Journal of Economic Perspectives—Volume 6, Number 1—Winter 1992—Pages 3-25

Effects of Tax Reform on Labor

Supply, Investment, and Saving

Barry Bosworth and Gary Burtless

T he U.S. tax system received two major overhauls during the 1980s: the
tax cuts of 1981, and the Tax Reform Act of 1986. Supporters of both
reforms argued that major changes in tax policy could boost saving,
investment, labor supply, and entrepreneurship. Eventually, it was argued,
such changes could reverse the slowdown in economic growth that began in the
early 1970s and spur improvemehts in American living standards. Despite the
unprecedented magnitude of thel tax changes, economists remain nearly as
divided in their assessment of the effectiveness of supply-side tax measures as
they were when tax reform was first proposed.
The aim of this paper is to assess whether the goals of increased labor
supply and capital formation were achieved. The paper begins by describing the
tax reforms of the 1980s, a more difficult task than it may first appear, since
simultaneous changes in different provisions of the tax code often had opposite
effects. For example, lower incom taxes in the early 1980s were offset for most
taxpayers by higher payroll taxes.
In the subsequent discussion of the effect of the tax changes, it should
become clear why economists disagree. First, they often differ on how to
measure supply-side performance, with each side in the debate emphasizing
different statistical indexes. Second, tax reform in the 1980s was not a con-
trolled economic experiment. Ch4nges in after-tax wages and rates of return
occurred for many reasons, which may have camouflaged or offset the direct
effects of the tax changes. Third, 7IJ.S. tax law is notoriously erratic. Taxpayers

■ Barry Bosworth and Gary BurtlesS are Senior Fellows, The Brookings Institution,
Washington, D.C. Research assistance was provided by Suzanne Smith.
4 Journal of Economic Perspectives

may have anticipated some of the changes or believed that others would not be
permanent, making it difficult to draw connections between the tax changes and
subsequent economic behavior. Finally, factors besides net wages and returns
have an important influence on behavior.
In spite of the interpretative difficulties, several lessons can be drawn from
the experience of the 1980s. Supply-side tax incentives probably had a modest
effect in increasing labor supply. However, the effect of tax policy on invest-
ment was swamped by changes in other factors affecting the cost and availability of
capital. And supply-side tax policy conspicuously failed to encourage private
saving.

Description of the Tax Reforms

The Economic Recovery Tax Act of 1981 (ERTA) reduced marginal per-
sonal income tax rates by an average of 23 percent within each tax bracket, with
the rate reductions becoming fully effective by 1984. The top bracket rate was
scaled back from 70 to 50 percent, effective in 1982. To eliminate bracket creep,
the act indexed personal exemptions, the standard deduction, and all income
thresholds for tax brackets beginning in 1985. To reduce the work disincentive
of a high marginal tax rate on the earnings of a secondary family earner,
Congress established a special tax deduction equal to 10 percent of the earnings of
the spouse with the lower wages, up to $30,000, for two-earner couples.
The tax burden on income from new capital investment was lightened by a
drastic shortening of the time period over which investors were allowed to
depreciate capital.1 The exclusion of 40 percent of realized capital gains from
taxable income was maintained. Finally, to encourage household saving, the
1981 act permitted all wage earners to make a tax deductible contribution of up to
$2,000 annually to an Individual Retirement Account (IRA). Under previous law,
only wage earners who were not covered by an employer pension plan were
permitted to contribute to IRAs.
The Tax Reform Act of 1986 is widely acknowledged to be the most far-
reaching structural overhaul of the income tax since World War II.' The Act
emphasized a broadening of the tax base and elimination of special tax
preferences in return for a sharp reduction in marginal tax rates. The previous
14 tax brackets, with tax rates ranging from 11 to 50 percent, were reduced to
four, with tax rates of 15, 28, 33, and 28 percent. Both personal exemptions and
the standard deduction were increased and indexed for inflation. The

'In 1982, a previously planned further liberalization of the 1981 depreciation provisions was
withdrawn and the benefit of the investment tax credit was limited by requiring a reduction in the
depreciation base equal to one-half of the credit.
2 effects,
For a description of the 1986 Reform as well as excellent analyses of its potential economic see
the Symposium on Tax Reform that appeared in the inaugural issue of this journal in Summer 1987.
 Barry Bosworth and Galy Burtless 5

special 10-percent-of-earnings deduction was repealed for dual earner couples, as

was income averaging for taxpayers with fluctuating incomes.
The 1986 reform also represented a major shift in the philosophy of capital
income taxation. Total taxes paid by the corporate sector were increased,
largely by reducing the variance of tax rates among different classes of business
capital. For example, the investment tax credit was eliminated, depreciation
allowances were scaled back relative to those allowed by the 1981 act, and the
attractiveness of many tax shelters was diminished. At the same time, the
number of brackets in the corporate income tax schedule was reduced from five
to three and the maximum rate cut from 46 to 34 percent.
In changes that might be expcted to affect household saving, preferential
treatment of capital gains was eliminated, and eligibility for a tax deduction on
IRA contributions was restricted to wage earners without an employer-
provided pension or those with incomes below certain thresholds. Interest on
IRA accounts continues to be exeript from taxation, however, until withdrawal at
retirement. The income tax deduction for nonresidential consumer interest
expenses was phased out over a five-year period.
To understand the effect of these reforms on the behavior of households, it is
useful to consider their impact on taxpayers in different parts of the income
distribution. The 1981 reform waS kindest to families with very high incomes. As
noted earlier, the top marginal rate was slashed almost immediately from 70 to 50
percent, and the average income tax rate was reduced as well. The share of
taxpayers affected by this cha ge was small, of course, because very few
taxpayers faced marginal rates m ch above 50 percent. The 1986 reform cut the
top marginal rate again—to st 28 percent—but had an uncertain effect on
average tax rates at the top Of the income distribution because a higher
percentage of income was included in the tax base.
Trends in marginal and average tax rates for three families nearer the
middle of the distribution are displayed in Table 1. What is striking in the table is
the small change in average tax rates after the two tax reforms. The
explanation is the jump in social security taxes, which rose over the decade by
2.7 percent of income for the median-income family. (Entries in the table
include both the employee's and t e employer's share of the payroll tax, as well as
the personal income tax.) On b ance marginal tax rates were reduced, but
primarily for families with above- verage income. For the decade as a whole,
including the period after the 1 86 reform, a family with twice the median
income experienced a 35 percent reduction in its marginal rate, but a much
more modest reduction in its average tax rate. Because the family's last dollar
earned was above the income limit for the payroll tax, its marginal rate was not
affected by the increase in payroll taxes. Its average tax, however, was boosted
by the payroll tax hike, largely offsetting the reduction in personal income tax
rates.
At the other end of the inco e distribution the effects of tax reform were
more mixed. The 1981 Act reduc d income tax rates, but the delay m indexa-
tion initially pushed low-wage rkers into higher tax brackets. Inflation
6 Journal of Economic Perspectives

