Tax Reform 1986 and marginal welfare changes for labor.

• Author: Wallace, Sandy
• Position: Tax Reform Act of 1986

1. Introduction

   During the 1980s in the United States, before-tax income shifted away from the poor and toward the upper income groups. Changing the distribution of tax burdens or after-tax income is one way to redress a growing imbalance in before-tax income. Pechman [14], Feldstein [6], and Wallace et al. [17] have all shown that the Tax Reform Act of 1986 (TRA86) increased the progressivity of the combined personal and corporate income taxes, an achievement not accomplished in the last two decades of income tax reform [14].

   Tax reform can also increase or decrease the welfare of individuals in an economy through its effect on the allocation of labor supply resources. TRA86 reduced the highest marginal income tax rates from 50 percent to 28 percent for high income persons and removed some lower-income persons from the tax roles. Such large marginal tax rate changes introduce significant potential for increased economic efficiency in labor supply and for welfare gains for the rich and poor alike. These changes should be part of the benefit analysis of tax reform. Indeed, Hausman and Poterba [10] report welfare cost changes that result from TRA86 for the average male and female. Their estimates, however, do not account for welfare cost changes throughout the income distribution. In addition to our use of microdata to estimate the marginal welfare cost of tax reform, we use more precise measures of marginal tax rates than other researchers.

   In this paper, we use Browning's partial equilibrium framework to examine the influence of the reduction in marginal tax rates from TRA86 on the distribution of welfare gains from labor supply reallocation for males by population decile and for females by population decile and by marital status. The empirical results illustrate how the tax reform affected low-income female household heads, where poverty is so heavily concentrated, as well as other household heads and spouses. The results indicate that TRA86 reduced welfare costs in the economy, but these welfare gains were distributed in a pro-rich manner or they grew as income increased for males and for females regardless of marital status. In fact, TRA86 resulted in less allocative efficiency and in welfare losses for individuals in the lowest population decile. Thus, in spite of TRA86's progressive changes in tax burdens, the labor supply welfare gains afforded by TRA86 were oriented toward the highest income individuals and away from the lowest income individuals.

   In the next section of the paper, we review several methods of estimating welfare changes from tax reform. We examine Browning's method and explain why we use it for our analysis. We then turn to the empirical values for key parameters of the model and discuss the micro data simulation file that we use to estimate the welfare gains. The results are reported in a fourth section of the paper and are followed by the conclusions that we draw from our work.

2. Marginal Welfare Cost

   Hausman and Poterba [10] report changes in welfare costs associated with labor supply decisions of men and wives due to the tax reforms of 1981 and 1986. Using Hausman's [9] indirect utility function and the IRS Public Use Tax Return data file, they compute welfare gains per dollar of revenue change associated with the labor supply of the average male wage earner at 0.03 and of the average wife at 0.055.(1)

   More general studies by Stuart [16] and Ballard, Shoven and Whalley [2] use general equilibrium analysis to estimate the marginal welfare cost changes associated with labor supply when tax rates change. They examine the marginal effects for hypothetical tax reforms and use aggregate data. We do not use their general equilibrium analyses, because it would require considerable aggregation, thus forcing us to forgo the benefits of our rich micro data set.

   Our analysis is performed in a partial equilibrium framework, as developed by Harberger [8] and modified by Browning [4]. Using welfare formulas, elasticity of labor supply elasticities, and changes in the tax system, welfare cost effects are then calculated for each individual by substituting the relevant compensated labor supply elasticities and tax parameters into the appropriate formula. Fullerton [7, 305] reconciles the general equilibrium approaches cited above with Browning's approach, concluding that, although not without limitations, Browning's approach is useful for comparing tax changes (our problem), because his method measures distortions appropriately.

   We employ Browning's [4, 12] modification of Harberger's [8] measure of the partial equilibrium welfare cost.(2) Our primary interest is in the marginal change in welfare cost or in the change in welfare cost divided by the change in tax paid for different groups of individual taxpayers.(3) The computation assumes that the additional expenditures financed by the tax changes have only an income effect.(4) Under these assumptions Browning [4] shows that the change in welfare costs (dW) when tax revenues from labor income increase by dR is given by:

   dW/dR = [(m + 0.5dm)/(1 - m)]nw[L.sub.2]dm/[w[L.sub.2]dt + wdL(m + dm)] (1) where

   m = marginal tax rate before tax reform,

   m' = marginal tax rate after tax reform,

   dm = (m' - m),

   n = compensated labor supply elasticity,

   w = net wage before tax reform,

   [L.sub.2]= labor supply before tax reform,

   dt = change in the average tax rate due to the reform,

   dL = total (income and substitution effects) change in labor supply due to tax reform.

   The numerator of equation (1) measures the change in the welfare costs associated with labor as a result of TRA86. The denominator of equation (1) measures the change in the tax revenue derived from labor income as a result of TRA86. The change in the tax revenue in the denominator means that the change in labor (dL) in the denominator represents both the income and the substitution effects for labor supply. On the other hand, the compensated elasticity of labor supply is included in the numerator to measure the change in the welfare cost.

   Because we do not have data on dL...