Tax Policy and the Economy, Volume 36

This volume presents five new studies on current topics in taxation and government spending.  
Natasha Sarin, Lawrence Summers, Owen Zidar, and Eric Zwick study how investors respond to taxes on capital gains, whether their incentives to invest are affected by those taxes, and whether that responsiveness has changed over time. Ethan Rouen, Suresh Nallareddy, and Juan Carlos Suárez Serrato revisit the question of whether cuts to corporate taxes increase income inequality, bringing new data and new statistical techniques to generate fresh findings. Alan Auerbach and William Gale investigate whether the advantages and disadvantages of different types of taxation are affected when interest rates stay low for long periods, as has been the case in the U.S. for many years. Nora Gordon and Sarah Reber study the distributional impact of emergency subsidies to schools made by the federal government during the recent COVID pandemic and whether those subsidies were sufficient to cover the increased school costs induced by the pandemic. Jacob Goldin, Elaine Maag, and Katherine Michelmore investigate the fiscal cost of an expansion of the U.S. child tax credit, which has been discussed extensively in policy circles recently. They take into account not only the direct expenditure on the allowance but how cost is affected by the existence of work incentives and by possible beneficial effects on childrens’ adult earnings.

• Language: English
• Publisher: University of Chicago Press Journals
• Release date: Jun 27, 2022
• ISBN: 9780226821788

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TPE v36n1 coverTPE_titleTPE_copyrightNBER_boardNBER_relationNBER_relation2

Contents

Copyright

NBER Board of Directors

Relation of the Directors to the Work and Publications of the NBER

Contents

Acknowledgments

Robert A. Moffitt

Introduction

Robert A. Moffitt

Rethinking How We Score Capital Gains Tax Reform

Natasha Sarin, Lawrence Summers, Owen Zidar, and Eric Zwick

Do Corporate Tax Cuts Increase Income Inequality?

Suresh Nallareddy, Ethan Rouen, and Juan Carlos Suárez Serrato

Tax Policy Design with Low Interest Rates

Alan J. Auerbach and William G. Gale

Were Federal COVID Relief Funds for Schools Enough?

Nora Gordon and Sarah Reber

Estimating the Net Fiscal Cost of a Child Tax Credit Expansion

Jacob Goldin, Elaine Maag, and Katherine Michelmore

Tax Policy and the Economy no. 36 (2022): iii–iv.

Copyright

© 2022 National Bureau of Economic Research. All rights reserved.

Tax Policy and the Economy no. 36 (2022): v–v.

NBER Board of Directors

© 2022 National Bureau of Economic Research. All rights reserved.

Tax Policy and the Economy no. 36 (2022): vii–viii.

Relation of the Directors to the Work and Publications of the NBER

© 2022 National Bureau of Economic Research. All rights reserved.

Tax Policy and the Economy no. 36 (2022): ix–ix.

Contents

© 2022 National Bureau of Economic Research. All rights reserved.

Tax Policy and the Economy no. 36 (2022): xi–xi.

Acknowledgments

Robert A. Moffitt

Johns Hopkins University and NBER, United States of America

This issue of the NBER’s Tax Policy and the Economy journal series contains revised versions of papers presented at a virtual conference on September 23, 2021. The papers continue the journal’s tradition of bringing high-quality, policy-relevant research by NBER researchers to an audience of economists in government and in policy positions in Washington and to economists around the country with interests in policy-oriented economic research. The papers in this issue are wide-ranging and diverse, from whether tax policy should be rethought in a time of low interest rates to how to score capital gains reforms to the design of a child allowance in the United States, to whether corporate tax cuts increase inequality and whether federal support to schools in the COVID-19 recession was well targeted.

I would like to thank Rob Shannon of the NBER for his usual expertise and organizational acumen in overseeing the logistical details, invitations, and operational aspects of the conference and to Jim Poterba for his continued assistance with the organization of the meeting. I would also like to thank Helena Fitz-Patrick for assistance in many other aspects of the conference, especially the shepherding of the papers toward final publication. And I would like to acknowledge the continued financial support of the Lynde and Harry Bradley Foundation. Finally, let me express my thanks to the authors themselves for the hard work they devoted to producing high-quality papers living up to the Tax Policy and the Economy standard.

© 2022 National Bureau of Economic Research. All rights reserved.

Tax Policy and the Economy no. 36 (2022): xiii–xvi.

Introduction

Introduction

Robert A. Moffitt

Johns Hopkins University and NBER, United States of America

The five papers in this issue of Tax Policy and the Economy are all directly related to important issues concerning US taxation, transfers, and federal aid.