Table 1
Average and Marginal Federal Tax Rates (Percent) at
Alternative Levels of Family Income, 1980-88a

Combined tax rateb

One-half Twice
Median income Median income Median income Median income
Year (dollars) Avg. Mrg. Avg. Mrg. Avg. Mrg.

1980 24,332 18.3 30.3 23.7 36.3 24.8 43.0

1982 27,619 19.9 29.4 24.5 38.4 25.9 39.0
1984 31,097 19.9 27.4 23.7 35.4 24.8 38.0
1986 34,716 20.9 28.3 24.8 36.3 25.7 38.0
1988 37,482' 19.8 30.0 24.2 30.0 23.9 28.0

Source: U.S. Department of the Treasury.

'Tax rates for a four-person family. It is assumed that each family contains only a single-earner and
that all taxable income consists of wage or self-employment earnings.
bCombined tax rate includes federal income tax and FICA payroll tax.
`Estimate.

reduced the income threshold at which families began to pay positive taxes
(from 3 percent above the poverty level for a family of four in 1980 to 17
percent below by 1984), and the real value of the Earned Income Tax Credit
(EITC) shrank. The 1986 Act was more generous to the poor. It reduced
average tax burdens and removed nearly six million low-wage workers from the
positive income-tax rolls. Liberalization of the EITC offset the effect of higher
social security taxes for the lowest income families. For the decade as a whole,
average tax burdens rose slightly, while the marginal rate was left almost
unchanged. On incentive grounds, there is little reason to expect that com-
bined changes in the income and social security tax systems should have
induced much response among breadwinners in lower income families.
For families in the middle of the income distribution both average and
marginal personal income tax rates were reduced by the 1981 and 1986 tax acts,
with the larger reduction occurring after 1986. The increase in social security
taxes, however, offset the reduction in average income taxes. Nonethe-
less, by the end of the decade the cumulative marginal tax rate faced by these
families had fallen by about 17 percent.
The effect of tax reform on the net marginal tax on capital income from
different types of assets is shown in Table 2. The calculations combine the
effects of changes in both the personal and corporate tax systems and are based on
the assumption of a closed economy.' In the area of capital taxation, it is

3This assumption is becoming increasingly untenable. Below we consider the effect of the tax
etermined in
reforms on saving and investment when the market rate of return is assumed to be d the
international market.
 Effects of Tax Reform on. Labor Supply, Investment, and Saving 7

Table 2
Effective Marginal Tax Rates (Percent) on Capital, 1980-88

Equipment

Information
Transpor-
Processing Industrial tation
Year Total Computers Equipment Equipment Other All

1980 28 5 31 27 17 26
1982 16 20 18 19 13 17
1984 12 15 16 15 9 13
1986 32 39 33 36 32 33
1988 31 39 32 35 31 32

Structures

Oil Indus, Public Com- Total Rental

& Gas Bldgs. Utility ! mercial Farm Other Business Housing

1980 14 57 34 53 47 61 48 46
1982 11 39 28 37 37 42 34 34
1984 26 41 25 38 37 44 35 35
1986 26 37 34 35 32 39 33 33
1988 26 37 34 35 32 39 33 33

Source: The effective tax rates were supplied by Jane Gravelle of the Congressional Research
Service. Marginal tax rates include both p rsonal and business taxes. The discount rate is the Baa bond
rate and inflation expectations are from a survey by Drexel-Burnham.

evident that the 1986 Act reversed rather than extended the 1981 changes. The
effective tax rate was dramatically reduced between 1980 and 1986, but when
the 1986 reforms took their full effect the marginal tax on equipment was
raised above its 1980 level, prim rily because of the repeal of the investment
tax credit. Nonetheless, the 1986 pct did achieve one of its major objectives of
narrowing the distribution of tax crliates among the various categories of tangible
capital. In that regard it produce a more neutral tax system.

Labor Supply Response to ax Changes

The conventional theory of 1 li.bor supply as it applies to tax reform is a

straightforward application of uti ity maximization. Workers regard after-tax
income as a good and hours spent in paid employment as a bad. Their utility is
increased by working fewer hou s, holding spendable income constant, or
receiving additional after-tax inco e, holding hours of work constant. Workers
face a given market-determined age, which determines the price at which they
can trade off leisure for addit onal spendable income.
8 Journal of Economic Perspectives

