CHAPTER 18

PERSONAL
TAXATION AND
BEHAVIOR

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Labor Supply
Income per week

D
|Slope| = w

G E1
iii

ii
Income
Leisure i
Work

0 F T Hours of leisure per week

18-2
time endowment
Effects of Taxation
Income per week

D
|Slope| = w

H
G E1
iii

ii
|Slope| = (1-t)w E2Hours of
G’ i
work after
tax

0 F I T Hours of leisure per week

18-3
Hours of work before tax
Effects of Taxation
Income per week

H
G E1
iii
E3
K Hours of ii
work after i
tax

0 J F T Hours of leisure per week

18-4
Hours of work before tax
Effects of Taxation
Income per week

D
|Slope| = w

|Slope| = (1-t2)w E1
N E4 (1-t1)$5,000 + (1-t2$5,000

(1-t1)$5,000
|Slope| = (1-t2)w |Slope| = (1-t1)w

0 P F T Hours of leisure per week

18-5
Hours of work before tax
Empirical Findings
 Eissa [2001]
 Males
 Females

18-6
Some Caveats
 Demand-side considerations
 Individual versus group effects
 Other dimensions of labor supply
 The compensation package
 The expenditure side

18-7
Labor Supply and Tax Revenues
Wage rate
per hour

SL
a j k c
w
b
(1-t1)w d
e
(1-t2)w f

(1-tA)w

h i
(1-t3)w

L3 LA L2 L1 L0 Hours
18-8
per week
Tax Rates versus tax revenue – Laffer Curve
Tax revenue

t1 t2 tA t3 Tax rate 18-9

Debate Over the Laffer Curve
 The Laffer curve and the elasticity of labor
supply
 Where on the Laffer curve is the economy
operating?
 Empirical estimates of the elasticity of labor
supply
 Other ways tax rates can affect tax revenues
 Determining the optimal tax rate
18-10
Saving
Future consumption c1

c1* E1
iii
ii
i
I1
Endowment point

Saving ІSlopeІ = 1 + r

M
c0 *
I0
Present consumption (c0)18-11
Deductible Interest Payments and Taxable
Interest Receipts
Future consumption c1

c1* E1
P
c1t After-tax budget line
I1 ІSlopeІ = 1 + (1-t)r
A

Saving
after
tax
Q
M
c0* c0t I0
Saving before tax Present consumption (c0)18-12
Deductible Interest Payments and Taxable
Interest Receipts
Future consumption c1

c1* E1
P
c1 t
After-tax budget line
I1 ІSlopeІ = 1 + (1-t)r
A

Saving
after
tax
Q
M
c0t c0* I0
Saving before tax Present consumption (c0)18-13
Nondeductible Interest Payments and
Taxable Interest Receipts
Future consumption c1

c1*
P
c1 t
After-tax budget line
I1 ІSlopeІ = 1 + (1-t)r
A

Q
M
I0
Present consumption (c0)18-14
Some Additional Considerations
 Real net rate of return
 Many assets
 Private saving versus social saving
 Validity of life-cycle model
 Empirical evidence: the effect of taxation on
saving

18-15
Tax-Preferred Savings Accounts
 Types of tax-preferred savings accounts and
how they work
 Are contributions to these accounts new
saving?
 Administrative details and effect on saving

18-16
Taxes and the Capital Shortage
 Taxes and investment
 Taxes and excess burden
 Closed versus open economy
 Empirical evidence

18-17
Housing Decisions
 Effects of the income tax on housing
decisions
 Rnet = R – I + ΔV
 Implicit rent not taxed
 Deductibility of mortgage interest and
property tax payments
 The decision to rent or buy

18-18
Proposals for Change
 Critique of subsidy for owner-occupied housing
 Are there significant positive externalities?
 Impact on distribution of income
 Political feasibility of taxing imputed rent
 Reform proposals
 Elimination of deduction for property tax and mortgage
interest
 Placing an upper-limit on deductions
 An efficient solution

18-19
Portfolio Composition
 Tobin’s model of portfolio composition
 Impact of proportional tax with full loss offset
 Impact on return
 Impact on risk
 Empirical evidence

18-20
A Note on Politics and Elasticities
 Ambiguity about effect of taxation on
behavior
 Importance of elasticities
 “Convenient” beliefs about elasticities

18-21
Taxes and Human Capital Accumulation
 Human capital
 Investing in human capital
 B–C>0
 (1 – t)B – (1 – t)C = (1 – t)(B – C) > 0
 Income versus substitution effects
 Shortcomings of model
 Returns uncertain
 Explicit costs
 Other taxes
 Progressive taxes

18-22
Effect of Taxation on Saving
 Problems using the regression approach
 Specification issues
 Measurement issues
 Bernheim [2002]

18-23