In the first paper, Natasha Sarin, Lawrence Summers, Owen Zidar, and Eric Zwick revisit how capital gains tax reform should be scored by the Joint Committee on Taxation, meaning how changes in capital gains tax rates affect revenue raised. Many scoring estimates assume highly elastic responses of capital gain revenues to changes in rates and often forecast that increases in those rates may raise little revenue because of large offsetting reductions in capital gains realizations. The authors suggest that these response forecasts may far exceed what actual responses would be for a number of reasons. One is that investors may simply change the timing of their realizations, generating short-run revenue losses that result in large realizations in later years. Another is that today, more than half of capital gains realizations are from pass-through entities and mutual fund distributions that are likely to be relatively inelastic with respect to capital gains rates. Realizations from these and other less elastic forms should also get bigger weight in the score because they are now a larger fraction of realizations. Capital gains rates closer to those for ordinary income may also reduce the distortionary effects of disparate rates arising from the substitution of capital income and other forms of income. Suggestive simulations by the authors that account for these features suggest that the revenue increases from raising capital gains rates by even 5% might be several times larger than official scorekeeper estimates.

In the second paper, Suresh Nallareddy, Ethan Rouen, and Juan Carlos Suárez Serrato study the effects of corporate taxation on income inequality. Their exercise uses cross-state variation in corporate tax rates and how income inequality in a state changes following a reduction in those state-level rates. Examining this relationship using a variety of different econometric techniques, the authors find that tax rate reductions increase income inequality. The authors’ measure of inequality is the share of income going to a top percentile of the income distribution, and they find that the increase in that share following a cut in corporate taxes arises from increases in income at both the bottom of the income distribution and at the top, but with a disproportionately larger increase for the latter than for the former. Examining forms of income, Nallareddy and coauthors find that the larger increase in income among those at the top of the income distribution arises in part because whereas earned income decreases slightly at the top, capital income gains at the top more than offset those decreases. In addition, capital income does not increase at all at the bottom. These results suggest that those with high earnings shift income from wage income to capital income following a tax cut.

Alan J. Auerbach and William G. Gale, in the third paper, note that interest rates on government debt have experienced a long-term decline and ask what implications this might have for tax policy design. The authors argue that at least four important issues in tax policy design are affected when sustained low interest rates are experienced. The first is the relative merit of income and consumption taxation, each of which has elements that affect different forms of income differently. The authors argue that the differences in tax burden and efficiency shrink when interest rates are low. A second is the relative merit of wealth taxation and capital income taxation, which can be analyzed by realizing that a wealth tax rate has an equivalent capital income tax rate, but that is higher as interest rates fall. Auerbach and Gale argue that as interest rates fall, a given wealth tax rate becomes more distortionary relative to a given capital income tax rate. A third issue in taxation that is affected when interest rates are low is the relative merit of different forms of depreciation deductions offered by the tax authority to firms. Interest rates affect the relative impacts of immediate versus spread-out depreciation deductions, for example, and hence, a reduction in interest rates reduces the differences between the two forms. Finally, a fourth aspect of taxation affected by low interest rates concerns carbon abatement policies with, say, the benefits and costs of a carbon tax—an important question for the merits of such a tax. The authors argue that, because the benefits are so backloaded and occur at such different times as the costs, a reduction in interest rates enormously increases the benefits of such taxation relative to its costs.

The next paper, by Nora E. Gordon and Sarah J. Reber, examines the substantial federal relief to school districts during the COVID-19 pandemic. Gordon and Reber ask whether the aid was sufficient to cover the likely costs of COVID-19 mitigation and recovery and how that aid varied across types of districts. The authors note that the aid was distributed to school districts using existing formulas that favored high-poverty districts relative to lower-poverty ones. The authors argue that the pandemic impacted costs in high-poverty districts more on average, compared with their lower-poverty counterparts. Gordon and Reber simulate the net fiscal impact under four scenarios with different assumptions about how the pandemic affected costs and revenues. They estimate that, on average, high-poverty districts received more in aid than they needed to cover additional costs related to COVID-19, and many low-poverty districts experienced small to moderate shortfalls because estimated pandemic-related costs were larger than federal aid. The authors note that many high-poverty districts have long-standing unmet needs, including for capital investments, and suggest that such districts could use the surplus funds to address those needs. They argue that state governments are generally in a good fiscal position and could assist low-poverty districts to cover their pandemic-related costs.