An income tax introduces a distortion into workers' choice of optimal labor

supply. It drives a wedge between the output workers produce and the income
they receive from an additional hour of work. Economists generally agree that a
cut in the marginal tax reduces economic distortion and welfare loss. They do not
agree, however, on the size or even the direction of effect of a tax cut on labor
supply.
In some cases economists can predict the direction, though not the magni-
tude, of the effect. Consider, for example, a worker who receives a cut in
marginal taxes but no change in total tax liability at his initial level of hours.
This could occur under a reform that reduced both marginal rates and the
income threshold at which households begin to pay taxes. In the example, the
worker's net income is initially unaffected by the reform, but the price of that
worker's leisure is raised. The worker's supply will be affected by a pure
substitution effect, with straightforward consequences on hours at work—labor
supply will rise.
The example just mentioned is not typical. Tax reform ordinarily affects
average as well as marginal tax rates, and the income effect of lower average
taxes can offset part or all of the substitution effect of lower marginal rates,
leaving the overall effect uncertain.
If the effect of reform is doubtful in individual cases, its effect in the
aggregate is even less certain. Workers in different parts of the income distribu-
tion received very unequal treatment under the two reforms, as shown in
Table 1. Between 1980 and 1988 the combined marginal tax rate fell 0.3
percentage points for families with one-half of median income, 6.3 points for
families at the median, and 15 points for families with twice the median income.
The corresponding changes in average tax rates were + 1.5, + 0.5, and — 0.9
percentage points, respectively. If labor supply responsiveness bears any rela-
tionship to the size of the marginal tax change, it is logical to expect the largest
effects to be visible in the upper tail of the income distribution. Since changes in
average tax rates were modest, especially in the middle of the income distribu-
tion, changes in marginal rates were probably decisive in influencing the
pattern of response to the reforms.
Given the diversity of workers' initial positions, the response to reform in the
1980s can not be predicted on the basis of the tax situation of the average
family. The soundest approach would be to estimate a well-specified labor
supply function using survey data from individual households and then apply
the resulting parameter estimates to predict the individual and aggregate
responses to specific tax changes. One advantage of this procedure is that it
would permit us to distinguish the effects of income tax reform, which reduced
average and marginal rates, from the effects of payroll tax changes, which
raised rates. If the appropriate longitudinal and cross-section data were avail-
able, the predicted aggregate responses could be compared with actual changes in
labor supply over time to validate the predictions and parameter estimates.
 Barry Bosworth and Gary Burtless 9

Previous Studies of Taxes and L bor Supply

Several economists have esti ated labor supply functions for important
groups in the U.S. population (Hausman, 1981a; MaCurdy, Green, and Paarsch,
1990; Triest, 1990). One of them even used these estimates to make detailed
predictions of the effect of tax reform (Hausman, 1981b; 1983). To our
knowledge, however, no one hat validated predictions of response to tax
changes by comparing them with rctual changes in behavior over time.
The best known estimates of labor supply behavior that account for the
influence of taxes are those of Jerry Hausman (1981a). In Hausman's forecast of
the effects of the 1981 tax act (1981b; 1983), he predicted that a 30 percent rate
reduction would cause priMe-age husbands to increase annual hours worked
by 2.7 percent and prime-age wives to raise annual hours by 9.4 percent. He
also estimated that a 10 percent rate reduction would lead to a 1.1 percent rise in
labor supply amo g husbands and a 4.1 percent rise among wives. The eventual
1981 tax cha ge lies between these two assumptions, once phase-in periods and
other adj stments are taken into account. Hausman concluded that labor
supply resppnses of this size were far too small to yield enough extra
government revent.e to offset the direct effects of the tax rate reductions
(Hausman, 1981b, pp. 194-96). Hausman and Poterba's (1987) predictions of the
work effort effects of the 1986 tax reform imply that labor supply would rise,
though by a much smaller amount than the predicted rise after the 1981 tax
reform.
Lawrence Lindsey (1987; 198 ; 1990) estimated the effect of tax reform on
earned income in a series of rece t papers. Using earnings information on the
returns of a sample of 1979 tax Filers, Lindsey calculated the distribution of
taxable income for 1981 and subsequent years under the assumption that the
earned income of each 1979 filing unit rose in proportion to the economy-wide
growth in average nominal earni gs. To infer the effect of the 1981 reform,
Lindsey compared the imputed istribution to the one actually reported in
subsequent tax years by the Inter al Revenue Service. Filing units near the top of
the distribution reported mothe income than predicted by Lindsey's tax
simulation; families near the bottom reported less.
Lindsey concluded from this attern that high—income families raised their
earnings disproportionately in response to the incentives provided by sharply
lower marginal rates, an obvious si pply-side response. An alternative interpre-
tation is that the earnings of low income families fell during the 1980s as a result
of the adverse trend in wlges.4 If true, this interpretation would not reflect well
on supply-side incentives.

4This explanation seems plausible, since much of the increased inequality during the 1980s
occurred as a result of a sharp rise in the iZquality of hourly wage rates rather than hours of work
(Burtless, 1990, pp. 109-14). Hourly wag s of low-income workers fell, depressing their share of
taxable income and raising the share received by high-wage workers.
10 Journal of Economic Perspectives

Lindsey attempted to calculate the percentage of extra earnings growth that

could be attributed to labor supply response. He concluded that 40 to 90 percent
of the rise in earnings was due to higher labor supply. The remainder was due to
the increased willingness of workers to accept compensation in the form of taxed
money wages rather than untaxed fringe benefits (Lindsey, 1988, pp. 143-47). He
estimated the value of the extra hours worked to be 2.5
percent of labor supply in the period between 1981-85, an estimate that may
not be far from Hausman's prediction.
Burtless (1991) adopted a simpler procedure to infer the effects of the tax
reforms. Using a variety of labor supply measures drawn from the Current
Population Survey—labor force participation, weekly hours worked, and so on —
he calculated supply trends for a half-dozen demographic groups. In time series
regressions spanning the period 1967 to 1987, Burtless then attempted to
determine whether labor supply trends after the Reagan reforms diverged from
trends before 1981. When average annual and weekly hours of work per person
were used to measure labor supply, a response was detected. Among men
between the ages of 25 and 54, Burtless estimated that by 1987 average annual
hours in the population rose between 2.3 percent and 4.1 percent from what it
would have been given the trend prior to the 1980s.5Arnong prime-age women,
average annual hours rose about 3.5 percent. The proportionate rise in work
effort among men and women over 54 was somewhat larger than the rise among
people under age 55.
Burtless found no evidence that the extra growth in labor supply was
matched by a rise in earnings per person, however. Among male wage and
salary workers, especially those in the middle and bottom of the earnings
distribution, the rate of annual earnings growth actually declined in the 1980s
compared with earlier periods because a fall in real hourly wages more than
offset the rise in annual hours.

