A suggestion: increased progressivity

Ricardo Reis has suggested increasing the progressivity of the personal income tax as a means to raise more revenue and tackle the budget problem (may be read here, in Portuguese). There are several good reasons for the government to take this suggestion seriously. As Ricardo himself writes, the labor supply elasticity of top income earners with respect to  marginal tax rates is empirically lower than what is generally accepted in the political debate. This recent paper surveys the empirical literature on the estimation of tax elasticities and concludes that there is room to increase tax revenue by increasing the marginal tax rates of top income earners.

The  elasticity may stem from four types of behavioral responses to tax rates which lead to a change in reported income following a tax reform. The first one is decreasing labor supply, the second is tax evasion and the third one is income shifting (i.e., shifting part of one's taxable income to corporate income tax by means of more or less complicated, albeit legal, administrative and accounting procedures). The fourth one is a bargaining channel - top income earners usually have decision power over the wages they offer themselves and may simply allocate a greater share of firms' profits to their own compensation packages. Their incentive to do so is obviously lower if they are subject to higher marginal tax rates.

The first channel is the only one which entails an efficiency cost. The second may be tackled by improving the tax administration competences and monitoring capacities. The third channel, in turn, implies that fiscal revenue will increase elsewhere, e.g., in corporate income tax (although in principle the total fiscal revenue decreases). Hence, if anything, the elasticities of reported income with respect to the income tax rate, which range between 0.12 and 0.4 are an upper bound on the actual efficiency cost of taxation. For instance, an elasticity of taxable income of 0.4 implies that a 1% increase in the tax rate decreases taxable income by 40%. Let's make this clear: an increase in the tax rate will only decrease tax revenue if this elasticity is higher than 1 - that is far from being the case.

The fourth channel is particularly appealing in the actual context of increasing inequality and economic crisis, because it entails a zero-sum transfer of resources from bottom to top income earners. This other paper suggests that this latter is the most important determinant of the elasticity of taxable income of top income earners, building a case for high marginal taxes on top incomes as a means to decrease the incentive of managers to offer themselves a larger share of the pie.

How does Portugal compare to the remaining OECD countries in the way it taxes top income earners? The Figure taken from this paper shows that it scores relatively low in this regard.

Source: Piketty, Saez and Stantcheva, "Optimal Taxation of Top Labor Incomes: a Tale of Three Elasticities", CEPR 2011.

And what about the efficiency consequences of increasing it? They are likely to be limited, as discussed above, and because there is no apparent link between changes in marginal tax rates of top income earners and GDP growth.

Source: Piketty, Saez and Stantcheva, "Optimal Taxation of Top Labor Incomes: a Tale of Three Elasticities", CEPR 2011.

With the current erosion in the political consensus around the rescue package in Portugal, this is interesting food for thought.