The impact of marginal tax rates on taxable income: evidence from state income tax differentials.

• Author: Long, James E.

1. Introduction

   The relationship of taxable income to the marginal tax rate has important implications for both the revenue consequences of tax policy and the deadweight loss of the income tax.(1) Not surprisingly, then, Feldstein's (1995b) analysis of the 1986 tax reform, in which he concluded that taxable income is highly responsive to changes in the marginal tax rate, has been closely examined and subjected to certain criticisms, which are summarized in Slemrod (1995b), Auten and Carroll (1995), and Goolsbee (1998). Two common criticisms of Feldstein's net-of-tax rate (i.e., one minus the tax rate) elasticity, which averaged either 1.26 or 2.10 depending on how taxable income was measured, were (i) that his panel data contained too few high-income taxpayers (e.g., there were only 57 individuals in the 49 or 50% tax bracket in 1985) and (ii) that his analysis was incomplete because it excluded nontax determinants of taxable income.

   Auten and Carroll (1995) addressed these and other criticisms in their reexamination of Feldstein's findings. Their estimate of a "taxes only" and a multivariable model of taxable income using a substantially larger data set (containing 4387 taxpayers in the top two brackets) yielded taxable income elasticities smaller than (in some instances less than half as large as) those reported by Feldstein. The methodological approach of the Feldstein and comparable longitudinal studies, in which changes over time in taxable income of different groups are compared to the changes in the tax rates of the groups, has also been criticized. Goolsbee (1998) argues that it rests on a questionable assumption, namely, that lower-income individuals are a valid control group for higher-income individuals. If high-income individuals have incomes that trend upward at a relatively faster rate or are more likely to be in forms whose timing can be shifted in the short run, then Goolsbee believes that the Feldstein net-of-tax rate elasticities may be substantially overstated, perhaps by 75% or more.

   In light of criticisms of existing studies, additional research on the impact of tax rate changes on taxable income is warranted, and a study that uses an alternative approach to measure the tax or net-of-tax rate elasticity may yield independent evidence on this important issue. In this article, the relationship between taxable income and the marginal tax rate is investigated using a cross section of federal individual tax returns filed for tax year 1991. The tax rate effect is identified on the basis of differences in state income tax rates among individuals having the same income and demographic characteristics. Because of reductions in the number of federal income tax brackets during the 1980s, basically all married taxpayers with incomes above about $80,000 faced the same statutory federal marginal tax rate in 1991, which is problematic for measuring tax rate or "price" effects. In contrast, state marginal tax rates in this income range varied considerably (from 0 to 12%), and the state income tax's share of the total income tax rate was substantially higher than in earlier periods. Previous research has exploited the variation in state tax rates to examine the impact of taxation on capital gains (Burman and Randolph 1994; Bogart and Gentry 1995), charitable contributions (Feenberg 1987; Ribar and Wilhelm 1995), individual retirement account (IRA) contributions (Long 1990), and income tax avoidance (Long and Gwartney 1987). However, state tax rate differentials have generally not been used to identify the response of taxable income as a whole to marginal tax rate changes.

2. Methodology, Data, and Preliminary Evidence

   As noted above, the basic approach followed in this study was a comparison of the taxable incomes of individual taxpayers who reside in different states and confront unequal state income tax rates. If taxable income is inversely related to the marginal tax rate, as results of recent studies suggest, then taxable income, on average, should be lower in high-tax states than in low-tax states. Data for this comparison were reported on individual tax returns contained in the Internal Revenue Service 1991 Individual Public Use Tax File, a stratified random sample of the Form 1040, Form 1040A, and Form 1040EZ federal tax returns filed for tax year 1991. To identify a taxpayer's state of residence and to measure the state marginal income tax rate, the analysis is restricted to tax returns with an adjusted gross income of less than $200,000.(2) Also excluded are tax returns filed by individuals (i) residing outside the 50 states and District of Columbia and (ii) without positive income.(3) These restrictions resulted in a sample of 66,723 tax returns, 10,839 of which reported incomes in 1991 of $100,000 or more. To make comparisons to the Feldstein and Auten and Carroll studies, analyses were also conducted on a smaller subsample of 30,796 returns filed by married taxpayers under the age of 65 who were not subject to the alternative minimum tax. There were 5292 tax returns in the subsample reporting incomes in the $100,000 to $200,000 range in 1991.