Some New Evidence on Labor Supply Effects

If the change in supply trends were actually attributable to tax reform, the
largest work responses should have occurred among workers at the top of the
income distribution; as discussed earlier, these individuals experienced the
biggest changes in marginal tax rates. To see whether the supply responses of
different income groups were proportionate to the rate changes they faced, we
used data from the March Current Population Survey to rank adults

5Average weekly hours are calculated as the population mean hours at work during the March
reference week; annual hours are calculated as the product of weekly hours and annual weeks at
work. Both averages include people whose reported hours are zero. The range of estimated
responses reported in the text reflects the range of coefficient estimates obtained under alternative
specifications of the effect of business cycle movements.
 Effects of Tax Reform on Labor Supply, Investment, and Saving 11

between the ages of 25 and 64 according to their taxable income.6 These adults
comprise a little less than 80 percent of all persons with wage or self-
employment earnings, and they earn 90 percent of all wages and self-employ-
ment income.
Public use versions of the Maich CPS are available for 23 years from 1968
through 1990. From these data, we can calculate annual hours of work and
earnings for the period 1967 through 1989. The general pattern is that hours
worked declined for men and rose for women during these two decades.
Among men, the decline was far steeper during the first half of the period than
during the second, with average hours tumbling 6.8 percent from 1967 to 1978
but only 1.5 percent between 1978 and 1989, ending up at 1856 hours per year.
Similarly, the rise in hours among women was stronger in the second half of the
period. Average hours worked climbed 18.6 percent between 1967 and
1978 but 25.6 percent between 1978 and 1989, reaching 1190 hours per year.
Such figures suggest a positive labor supply response to tax changes in the
1980s, but they ignore the distribution of hours changes across the income
distribution and the influence of business cycle movements. A straightforward
adjustment for business cycle effects is to include the unemployment rate or
some other cyclically sensitive variable in a time-series regression on annual
hours. We adjusted the series by including the Congressional Budget Office's
estimate of the percentage gap between actual and potential gross domestic
product.? Under conditions of full employment, the regression results imply that
male hours dropped 10 hours-or one-half percentage point-per year
between 1967 and 1980. After 1981, annual hours began to stabilize or rise
slowly. By 1989, average male work effort was 105 hours per year-or 6.0
percent-above the level it would have attained if the trend before 1981 had
continued through the 1980s. For women, the growth in female labor supply

6We first sorted adults represented in the March CPS into income quintiles. The income of each tax
filing unit was measured as the sum of all forms of taxable income minus personal exemptions.
Each person represented on the file was assigned the income of his or her tax filing unit. The filing unit
includes the spouse and any children under the age of 18 who reside with the person.
7
Our basic specification includes two-time trend variables, one, T, that rises over the entire period
covered by the regression (1967 through 1989) and a second, T81, that begins in 1981 and rises
through 1989. The GAP variable represents the adjustment for full employment. Coefficients on
the latter variable should capture the difference between labor supply trends bCfore and after
implementation of the first tax reform in 1081. Here are the results for all 25-64 year-old men (the first
equation) and women (the second equation).

H = 1970.1 - 12.7 GAP - 10.1 T + 11.6 T81; R2 = 0.969; p = 0.27.

(10.6) (1.5) (1.4) (2.8)

H = 765.7 - 4.4 GAP + 16.4 T + 6.8 T81; R2 = 0.994; p = 0.82

(17.2) (1.1) (1.9) (3.9)

Both regressions include a first-order autocorrelation correction. Estimates of p as well as corrected R2

are shown on the right; standard errors of the coefficients are reported in parenthesis.
 12 Journal of Economic Perspectives

Table 3
Change in Annual Hours of Work by Income Quintile, 1989 (Percent')

Demographic Bottom Second Middle Fourth Top All

group quintile quintile quintile quintile quintile quintiles

Men
Aged 25-64 31.0* 3.6 4.1* 2.5* 3.2* 6.0*
Aged 25-44 10.5* 1.5 2.5 2.7 1.8 3.3*
Aged 45-64 96.4* 6.3 4.0* 3.5 4.3* 9.2*
Married,
aged 25-64 19.4* 2.2 2.3 3.9* 3.6* 5.1*

Women
Aged 25-64 16.7* -6.9* 6.4 10.5* 11.8* 5.4
Aged 25-44 -14.0* -11.1* 4.5 4.8 2.2 - 1.6
Aged 45-64 141.4* 0.1 6.3 19.3* 27.4* 18.1*
Married,
aged 25-64 20.9* 1.2 4.9 3.9 13.8* 7.1*

Source: Authors' tabulations using 1968-1990 March Current Population Surveys.

*Significantly different from zero at 5 percent level.
a Percentage change in annual hours calculated as nine times coefficient on T81 divided by
predicted hours in 1989 minus nine times coefficient on T81 (see text).

accelerated after 1981, leading to extra growth in work effort of 61 hours per
year by 1989, representing a gain of 5.4 percent in average hours above the
previous trend.
We then estimated the same regression for each of five income quintiles, as
well as for persons of different age, sex, and marital status. The pattern of labor
supply response across income groups is shown in Table 3.8 Note that male
labor supply increased within every group and income class, exactly as early
supply-siders hoped. Older men appear to have raised their labor supply by the
largest amount.
However, contrary to the hypothesis that the biggest responses occurred in
the highest income classes, the results indicate that men in the bottom quintile
increased their labor supply by the greatest absolute and percentage amount. Yet
low-income men typically faced unchanged or rising average and marginal tax
rates over the 1980s, at least until 1987 when income tax rates on some of the
lowest income workers were cut. The labor supply response of married men
tended to increase from the second to the fifth income quintile. But even in this
group, the largest response is found among men in the bottom quintile.
The pattern of response among women is broadly similar, with the largest
supply changes occurring in the lowest income category. The responses among

8
The quintile rankings are separately calculated for every group of men and women defined in the
table. Thus, the income thresholds for the second quintile will differ for the several groups. A 35-
year-old man might have an income rank that places him in the third quintile of all men aged 25-64,
but only in the second quintile of married men between 25 and 64.
 Barry Bosworth and Gary Burtless 13

