Public economics.

• Author: Poterba, James M.
• Position: Report on the Program in Public Economics

The NBER Program in Taxation was renamed the Program in Public Economics in 1991. This change recognizes that governments face significant challenges in designing expenditure policies as well as tax policies, and broadens the program to encompass research on these decisions as well as on issues of raising revenue. Since the last program report just over two years ago, members of the public economics program have conducted research on a wide range of subjects including the impact of tax policies on individuals and firms, the effects of taxation in an increasingly international economy, and the design of policies to reduce pollution. This report provides a brief overview of these recent activities.

Taxation and the Behavior of Households and Firms

One of the perennial research issues in public finance is the nature and effects of the incentives created by tax policies. In the aftermath of a decade of major tax reforms, NBER researchers have begun the substantial task of estimating how tax policy affects household and corporate decisionmaking.

Recent research has considered how tax and spending policies affect household behavior. For example, NBER studies: demonstrate that declining individual marginal tax rates have shifted the mix of worker compensation away from fringe benefits and toward taxable wages; suggest that the high implicit marginal tax rates in some welfare programs reduce the labor supply of potential program beneficiaries; and, conclude that the Social Security payroll tax and benefit formulas are responsible for significant individual differences in the total marginal tax rate on labor income.(1)

Further, several recent studies have contributed to the ongoing debate about the incentive and revenue effects of capital gains taxation. NBER researchers have gathered new evidence on the elasticity of gains realizations with respect to tax rates, and on the long-run effects of changing those rates; they also have studied how to design a realization-based tax on capital gains without distorting incentives to realize gains.(2)

The substantial, and in many cases offsetting, changes in the taxation of corporate capital income in the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986 provide a rare opportunity for directly assessing how tax policy affects investment and financing decisions. A number of NBER affiliates currently are investigating these issues. Two recent papers suggest that tax-related changes in incentives for investing in different types of assets are reflected in the observed levels of investment during the 1980s.(3)

Another line of research has explored the effect of tax policy changes on the decision to hold assets in corporate or noncorporate form.(4) This study suggests that the sharp changes in the relative tax rates on individuals and firms in the 1986 Tax Reform Act reduced the incentives to incorporate, and this explains the rapid growth of Subchapter S corporations since 1986. Finally, NBER researchers have continued to contribute to the basic theory of corporate investment and financial policy,(5) providing the foundation for further empirical research on taxation and firm behavior.

Tax Policy in an International Economy

The growing integration of world capital markets, and the declining importance of national borders in Europe and elsewhere, has created a fundamentally new economic environment for tax policy. It is increasingly apparent that companies can transfer operations and especially taxable profits across state and national boundaries, in many cases distorting EC decisions and thwarting the intentions of tax authorities. This trend poses a new set of research issues for economists who study taxation, and even has led some to question the long-term viability of some existing tax instruments.(6) It is the basis of an ongoing NBER Project on International Taxation.

Researchers studying international taxation must master a substantial volume of complicated tax law, use this information to model the tax incentives facing companies, and then analyze whether firm behavior seems to respond to these incentives. Recent studies have applied this methodology to analyzing the influence of tax policy on several aspects of firm behavior. One study shows that corporate R and D spending is sensitive to the tax incentives generated by the post-1986 rules on allocating R and D expenses to worldwide income, and suggests that each...