ABSTRACTThis paper presents a model of optimal labor income taxation where top incomes respond to marginal tax rates through three channels: (1) standard labor supply, (2) tax avoidance, (3) compensation bargaining.
We derive the optimal top tax rate formula as a function of the three corresponding behavioral elasticities.
The first elasticity (labor supply) is the sole real factor limiting optimal top tax rates. The optimal tax system should be designed to minimize the second elasticity (avoidance) through tax enforcement and tax neutrality across income forms. The optimal top tax rate increases with the third elasticity (bargaining) as bargaining efforts are zero-sum in aggregate. We provide evidence using cross-country times series macro-evidence and CEO pay micro-evidence. The macro-evidence from 18 OECD countries shows that there is a strong negative correlation between top tax rates and top 1% income shares since 1960, implying that the overall elasticity is large. However, top income share increases have not translated into higher economic growth. US CEO pay evidence shows that pay for luck is quantitatively more important when top tax rates are low. International CEO pay evidence shows that CEO pay is strongly negatively correlated with top tax rates even controlling for ˝rm characteristics and performance, and this correlation is stronger in firms with poor governance. These results are consistent with bargaining effects playing a role in the link between top incomes and top tax rates. If bargaining effects in fact exist, optimal tax rates should be higher than commonly assumed.
Thomas Piketty Stefanie Stantcheva Paris School of Economics MIT Department of Economics 48 Boulevard Jourdan 50 Memorial Drive 75014 Paris, France Building E52 firstname.lastname@example.org Cambridge, MA 02142-1347 email@example.com Emmanuel Saez Department of Economics University of California, Berkeley 530 Evans Hall #3880 Berkeley, CA 94720 and NBER firstname.lastname@example.org The share of total pre-tax income accruing to upper income groups has increased sharply in the United States. The top percentile income share has more than doubled from less than 10% in the 1970s to over 20% in recent years (Piketty and Saez, 2003). This trend toward income concentration has taken place in a number of other countries, especially English speaking countries, but is much more modest in continental Europe or Japan (Atkinson, Piketty, Saez, 2011 and Alvaredo et al. 2011). At the same time, top tax rates on upper income earners have declined sharply in many OECD countries, again particularly in English speaking countries.
While there have been many discussions both in the academic literature and the public debate about the causes of the surge in top incomes, there is not a fully compelling explanation.
Most explanations can be classiﬁed into market driven changes vs. institution driven changes.
The market driven stories posit that technological progress and globalization have been skilledbiased and have favored top earners relative to average earners (see e.g., Gabaix and Landier (2008) for CEOs and Rosen (1981) for Winner-Take-All theories for superstars). Those pure market explanations cannot account for the fact that top income shares have only increased modestly in a number of advanced countries (including Japan, Germany, or France) which are also subject to the same technological forces. The institution driven stories posit that changes in institutions, deﬁned to include labor and ﬁnancial market regulations, Union policies, tax policy, and more broadly social norms regarding pay disparity, have played a key role in the evolution of inequality. The main diﬃculty is that “institutions” are multi-dimensional and it is diﬃcult to estimate compellingly the contribution of each speciﬁc factor.
Related, there is a wide empirical literature in public economics analyzing the eﬀects of tax rates on pre-tax incomes (see Saez, Slemrod, and Giertz, 2012 for a recent survey) that reaches two broad conclusions. First, there is compelling evidence that upper incomes respond to tax rates whenever the tax code oﬀers opportunities for tax avoidance. Such responses can sometime be quite large, especially in the short-run. Second however, when the tax base is broad and does not oﬀer avoidance opportunities, the estimated elasticities are never large at least in the short or medium-run. To our knowledge, no study to date has been able to show convincing evidence in the short or medium-run of large real economic activity responses of upper earners to tax rates. However, it is diﬃcult to provide compelling estimates of long-run elasticities. As we shall see, international evidence shows a strong correlation between top tax rate cuts and increases in top income shares in OECD countries since 1960.
1 There are three narratives of the link between top tax rates and upper incomes. First, after noting that top US incomes surged following the large top marginal tax rate cuts of the 1980s, Lindsey (1987) and Feldstein (1995) proposed a standard supply-side story whereby lower tax rates stimulate economic activity among top income earners (work, entrepreneurship, savings, etc.). Second, it has been pointed out–originally by Slemrod (1996)–that many of those dramatic responses were actually primarily due to tax avoidance rather than real economic behavior. Although this argument started as a critique of the supply-side success story, it has more recently been used to deny that any real increase in income concentration actually took place. Under this scenario, the real US top income shares were as high in the 1970s as they are today but a smaller fraction of top incomes was reported on tax returns in the 1970s than today.
A third narrative contends that high top tax rates were part of the institutional set-up putting a brake on rent extraction among top earners. When top marginal tax rates are very high, the net reward to a highly paid executive for bargaining for more compensation is modest. When top tax rates fell, high earners started bargaining more aggressively to increase their compensation.