high-income women are quite large, however, especially in the case of older and
married women. The pattern of response among married women comes closest to
vindicating the predictions of supply-side advocates, with the size of the change
in trend growing strongly at higher income levels. It is likely that part of the
estimated change among high-income women is attributable to marginal tax
rate reductions. The sizable increase in labor supply among low-income,
older women is a lit more difficult to explain under a naive supply-side
model. Average and Marginal tax rates did not fall in this group; they rose.
Assuming the rise in supply during the 1980s is partly due to tax reform, it is
worth considering how much extra earnings and tax revenues may have been
generated. The calculation would be straightforward if wages had remained
constant or maintained their previous trend rate of growth. For many classes of
workers, however, wages actually 'ell.
Figure 1 shows the pattern clf real hourly earnings growth over the two
decades from 1969 to 1989, separately for men and women. The lightly shaded
bars measure annual real wage growth between 1969 to 1979; the solid bars
measure growth between 1979 and 1989.9 Clearly, hourly wage growth has
been substantially slower in the 1980s than it was during the 1970s for most
U.S. workers; among men, only those in the top income quintile have seen a
slight increase in wage growth in the 1980s. For men in the middle three
quintiles, annual wage growth fell more than one percentage point. Overall,
male wage growth was 0.9 percent a year slower in the 1980s than it was during
the 1970s.
Women in the top two quintiles achieved larger wage gains in the 1980s,
nearly counterbalancing the slowdown in wage growth among women in lower
income families. The gains in money wages at the top of the income distribu-
tion may represent a response to tax reform, since men and women in high tax
brackets now have a smaller incentive to receive their compensation as untaxed
fringe benefits. Nonetheless, the drop in wage growth for most U.S. workers has
largely offset the effects on earnings and tax revenues that could be
expected from a rise in labor supply. In the aggregate, as the wage distribution
has tilted in favor of well-paid earners in affluent families, earnings are some-
what higher. This has also raised the yield of the income tax system in
comparison to the revenue that would have been obtained if labor supply
trends and the distribution of wages had remained unchanged in the 1980s.
Lindsey's conclusions about the effectiveness of supply-side policy are largely
based on this distributional trend.,

9These years were selected because they represent comparable points in the business cycle. If
instead we displayed rates of change in read wages adjusted for business cycle effects for the periods
1967-1980 and 1980-1989, the pattern of wage changes would be virtually identical. Real hourly
wages are calculated by dividing total annual earnings reported in a quintile by total hours of work.
Nominal earnings reported on the CPS tre deflated using the CPI-UXI inflation series, which treats
housing costs appropriately.
14 Journal of Economic Perspectives

Figure 1
Annual Growth in Real Hourly Earnings, By Income Quintile,
1969-79 and 1979-89

Men, Ages 25-64

1969-79

_2
Bottom Second Middle Fourth IN 1979-89
Top
Income Quintile

Women, Ages 25-64

4d 1
U

1
1969-79
—2 1111 1979-89
Bottom Second Middle Fourth
Top
Income Quintile

On balance, these results weakly support the prediction by Hausman and the
simulation estimates of Lindsey that tax reform in the 1980s caused an increase
in labor supply. As predicted, the labor supply gains were larger among
wives than husbands in high-income families. The results also suggest, however,
that the net benefits for less affluent families have been negligible or perverse.
By contrast, the gains enjoyed by high-income families have been substantial.

Capital Formation

Both the nation's rate of saving and net domestic investment declined
precipitously throughout the 1980s from levels that were, by international
 Effects of Tax Reform on Labor Supply, Investment, and Saving 15

standards, already quite low. National saving fell from 7.7 percent of net
national product (NNP) in the 1970s to a low of 1.4 percent in 1987, before
rebounding slightly to between 2 and 3 percent at the end of the 1980s.
Responsibility for the trend decline in saving can be split roughly equally
between greater public dissaving and a lower rate of private saving.10 The
decline in the domestic investment rate was smaller than the drop in saving—net
domestic investment fell from an average of 7.7 percent of NNP in the 1970s to
5.3 percent in 1987 and 3.8 percent in 1990. Over the full decade, 45 percent of
domestic capital accumulation was financed by the inflow of resources from
abroad, limiting the decline in investment to about half that of domestic saving.
For a variety of reasons, however, these aggregate trends are not conclu-
sive evidence about the effect of supply-side tax incentives. First, the saving arid
investment figures just cited are net—that is, they take depreciation of existing
capital into account—whereas sorne analysts prefer to focus on gross measures of
saving and investment. This is not an insignificant issue; rates of depreciation rose
sharply in the early 1980s, reducing net capital investment.
Second, many other events occurred during the decade with potential
impacts on saving and investment: for example, large increases in market
interest rates, large capital gains generated by the recovery of the stock market,
and changes in the demographic structure of the population. It is therefore
difficult to agree on baseline paths for investment and saving from which to
measure the influence of the tax Changes.

Taxes and Investment in the 19tOs

The ambiguities in the assessment of supply-side performance are particu-
larly evident in the case of investment. One standard measure of investment is
the share of GNP in constant prices devoted to gross business investment,
which rose throughout the 19805. Another standard measure of investment is the
rate of net additions to the dapital stock, which declined sharply over the
decade. It is hard to resolve the debate over the role of taxes when analysts
cannot agree on whether the rate of investment rose or fell.
The divergence of these investment measures arises from the role of
investment in office computing equipment. Computers have a large impact on the
aggregate indexes for two reasons. First, their prices have been rapidly
declining—the 1989 relative price index was only 18 percent of its 1979 level.
Thus, while nominal outlays on office computing equipment remained rela-
tively stable at 0.6 to 0.8 percent of GNP, that amount of money bought

'°
Including a separate capital account for the government, as the U.S. prepares for OECD use, raises
the overall rate of national saving by about 1 percent of NNP. But if government capital were included
in the statistics, the trend rate Of decline in national saving would appear worse, since many of the
public spending restraints of the 1980s were concentrated in the area of capital programs.
16 Journal of Economic Perspectives