In the final paper, Jacob Goldin, Elaine Maag, and Katherine Michelmore study the fiscal cost of reforms to the federal Child Tax Credit (CTC) that have recently appeared in policy discussions. The authors note a common criticism of the CTC as it existed in most years since it was enacted in 1997 is that limitations on the amount of the credit that could be received by families with low income (the so-called nonrefundability provision) meant low-income families received little or nothing from the credit, and far less than higher-income taxpayers. They consider the costs of three different expansions of the CTC: one that removes those limitations (restoring full refundability), one that also increased the size of the credit, and one that does not phase it out with income but instead makes it universal. The authors calculate the direct fiscal cost of each expansion but also estimate two other costs: the increased cost resulting from labor supply reductions but also the likely decreased cost arising from higher adult earnings of children in families receiving the credit, an effect revealed by recent research. The authors find that the direct costs of the three variations rise with the CTC’s expansion; higher benefits raise costs relative to just restoring full refundability, and a universal credit raises costs even more. They also find that in none of the three expansions are increases in costs from reduced labor supply very large as a percent of the direct cost. But they find that the reduction in costs from higher child earnings in the future often reduce fiscal costs by 15%–20%.

Endnote

For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see https://www.nber.org/books-and-chapters/tax-policy-and-economy-volume-36/introduction-tax-policy-and-economy-volume-36.

© 2022 National Bureau of Economic Research. All rights reserved.

Tax Policy and the Economy no. 36 (2022): 1–33.

Rethinking How We Score Capital Gains Tax Reform

Natasha Sarin

US Treasury Department, United States of America

Lawrence Summers

Harvard University and NBER, United States of America

Owen Zidar

Princeton University and NBER, United States of America

Eric Zwick

University of Chicago Booth and NBER, United States of America

Executive Summary

We argue the revenue potential from increasing tax rates on capital gains may be substantially greater than previously understood. First, many prior studies focus primarily on short-run taxpayer responses, and so miss revenue from gains that are deferred when rates change. Second, the rise of pass-throughs and index funds has shifted the composition of capital gains in recent years, such that the share of gains that are highly elastic to the tax rate has likely declined. If some components are less elastic, then their elasticity should get more weight when scoring big changes because they will comprise more of the remaining tax base. Third, closer parity to income tax rates would provide a backstop to the rest of the tax system. Fourth, additional base-broadening reforms, like eliminating stepped-up basis, making charitable giving a realization event, reforming donor advised funds, and limiting opportunity zones to places with the highest poverty rates, will decrease the elasticity of the tax base to rate changes. Overall, we do not think the prevailing assumption of many in the scorekeeping community—that raising rates to top ordinary income levels would raise little revenue—is warranted. A crude calculation illustrates that raising capital gains rates to ordinary income levels could raise hundreds of billions more revenue over a decade than other leading estimates suggest.

I. Introduction

Capital gains taxes are a perennial issue in tax reform debates. Some maintain that preferential rates on capital gains encourage entrepreneurship and capital formation. Others question whether these benefits are sufficiently large to outweigh the equity and fiscal costs of lower rates. Although the direct equity costs of lower rates are clear—the wealthiest 1% account for two-thirds of capital gains realizations in the 2019 Survey of Consumer Finances—the fiscal costs are more uncertain.

The Joint Committee on Taxation (JCT) estimates these costs. In the parlance of policy makers, the JCT is the official scorekeeper that decides how tax legislation scores if implemented.¹ The prevailing wisdom among some in the scorekeeping community (e.g., Tax Policy Center, Tax Foundation, Penn Wharton Budget Model) has been that the revenue-maximizing capital gains rate is around 30%, such that setting a rate too far above this level could actually reduce the total amount of revenue collected.² This Laffer rate is well below both current top marginal tax rates on other income and top rates recently under debate. The rationale for a low Laffer rate is that the static revenue gains expected from a high rate will fail to materialize because the dynamic response of taxpayers dramatically shrinks the tax base.

A simple example highlights the role of dynamic responses in revenue estimation. The current realization elasticity used by JCT and others in the scorekeeping community is approximately −0.7, based on historical scores (Joint Committee on Taxation 1990), recent scores (Joint Committee on Taxation 2021), and recent academic research (Dowd, McClelland, and Muthitacharoen 2015). If tax rates increased by 100%, a crude application of this elasticity implies that realizations would fall by 70%.³ In concrete terms, roughly $1.25 trillion of annual realizations would shrink to around $375 billion due to an increase in capital gains tax rates from 20% to 40%. This assumed $875 billion response is large enough that raising capital gains rates to ordinary income levels could be scored as losing tax revenue.

Accounting for the difference between static and dynamic scores is clearly important. For example, the official score attached to changes in the top income tax rate is perhaps 12% lower than the static score, because some taxpayers will choose to work less or hire tax planners to help avoid taxes more.⁴ And it is reasonable that the dynamic effects in the case of capital gains are more pronounced than for other policies: retiming a capital gain realization in an investor’s stock portfolio is easier than changing investment strategy for executives seeking to avoid a corporate tax increase or reducing labor supply for workers when income tax rates rise.