   As a preliminary to the more rigorous econometric analyses described below, the following simple test was conducted. Individual tax returns were sorted into eight income groupings and then placed into one of two categories: (i) returns filed by residents of states with maximum state income tax rates of 8% or more and (2) returns of taxpayers from states with maximum rates of less than 3%.(4) A t-test was then performed to determine whether mean taxable income for each income cell differed between high- and low-tax states as defined above. Because state income tax payments are deductible on the federal return, a finding that taxable income is relatively lower in high-tax states might merely reflect differences in state tax liabilities rather than behavioral responses by individuals to higher tax rates.(5) Consequently, the t-tests (and all analyses reported below) were conducted on modified taxable income, defined as follows. If total itemized deductions exclusive of state(6) income taxes paid exceed the standard deduction amount, modified taxable income equals adjusted gross income minus nonincome tax deductions minus personal exemptions. Otherwise, modified taxable income equals adjusted gross income minus the standard deduction minus personal exemptions. In effect, this adjustment results in deductible state income tax payments being added back to federal taxable income.

   Mean taxable incomes according to income grouping in the high- and low-tax state samples are reported in Table 1.(7) In all but the lowest income category, average taxable income is relatively lower in states with higher tax rates on individual income. The t-statistics in the taxable income column indicate that the reductions in taxable income associated with high marginal tax rates are statistically different from zero at the 0.01 level in all but one instance. A preview of what phenomena might explain why taxable income is negatively related to the marginal tax rate is provided in the last two columns, which describe how taxpayers in high- and low-tax states differ in terms of (i) deductible expenses, consisting of itemized deductions other than state income taxes paid plus adjustments to income such as IRA contributions; and (ii) the amount of negative incomes (losses) that might reflect tax shelter investments. These activities constitute the avenues for tax avoidance that can be investigated with the type of data used in this study. The pattern of these high-tax/low-tax [TABULAR DATA FOR TABLE 1 OMITTED] differentials strongly suggests that taxable income declines as the marginal tax rate rises because individuals increase tax-deductible expenditures.

   Although the results in Table 1 are suggestive, the analysis described here does not constitute a definitive test of the direction or source of the relationship between taxable income and the marginal tax rate. For example, there may be differences between taxpayers living in high-tax and low-tax states, perhaps in age, marital status, or sources of income, that underlie the observed differentials by state in deductible expenditures and taxable income. Furthermore, the state income tax rate may be correlated with other variables that affect taxpayer behavior; hence, the reduction in taxable income should be partially attributed to these variables rather than to high tax rates alone. In the next section, these issues are addressed by a multivariate analysis of taxable income.

3. Econometric Analysis

   The econometric model specifies the taxable income reported on individual tax returns to be a function of the state marginal income tax rate and various nontax control variables suggested by previous studies in this area. Following the customary practice in empirical studies of taxpayer behavior, the marginal tax rate is measured on a "first-dollar" basis (Feldstein 1975). This is the rate of taxation on the marginal dollar of positive income and thus measures the tax savings resulting from the first dollar of income tax avoidance. Operationally, each individual taxpayer is assigned the effective state marginal tax rate applicable to preavoidance income, which is defined as total positive income minus the applicable personal exemptions under the state income tax.(8)

   Using the formula for the total marginal tax rate found in Feenberg (1987), Ribar and Wilhelm (1995), and elsewhere, the effective state marginal tax rate (SMTR) is computed using the following equation:

   SMTR = [(f + [sd.sub.s] - [fst.sub.s] - [fsd.sub.s])/(1 - [t.sub.s]fs)] - f (1)

   where f and s are the statutory marginal federal and state rates, respectively; [t.sub.s] is 1 if federal taxes can be deducted on the state return and 0 otherwise; and [d.sub.s] is 1 if itemized deductions are allowed on the state return and 0 otherwise.(9) Feenberg (1987) has...