seven-fold more in quality-adjusted volume terms. Because of the contribution of

computers, the relative price of capital goods as a whole has fallen by 20
percent, leading to a sharp divergence between dollars spent on investment and
physical volume of goods received. Exclusive of office computers, gross
investment as a share of GNP declined by 2.3 percentage points in both
nominal and constant prices.
An additional measurement issue arises because the service life of comput-
ers is much shorter than that of capital goods in general. This causes a
divergence in the trends of gross and net investment. In effect, high rates of
gross investment are offset by a faster rate of depreciation. The rise in deprecia-
tion mentioned earlier is largely due to the shift toward shorter-lived computer
equipment.
Which measure should we believe? Gross investment avoids the problems of
estimating depreciation. Yet, net investment corresponds to the change in the
capital stock and is more appropriate to assessing national wealth accumula-
tion, and it corresponds to NNP which is more closely related to living
standards than is GNP. For purposes of analyzing the contribution of capital to
production, however, the capital stock is not an adequate index of the gross flow
of capital services whenever the durability of capital is changing. The
appropriate measure of the growth in capital depends upon the specific context in
which the data are used although we believe (in contrast to de Leeuw, 1989) that
the net rate of accumulation is of more general use. Whatever measure is used it
is important to disaggregate total investment, because office computing
equipment, the source of the divergence between gross and net investment, was
largely unaffected by the 1981 Act. Further, the 1986 changes varied substan-
tially across different types of capital.
Some similar problems of focusing on aggregate measures also exist for
investment in structures. Although, this investment fell off after 1985, about two-
thirds of the decline is related not to taxes, but to lower investment in oil
exploration following the collapse of oil prices in the middle of the decade.
The assessment of the investment incentives is further complicated by
controversy over the measurement of the cost of funds. While the usual practice is
to calculate some weighted average of the after-tax real bond rate and the return
on corporate equities, there is no agreement on how to measure the latter.
Many studies ignore the expected capital gain on equity and use only the
dividend-price yield. Under this assumption, the stock market recovery reduced
the cost of equity finance in the 1980s, offsetting the increased real cost of bond
finance. Yet firms behaved as though they believed the opposite, switching
from equity to debt financing." Interpreted as the real after-tax cost

e the expected rate of general

"In adjusting nominal bond rates for inflation, some investigators us
prices, a number near
inflation, a number near 4 percent; others use the change in capital goods zero,
generating still another source of divergence.
 Barry Bosworth and Gary Burtless 17

of debt finance (Stiglitz, 1973), the marginal cost of funds increased dramati-
cally in the 1980s.
Problems in measuring the cost of funds are evident in recent empirical
studies of investment in equipment and structures. Despite the large variations in
effective tax rates, their effect on the cost of capital has been dominated by even
larger variations in the relative price of capital goods (like the change in the
price of computers) and the cost of funds (Bosworth, 1985), In general, most
analysts conclude that tax changes played a relatively minor role in
explaining the pattern of aggreg4te investment over the decade. According to
one of the most detailed studies] the stimulative effects of the legislative tax
changes of the early 1980s amounted to 2 percent of business gross investment
by 1985 (Corker, Evans, and Kenward, 1989).
However, the studies also foUnd a significant degree of parameter instabil-
ity in estimates of the neoclassical investment model when investment is mea-
sured inclusive of office computing equipment (Auerbach and Hassett, 1990a;
Corker, Evans, and Kenward, 1989; Evans, 1990). The demand for office
computing has been driven by technological innovations, not taxes, and varia-
tion in this factor is ignored in standard neoclassical formulations of investment
demand
An alternative analytical strategy has been to examine the effect of taxes on
the composition of investment. The advantage of this approach is that the tax
changes varied substantially across asset categories, whereas many nontax
changes affected all categories equally (the cost of funds) or only a small
number of categories (relative prices). Bosworth (1985) found little or no
correlation between the size of 1981 tax changes and changes in investment in
various categories. More recently, a similar study by Auerbach and Hassett
(1990b) of the 1986 reforms emphasized the importance of accounting for
taxpayer expectations. They repoi-t, contrary to Bosworth, a strong correlation
between the unanticipated part of the 1986 tax changes and forecast errors for
22 categories of equipment investment, but no correlation for the structures
components.12
The experience of the 1980s floes not invalidate the view of most economists
that taxes are an important determinant of investment. But it does illustrate
what happens when tax policy is not coordinated with other important policy
measures. If the tax cuts of the early 1980s were designed to increase invest-
ment incentives, they also helped to create large budget deficits and higher real
interest rates that overwhelmed the tax incentives and depressed capital
formation.

120ne major source of difference betwee* the two studies is the large magnitude of the forecast errors
in the Auerbach and Hassett study, which they correlate with the tax changes. The forecast errors
imply that there would have been an enormous investment boom after 1986 in the absence of tax
reform. That is somewhat implausible in view of the subdued output growth during the period.
18 Journal of Economic Perspectives

Figure 2
Components of Private Saving, 1960 -89
(Percent of Net National Product)

o.

1960 1965 1970 1975 1980 1985

Taxes and Private Saving in the 1980s

The components of private saving can be broken down into nonretirement
saving, retirement saving (pension funds and IRAs), and retained earnings of
corporations. The pattern of these components since 1960 is shown in Figure 2.
During the 1960s and most of the 1970s, nonpension saving was 3-4 percent of
NNP, pension funds were 2-3 percent, and retained earnings were another 3-4
percent. Each one varied a bit, of course, but not very much."
The 1981 tax changes should have provided a boost in the incentives for
nonpension saving. Marginal tax rates on capital income were cut substantially —
especially for high-income families who account for the bulk of saving. In
addition, taxpayers were provided with an expanded menu of tax-exempt and
tax-deferred saving instruments, principally through the liberalization of eligi-
bility for IRAs.
The 1986 Act had a more mixed effect on saving incentives. As noted
earlier, the tax burden was shifted from households to businesses, but the
impact of this change on saving incentives is controversial. In a closed economy in
which the income from domestic capital flows to domestic savers, the point at
which the tax is collected makes little difference. Therefore, the net effect of the
1986 reforms was to increase the overall tax rate on capital income—higher
business taxes offset the lower tax rates on individuals. On the other hand, if
interest rates are determined in open international markets, the increased

