Should tax rates decline with age?

• Author: Hemel, Daniel

For nearly a century, economists have recognized that it is "advantageous to ... tax most the source of supply which is least elastic." (1) But although the "inverse elasticity rule" is now a basic tenet of public economics, (2) it rarely yields practicable prescriptions for tax policy. (3) For example, the inverse elasticity rule would suggest that marginal tax rates should decrease as income increases, (4) as taxes are more likely to disincentivize labor for high-income individuals than for low- and moderate-income individuals. (5) However, such a policy may not be politically feasible (6)--or normatively desirable (7)--on account of its regressive implications.

Still, there is one segment of the workforce whose labor supply is highly price-elastic and whose relative tax rates (8) might be lowered without triggering the political concerns and distributive qualms mentioned above: older workers. (9) By one estimate, the price elasticity of labor supply--the percentage increase in hours worked for every one percent increase in after-tax income--is approximately three times as high for sixty-year-olds as it is for forty-year-olds. (10) Other estimates indicate an even more dramatic increase in labor supply elasticity over age. (11) Thus, the deadweight loss per dollar raised from income taxation is much larger for taxes imposed on older Americans than for taxes imposed on prime-age workers. (12) Congress could raise the same amount of revenue while generating less deadweight loss if it increased rates on prime-age workers and lowered rates on older ones. (13)

This Comment evaluates age-adjusted tax rates from the perspectives of economic efficiency, distributive equity, and political feasibility. (14) It presents the first sustained case from a law-and-economics perspective for reducing income tax rates on individuals as they enter old age. It also explains how age-sensitive tax rates can be consistent with distributive equity objectives. Finally, it shows the importance of reconciling optimal taxation theory with political reality and constitutional law. Until now, tax theorists have derived optimal tax rules without reference to political and constitutional constraints. By incorporating political considerations into the optimal tax calculus, economists and tax law scholars can generate policy prescriptions that not only are efficient in theory but also stand a chance at implementation.

1. THE ECONOMIC EFFICIENCY OF AGE-ADJUSTED TAX RATES

   Economists of all political persuasions agree that income taxes disincentivize labor to some degree, (15) although they differ dramatically in their estimates of the magnitude of this effect. (16) There are at least three reasons why we might expect labor supply to be relatively insensitive to taxes. First, workers may not respond to changes in their tax burden because they cannot comprehend the intricacies of the Tax Code. Second, nonpecuniary factors such as social pressure may lead individuals to remain in the workforce even when marginal tax rates are extraordinarily high. (17) Third, wage earners do not necessarily have full control over their labor supply. It may be difficult for them to slide along the "intensive margin" (that is, to adjust the number of hours that they work per day or the number of weeks that they work per year) because employers often demand a minimum number of hours from their employees. By contrast, workers generally have much more freedom to make choices at the "extensive margin," such as to exit the labor force entirely. (18)

   If individual workers cannot make marginal adjustments to their hours, then we would expect the price elasticity of labor supply to be greater for individuals who are considering exit from the workforce than for individuals who might desire an incremental reduction in hours. (19) In other words, we would expect the disincentive effects of taxation to be greater around the retirement decision than at midcareer. Empirical evidence largely supports this intuition. According to one estimate using U.S. data, labor supply elasticity is approximately 0.03 for thirty-year-olds, 0.24 for forty-year-olds, and 0.54 for fifty-year-olds, but it rises rapidly to 1.42 for sixty-year-olds and 2.69 for sixty-five-year-olds. (20) These findings are consistent with elasticity estimates from other advanced economies. (21)

   One possible implication of this data is that high marginal tax rates on older workers generate greater deadweight loss than similarly high rates on prime-age individuals. (22) However, if workers respond to tax incentives through extensive-margin shifts rather than intensive-margin adjustments, then the relevant statistic for older workers is not the marginal tax rate but the average tax rate. In other words, if older workers are choosing between working forty hours per week and not working at all, then their decisions will be influenced by their expected aggregate tax liabilities, not the marginal tax rate on the last hour worked.

   Section 63 of the Internal Revenue Code already accords a small benefit to senior citizens: the standard deduction increases by $1100 for individuals over age sixty-five. (23) However, this provision does nothing to reduce tax liabilities for taxpayers over age sixty-five who itemize their deductions. (24) To implement age-adjusted taxation for all taxpayers, Congress could amend [section] 151 of the Internal Revenue Code such that individuals would be able to claim a larger personal exemption as they age. (25) This would provide a benefit for itemizers and nonitemizers alike, although it would not necessarily reduce marginal rates for older taxpayers. (26) Alternatively, Congress could choose to reduce marginal rates for older workers in all tax brackets (which would, in turn, lower average rates as well). The tax break could kick in gradually after workers pass a particular age. For example, fifty-five-year-olds might be taxed at the same marginal rate as younger workers with the same income; fifty-six-year-olds might be eligible for a one-percentage-point reduction; fifty-seven-year-olds might be eligible for a two-percentage-point reduction; and so on. This might mitigate the tax deferral incentives that would arise if the reduction kicked in all at once. (27)

   Questions about the details of an age-adjusted tax system lie beyond the scope of this Comment. One might argue that age-adjusted tax rates should take effect through deductions available to all older taxpayers (nonitemizers and itemizers alike) without any change to the marginal rate schedule. Alternately, one might argue that age adjustments should be integrated into the marginal rate schedule set forth in 26 U.S.C. [section] 1. Regardless of the implementation details, the core claim of this Comment remains the same: because the price elasticity of labor supply increases over worker age, tax rates should be lower for older workers than for younger ones. Such a system would reduce the deadweight loss generated by the government's revenue-raising activities.

2. DISTRIBUTIVE EQUITY AND AGE-ADJUSTED TAX RATES

   Distributive equity stands side-by-side with efficiency as an objective of the Tax Code. (28) Commentators on tax policy often classify equity concerns into two categories: "horizontal equity" (the premise that "[u]nits with the same level of well-being should be liable for the same tax" (29) and "vertical equity" (the premise that "people with greater income [should] pay greater amounts of that income in tax" (30). At first glance, age-adjusted tax rates might seem to conflict with the principle of horizontal equity, as a forty-year-old and a sixty-five-year-old with the same income would face different tax bills. Yet this fact only raises horizontal equity concerns if an individual's "well-being" is measured according to annual income. If horizontal equity is judged over the course of a lifetime, (31) the forty-year-old may end up paying just as much total tax as his older counterpart.

   Admittedly, age-adjusted tax rates may generate disparities between individuals whose lifetime earnings are front-loaded (for example, those who garner the majority of their income in the first few decades of their working lives) and individuals whose earnings are spread more evenly over the course of a long career. Under an...