We suspect that estimates of such large behavioral responses to capital gains rate changes may miss several important factors. For one, medium-term retiming of realizations would offset lost revenues in the short term. For simplicity, consider a 2-year example. Suppose that doubling capital gains rates from 20% to 40% causes realizations to occur half as often: instead of realizing gains every year, individuals realize gains every 2 years. If assets grow at 10% annually, then in the low-tax regime, $100 of assets yield realizations of $10 in year 1 and $10.80 in year 2 (after paying two dollars of tax in year 1). In the high-tax regime, $100 of assets yield realizations of $0 in year 1 and $21 in year 2. Despite the appearance in year 1 of a large elasticity of realizations in response to the tax increase, total revenues over both years increase from $4.16 in the low-tax regime to $8.40 in the high-tax regime. In this simple example without other behavioral responses, the short-run revenue score is zero and the medium-run revenue score is double the baseline. Clearly, the latter revenue score is more relevant for policy purposes.

Consistent with this example, we present evidence that suggests medium-term retiming of realizations is empirically relevant. First, in the time series around the reduction in capital gains rates in 2003, the share of assets held for more than 10 years drops and the ratio of sales price to basis falls. Second, we present new cross-sectional evidence from the population of information returns from Smith, Zidar, and Zwick (2021), which shows that high-tax states tend to have longer holding durations and higher price-to-basis ratios in 2016.

It is not clear to what extent these dynamic factors are incorporated in current scorekeeping methods, or if instead the current approach predicts that annual realizations would permanently fall. It is also unclear how much additional base-broadening reforms—stepped-up basis at death, making charitable giving a realization event, reforming donor advised funds, and limiting opportunity zones to places with the highest poverty rates—would affect estimates of lost tax collection due to indefinite deferrals.

Beyond the issue of deferred gains, we highlight three additional considerations that suggest conventional elasticities may be overstated. First, the composition of capital gains has shifted over time, such that the share of capital gains that are highly elastic to the tax rate has likely fallen. In recent years, more than half of capital gains accrue through pass-through and mutual fund distributions outside of the direct control of taxpayers. For example, around 70% of gains in partnerships come from funds with nonindividual owners who face different incentives to realize gains. If half of capital gains are not sensitive to the tax environment, then for Math image to be the right average elasticity across all gains, the elasticity for the other half of gains would be Math image . Even if timeable realizations were so sensitive as to fall to zero in response to a tax increase, a large stock of nontimeable gains would remain to be taxed at the higher rates. Second, the appropriate elasticity for scoring big tax increases should put more weight on the elasticity of the less timeable portion because it will account for more of the remaining tax base. Third, revenue estimates may understate the substitution between capital gains and other forms of income. Closer parity to income tax rates would provide a backstop to the rest of the tax system, which can affect the level of tax avoidance and evasion, as well as the prevalence of recharacterized wages and carried interest compensation.

We conclude with crude estimates of the wide range in revenue potential from raising capital gains rates under different assumptions. According to Joint Committee on Taxation (2021), raising long-term capital gains tax rates by 5 percentage points yields expected revenue of $123 billion over 10 years. This estimate is only 16% of the mechanical tax revenue ($759 billion) based on the Congressional Budget Office’s (CBO’s) forecast. Applying elasticity estimates from Agersnap and Zidar (2020) to the baseline CBO forecast yields $410 billion, or 3.3 times as much. The gap between the JCT score and other estimates is even larger when considering alternative forecasts. Specifically, CBO’s baseline forecast has capital gains as a share of gross domestic product (GDP) falling slightly over the next decade. If the capital gains share of GDP is stable or increasing (due to rising wealth-to-GDP and wealth concentration), then the revenue potential of capital gains taxes would be even larger. If we apply elasticity estimates from Agersnap and Zidar (2020) and hold the realizations-to-GDP ratio fixed at recent levels, then the revenue estimate is $485 billion. Finally, pairing rate increases with the elimination of loopholes that erode the capital gains tax base—like stepped-up basis and the tax preference for charitable gifts of appreciated assets—would produce larger revenue estimates.

Our point is not to offer an official score, but instead to illustrate the magnitude of potential revenue and how sensitive capital gains revenue estimates are to various assumptions. With our simple calculations, which abstract away many important details, we offer not an official score, but an illustration of how sensitive capital gains revenue estimates are and how reasonable alternatives to the standard set of assumptions suggest large revenue potential.

II. Short-Run Deferral Increases Medium-Run RealizationsA. Longer Estimation Window Produces Smaller Elasticity Estimates

Gains deferred when taxes rise need not be deferred indefinitely.