13We focus most of our attention on the behavior of the total private as opposed to the household
saving rate. In part, this is because we would expect equity-holders to take account of the saving done
for them by their corporate agents. But, also, the personal saving rate does not truly distinguish
between business and individual saving since it includes the saving of noncorporate enterprises.
 Effects of Tax Reform on Labor Supply, Investment, and Saving 19

taxation of American business would have a small impact on the return to U.S.
savers, who clearly benefited from a second round of marginal income tax
reductions. In either case, the eliMination of the capital gains preference and the
elimination of many tax shelters both represented reductions of incentives for
saving. The phasing out of the tax deductibility of consumer interest was an
offsetting factor to encourage saving, but the Act left a major loophole in the
form of the continued deductibility of interest on home equity loans.
Throughout the decade the increased saving incentives coming from tax
reform were magnified by the availability of dramatically higher rates of return on
financial market assets. Over the same period, regulatory reform, such as the
elimination of deposit-rate ceifings, made high returns available to a wider range
of savers. Despite the surge in after-tax real returns, the private saving rate fell
throughout the decade. Nonretirement saving actually turned negative in the
middle of the decade before rebounding a bit by the end.
Part of the decline in private !saving is a reflection of a longer term trend
decline in corporate retained earnings, which fell as a share of NNP from 3.7
percent in the 1960s to 2.7 percent in the 1970s and less than 1 percent in
1989--90. The recent drop can I be traced to the large losses of financial
corporations. However, there is an underlying trend of declining corporate
earnings resulting from a shift in corporate financial structure toward increased
debt, with a consequent increase ire the proportion of capital income paid out to
bondholders. It is not due to a degline in the rate of return to capital. (The rate of
return on tangible capital did decline slightly within the nonfinancial sector
during the 1970s, but it held constant during the 1980s.) If investors were aware
of the saving being done by the corporation as their agent, the reduced rate of
earnings retention should have been offset by increased household saving on
the part of those who received the interest income, but this did not happen.
If there is a case that tax policy had an effect on increasing household
saving in the 1980s, it must have operated through the promotion of retire-
ment accounts—pension funds and IRAs—since other forms of saving declined
precipitously. The benefits may have been offset in the aggregate by changes in
other factors like capital gains aria demographic changes. Let us briefly con-
sider each of these issues.
Pension fund saving. Formal retirement plans have become the dominant
form of household saving. Also, the rate of reserve accumulation has been
slowing in recent years after several decades of substantial growth, suggesting
that factors affecting pension reserve accumulation may be a significant part of
the explanation for changes in overall saving. Despite the fact that 45 percent of
the private workforce is covered by such plans, pension accumulations are often
overlooked in studies of saving be avior, reflecting an implicit assumption that
variations in the accrual of savi g within pension funds are offset by the
behavior of households and firm. Empirical evidence on the plausibility of
these assumptions is limited and inconclusive (Munnell and Yohn, 1990).
20 Journal of Economic Perspectives

In the national accounts, the accumulation of reserves within private

pension funds is attributed to household saving." Employer contributions are
included in employee compensation and the interest and dividend income are
imputed to personal income. Contributions to employer-provided pension
funds have long been exempt from taxation, but they differ from IRAs, because
the employer contribution does not vary in response to the tax situation or
saving preferences of the individual employee.
The 1974 Employee Retirement Income Security Act (ERISA) increased the
probability that workers would actually receive a benefit in future years and set a
floor on funding for programs that assured a defined benefit. Both of these
factors led to higher employer contributions during the later 1970s. Saving
within pension funds rose from less than 2 percent of NNP in 1970 to
4 percent by 1980.
With the onset of high interest rates and the recovery of the stock market in
the 1980s, however, many defined-benefit plans became over-funded under IRS
definitions, and employers were unable to deduct further contributions in
calculating their tax liability.' The result was a sharp falloff in the net inflow of
funds to defined-benefit plans. Their contribution to national saving declined by
about 2 percent of NNP over the decade of the 1980s. As pointed out by
Bernheini and Shoven (1988), defined.henefit pension funds are an extreme
example of a target saver who reduces the flow of new saving in response to a
higher return on existing savings. This response of pension funds to market
returns may provide a partial explanation for the failure of a higher after-tax
return to serve as a positive incentive for total saving.
Furthermore, in an effort to raise taxable profits in the short run, Congress
significantly revised the criteria for what constitutes a fully-funded pension plan in
the Omnibus Budget Reconciliation Act of 1987, causing more plans to become
over-funded. In addition to prohibiting a tax deduction for contribu-
tions to such plans, the 1987 Act introduced a new penalty tax on excess
contributions. The likely result will be a further reduction in the reserve
accumulation within defined-benefit pension plans.
Some of the negative influence on saving of a reduction of defined-benefit
plan contributions has been offset by the growing popularity of defined-
contribution plans, many of which permit a substantial employee contribution.
By 1987, these plans accounted for 40 percent of pension fund assets. For most

"The national accounts includes public employee pension programs within the government sector. In
all the statistics cited in this paper, however, we have transferred the funded programs of state and
t
local governments to the household sector to match the treatment of private pensions. Mos federal
pensions are not funded in any meaningful sense.
lated to the
15Defined-benefit programs promise the worker a specific future retirement benefit re
akes an explicit
number of years of service. With defined-contribution plans the employer m
1980
contribution and the ultimate pension depends on future performance of the fund. Prior to most
ion
pension programs were of the defined-benefit type, but the share of defined-contribut plans is
now growing rapidly.
 Barry Bosworth and Gary Burtless 21

employees, contributions to these plans are not restricted by the funding rules
that give rise to a negative saving response when market rates of return climb
Individual Retirement Accounts. IRAs have been at the center of the debate
over tax incentives for private saving. The 1981 version of the IRA allowed
individuals to deduct their contribution to the IRA from taxable income,
accumulate income within the account at the pre-tax rate of return, and pay tax
on the full amount upon withdrawal. In effect, the deduction caused the
government to defer collecting ta$es until retirement, when they were collected
with accumulated interest. On a present value basis, the benefit of the lax
deduction was counterbalanced b taxation upon withdrawal, and the real tax
advantage of the IRA was the op ortunity to compound the funds within the
account at the pre-tax rate of int rest. The 1986 Act reduced the benefits for
high-income workers who represented a large proportion of the previous
contributors to IRAs.
The strong growth of IRA s ving following the expansion of eligibility in
1981, and the equally abrupt co traction after the 1986 tax reform, provides
strong evidence that individuals re sensitive to tax incentives in making their
saving decisions. The major issue, however, is whether the response repre-
sented a substitution of tax-preferred for non-preferred forms of savings or an
increase in overall saving—a substitution of future for current consumption.
Contributions to tax-exempt IRAs and Keogh plans soared from less than
0.2 percent of NNP in 1980 to L2 percent in 1986. With the 1986 reform,
contributions fell off very sharply to 0.4 percent of NNP in 1989, despite the
substantial remaining tax advantage. Large swings such as these, if they repre-
sent genuine moves in net private saving, should be visible in the aggregate
data. Yet the overall private savi g rate fell as IRAs expanded and rose when
IRAs contracted after 1986.
The most extensive research On IRAs has been based on survey data from
individual households rather th4i trends in aggregate saving or its compo-
nents. The surveys suggest that nfrost IRA accounts were held by families with
substantial holdings of other financial assets, and many IRA contributors were in
the age and income brackets where annual saving could be expected to exceed
the $2,000 limit. For the e individuals the IRA was a very attractive option,
but one that could be exploited simply by shifting funds from taxable accounts
with no net impact on the overall saving of the household. The fact that 75
percent of participants contributed the maximum implies that the program
provided an insignificant saving incentive at the margin, providing instead an
inframarginal subsidy to wealthier taxpayers (Galper and Byce, 1986).
Recent microeconomic studie on the effect of IRAs have reached conflict-
ing conclusions. Venti and Wise (1986, 1987) and Feenberg and Skinner (1989)
asserted that IRA incentives pro uced a substantial increase in private saving
between 1982 and 1986, while a ater study by Gale and Scholz (1990) found
that an increase in the IRA co tribution limit would lead to a very small
22 Journal of Economic Perspectives