The ﬁrst goal of this paper is to present a very simple model of optimal top labor income taxation that can capture all three avenues of response, the standard supply side response, the tax avoidance response, and the compensation bargaining response to assess how each narrative translates into tax policy implications. We therefore derive the optimal top tax rate formula as a function of the three elasticities corresponding to those three channels of responses. The ﬁrst elasticity e1 (supply side) is the sole real factor limiting optimal top tax rates. A large tax avoidance elasticity e2 is a symptom of a poorly design tax system. A very high top tax rate within such a system oﬀering many tax avoidance opportunities is counter-productive. Hence, the optimal tax system should be designed to minimize tax avoidance opportunities through a combination of tax enforcement, base broadening, and tax neutrality across income forms.
In that case, the second elasticity (avoidance) becomes irrelevant. The optimal top tax rate increases with the third elasticity e3 (bargaining) as bargaining eﬀorts are wasteful and zerosum in aggregate. If a substantial fraction of the behavioral response of top earners comes from bargaining eﬀects and top earners are not paid less than their economic product, then the optimal top tax rate is much higher than the conventional formula and actually goes to 100% if the real supply-side elasticity is very small.1 If bargaining eﬀects are moderately large, 1 The optimal top tax rate is moderate if the supply elasticity is fairly large and top earners are underpaid relative to their product, a situation that is theoretically possible in our model and might exist in countries with 2 the quasi-conﬁscatory top marginal tax rates–80%-90% or more–applied in the United States and the United Kingdom between the 1940s and the 1970s, might have been consistent with a sensibly-speciﬁed optimal tax model.
The second goal of the paper is to provide empirical evidence on the decomposition of the total behavioral response of top incomes to top tax rates into those three channels. We consider both macro-level cross-country/times series evidence and CEO pay micro-level evidence.
The macro-evidence uses time series on top income shares from the World Top Incomes Database, top income tax rates, and real GDP per capita data. We obtain three main results.
First, we ﬁnd a very clear correlation between the drop in top marginal tax rates and the surge in top income shares since 1960. This suggests that the long-run total elasticity of top incomes with respect to the net-of-tax rate is large, around 0.5. Second, examination of the US case suggests that the tax avoidance response cannot account for a signiﬁcant fraction of the long-run surge in top incomes because top income shares based on a broader deﬁnition of income (that includes realized capital gains and hence a signiﬁcant part of avoidance channels) has increased virtually as much as top income shares based on a narrower deﬁnition of income subject to the progressive tax schedule. Third, we ﬁnd no evidence of a correlation between growth in real GDP per capita and the drop in the top marginal tax rate in the period 1960 to the present.
This evidence is consistent with the bargaining model whereby gains at the top come at the expense of lower income earners. This suggests that the ﬁrst elasticity is modest in size and that the overall eﬀect comes mostly from the third elasticity.
The micro-evidence uses data on CEO pay in the United States since 1970 and international CEO pay data for 2006. We obtain two main results. First, the US evidence shows that pay for ﬁrm’s performance outside of the control of the CEO (due to industry–wide performance as in Bertrand and Mullainathan, 2001) is quantitatively more important when top tax rates are low. This suggests that low top tax rates have induced CEOs to increase the component of their pay not directly related to their own performance. The main channel may have been the development of stock-options in the 1980s and 1990s which do not ﬁlter out performance unrelated to CEOs’ actions (Hall and Murphy, 2003). Second, international CEO pay evidence for 2006 shows that CEO pay is strongly negatively correlated with top tax rates even controlling for ﬁrm’s characteristics and performance, and that this correlation is stronger in ﬁrms with very low income concentration.
3 poor governance. This suggests that the link between top tax rates and CEO pay does not run through ﬁrm performance but is likely due to bargaining eﬀects as the bargaining position of the CEO is stronger when top rates are low and in ﬁrms with poorer governance.
All those results suggests that bargaining eﬀects play a role in the link between top incomes and top tax rates implying that optimal top tax rates could be higher than commonly assumed.
Bringing together the model and the empirical evidence, in our preferred estimates, we ﬁnd an overall elasticity e = 0.5, which can be decomposed into e1 = 0.2 (at most), e2 = 0 and e3 = 0.3 (at least). This corresponds to a socially optimal top tax rate τ ∗ = 83% - as compared to τ ∗ = 57% in the standard supply-side case with e = e1 = 0.5 and e2 = e3 = 0. This illustrates the critical importance of this decomposition into three elasticities.
Our paper is related to a large body of theoretical work in optimal income taxation and empirical work on estimating behavioral responses to taxation. Previous work has focused mostly on the traditional supply-side channel and the tax avoidance/evasion channels.2 There is much less work in optimal taxation using models where pay diﬀers from marginal product. A few studies have analyzed optimal taxation in models with labor market imperfections such as search models, Union models, eﬃciency wages models (Sorensen, 1999 provides a survey). The main focus of those papers has been on eﬃciency issues rather than redistributive issues, with most of the focus on the employment vs. unemployment margin. Fewer papers have addressed redistributive optimal tax policy in models with imperfect labor markets.3 Motivated by recent events, a few papers have proposed models of optimal taxation with rent-seeking.