9.3 Income Tax Evaluation

Income taxation introduces a potential distortion in the choice between work and leisure, as it taxes income but not leisure. This could discourage work, as individuals may opt for more leisure time rather than earning additional income that will be taxed.

Similarly, the tax system affects the balance between savings and consumption. Savings, particularly interest income, are taxed twice—once when the income is earned and again when the interest is received—while consumption is taxed only once. This structure may encourage people to reduce savings and shift their investments towards real estate or other assets that offer tax advantages over financial investments.

The efficiency of the income tax system also diminishes as marginal tax rates increase. Higher marginal rates can lead to greater efficiency losses, as they create stronger disincentives to earn additional income. This creates a trade-off between achieving greater tax progressiveness and maintaining economic efficiency. Additionally, some deductions and exemptions, while promoting horizontal equity, can further reduce efficiency by distorting individual financial decisions.

9.3.1 New Jersey Millionaires Tax

“This paper examines the migration response to a millionaire tax in New Jersey, which raised its income tax rate on top earners by 2.6 percentage points to 8.97 percent, one of the highest tax rates in the country. [], we estimate the migration response of millionaires to the rate increase, []. The results indicate little responsiveness, with semi-elasticities generally below 0.1. Tax-induced migration is estimated to be higher among people of retirement age, people living on investment income rather than wages, and people who work (and pay tax) entirely in-state. The tax is estimated to raise $1 billion per year and modestly reduce income inequality.”

Young and Varner (2011) Millionaire Migration and State Taxation of Top Incomes: Evidence from a Natural Experiment National Tax Journal 64(2), 255-284.

9.3.2 Equity, Adequacy, and Elasticity

In terms of equity, income taxation is adjusted to account for taxpayers’ ability to pay. Horizontal equity is improved by deductions for medical and dental expenses, as well as state and local taxes, ensuring that taxpayers with similar financial circumstances are treated fairly. However, certain provisions, such as the home mortgage interest deduction, can favor homeowners over renters, creating an imbalance in horizontal equity.

Vertical equity, which focuses on the fairness of tax burdens across different income levels, is sometimes compromised by deductions and loopholes that reduce the overall progressiveness of the tax system. These provisions can allow higher-income individuals to reduce their tax liability disproportionately.

In terms of adequacy, income tax is considered a broad-based tax, meaning it has a large tax base and provides substantial revenue, making it a reliable source of funding for government operations.

The elasticity of income tax is tied directly to personal income, meaning tax revenues tend to rise with increasing incomes. However, there is also the potential for bracket creep, where inflation pushes taxpayers into higher tax brackets without an increase in real income, distorting the tax burden.

9.3.3 Bracket Creep and Indexation

In the setup, a taxpayer with a current income of $100,000 falls into the 28% federal income tax bracket. The marginal tax rate increases to 30% for income above $102,000.

Bracket creep occurs when inflation leads to a salary increase, in this case by 3%, raising the taxpayer’s income to $103,000. Despite the increase in nominal income, the taxpayer’s real purchasing power remains unchanged. However, the higher income pushes them into a higher tax bracket, resulting in a greater tax liability without an actual improvement in their financial situation.

To eliminate bracket creep, tax systems use indexation, which adjusts marginal tax brackets in line with inflation, ensuring that taxpayers do not face higher tax rates simply due to inflationary increases in nominal income.

Feasibility: Income taxation is generally feasible due to its ease of administration for the government. Identifying taxpayers is manageable, and the assessment and collection of taxes are streamlined through payroll deduction (withholding), either by individuals or their employers. The government’s primary administrative costs are related to enforcing tax laws and conducting sample audits to ensure compliance.

However, income taxation also imposes significant compliance costs on taxpayers. These costs arise from the effort required to file tax returns, understand tax laws, and keep up with any changes or updates in the tax system.