increase in net private saving, an increase that would be more than offset by the
rise in government dissaving. These studies and others were reviewed in the
Spring 1991 issue of this journal by Jane Gravelle, who concludes that while tax
incentives for IRAs certainly affect the way in which money is saved, they
appear to have little effect on overall private saving.
Alternative Explanations for the Decline in Saving. While the experience of the
1980s must be discouraging to those who believe saving behavior is highly
sensitive to the after-tax rate of return, it is possible to argue that other factors
changed sufficiently to offset what would have been a strong positive response.
For example, some researchers have explored alternative definitions of saving
that adjust for the effects of inflation on capital income, or have redefined
investment to include consumer durables. However, these definitional changes
have only minor effects in altering the timing and magnitude of the saving
decline (Bradford, 1990).
The national income accounts' concept of private saving has also been
criticized for its failure to include capital gains. It has been asserted that the
direct inclusion of capital gains (especially from stocks and housing equity)
would eliminate the apparent decline of saving in the 1980s.
The inclusion of capital gains, however, would create an even greater
puzzle about saving behavior. Adjusted for general price inflation, households
have experienced real capital losses, not gains, over the last two decades. Using
data compiled by the Federal Reserve Board (1990), household wealth accumu-
lation, measured in constant prices, can be allocated between saving as co.nven-
tionally measured and real capital gains or losses. On that basis, households lost
about 10 percent of their wealth in the 1973-74 stock market decline, recov-
ered a portion through real estate gains in the late 1970s, and suffered another
large loss in the fall of the stock market and real estate prices in the early 1980s.
Since 1982 the strong growth of the stock market has resulted in real capital
gains, but not enough to offset the previous losses. If capital, gains reduced
saving by large amounts after 1982, why didn't saving rates rise substantially in
the mid-1970s and the early 1980s?
Conventional, models of saving behavior do not ignore capital gains since
changes in the value of existing wealth are included as a major determinant of
consumption and saving. Most empirical studies find that the coefficient on
wealth in annual consumption functions is 0.05 or less, and that consumers
discount short-run fluctuations in equity prices. The 0.15 rise in the wealth-
income ratio since 1982 would account for a 0.75 percentage point decline in the
saving rate. The 0.35 rise in the wealth-income ratio due solely to capital gains
would account for as much as a 1.8 percentage point decline in the saving rate.
Demographic change has also been credited as an explanation for recent
changes in the saving rate. Analysts argue that the baby-boom workers, enter-
ing into the early years of their careers when consumption demands are high, are
responsible for much of the recent decline in saving. The implication is that the
saving rate will recover when this huge generation of workers reaches its peak
saving years.
 Effects of Tax Reform on Labor Supply, Investment, and Saving 23

There are several problems with this argument. First, it ignores the fact that
until the 1980s, saving was relatively constant in spite of wide swings in the age
profile of the population. If the very young and the retired are responsible for the
bulk of the dissaving, we should have observed a sharp decline in the private
saving rate in the 1960s and 1970s when there was a rapid growth in the
proportion of the population that was young or retired, but no such decline
occurred (Aaron, Bosworth, and Burtless, 1989).
Second, microeconomic surv0 data show that the decline in overall saving is
caused by reduced saving across all age brackets (Bosworth, Burtless, and
Sabelhaus, 1991). In fact, contrary to arguments that young families have been
responsible for the lower saving (Boskin and Lau, 1988), the decline seems
largest among older households. Finally, microeconomic surveys do not show
enough difference in saving rates hy age to yield a major change in saving from
the recent demographic swing.
Despite the coincidence of drilling, we would not go so far as to argue that
the reduction of tax rates during he 1980s caused a decline in private saving.
Nonetheless, the decade offered a very powerful test of the hypothesis that
saving is sensitive to the after-tax rate of return. Without some convincing new
evidence, government policy-ma ers should act under the presumption that
income tax incentives for saving e likely to fail. If the government desires to
increase net national saving, a useful first step would be to reduce government
dissaving. Fears that such efforts would simply be offset by lower household
saving are not supported by the 080s experience.

Conclusion

The increase in labor suppli during the 1980s provides the strongest
support for supply-side gains rffromm tax reform. The growth of work hours
among adult women accelerated ii the 1980s, and average hours among adult
men stabilized or rose slowly after la long period of decline. Noticeable increases
occurred among earners in the most affluent families, who enjoyed the largest
marginal tax cuts, and especially among married women in those families, who
were predicted to be the most re ponsive to tax cuts. However, much of the gain
in labor supply cannot be a tributed to tax reform, since it was concen-
trated among poor households t at were unaffected by tax changes. Much of the
surge in aggregate supply in the 1980s was evidently due to factors other than tax
reform.
The success of tax reform in raising labor supply was at least partly offset by
its failure to raise or even ml.intain capital investment. While we do not
conclude that investment tax incentives were wholly ineffective, the fact that net
investment fell as a share of national income over the decade shows the limits of
even massive microeconomic tax incentives. The fall in private saving was even
more severe, and occurred in spite of costly new saving incentives and an
extraordinary rise in the real rate lof return.
24 Journal of Economic Perspectives
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