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The Economics of Taxation:
Theory and Evidence for Budget Evaluation
John A. Spry, Ph.D.
The views expressed herein are solely those of the author and do
not represent the views of the State of Minnesota or the
University of St. Thomas. All errors are my own.
Key Facts about Proposed Budgets

The Governor’s and President’s budgets would raise
Minnesota’s combined marginal income tax rate on working
from 43% to as high as 55%.
◦ Federal rate hikes from 35% to 39.6%.
◦ Minnesota rate hike from 7.85% to 13.95%
◦ 3.8% Medicare tax (employee and employer) in 2013
◦ Pease and PEP provisions limit federal deductibility of Minnesota taxes.


The economic damage from raising tax rates from 43% to
55% is far greater than the 27.9% increase in tax rates. The
economic inefficiency from this higher tax rate would be
approximately 63% higher than the economic inefficiency
from the current rate.
The marginal cost of public funds at the current 43% rate is
around somewhere between $1.50 and $4.80 per additional
dollar of tax revenue raised.
Higher Marginal Income Tax Rates Cause
Economic Inefficiency Several Ways
A strong incentive to time taxable transactions to occur in
years with lower tax rates.
 A strong incentive to rearrange financial and accounting
transactions to engage in the maximum legal tax avoidance.
 A disincentive to supply additional hours of effort.
◦ This affects female workers the most.
 A disincentive to invest in education and on-the-job-training.
 A disincentive to take risky, disagreeable jobs that receive a
higher, compensating wage premium for less pleasant working
conditions.
 A strong incentive to take compensation in tax preferred
forms (perks, exotic business trips, tax-free benefits, ect.)
 A strong incentive to invest in lower-risk, tax free investments
(Municipal bonds and Treasuries) instead of taxable equity in
high-risk startups.

The Marginal Cost of Public Funds
The marginal cost of public funds measures the
total cost to the economy of collecting one more
dollar of tax revenue.
 The deadweight loss or excess burden of a dollar
of tax revenue measures the dollar value of all the
bad decisions made because of taxation beyond the
dollar of revenue collected.
•

The marginal cost of public funds is the sum of a
dollar of revenue and the deadweight loss from an
additional dollar of additional revenue.
The Marginal Cost of Public Funds
“Because taxes generally distort relative prices,
they impose a burden in excess of the revenues
they raise. Recent studies of the U.S. tax system
suggest a range of values for the marginal excess
burden, of which a reasonable estimate is 25
cents per dollar of revenue.” -The Obama
Administration’s OMB
◦ This means on average $1.00 in federal tax
revenue costs the economy $1.25.
The Marginal Cost of Public Funds
The marginal cost of public funds will be greater
when:
The tax is imposed on a more responsive or mobile tax
base.
2. The tax rate is larger.
3. The tax is imposed on top of other market distortions.
1.
The decision to focus the additional revenue in the
Administrations’ budgets on a narrow tax base at
high tax rates will make the marginal cost of public
funds from income tax hikes particularly large.
The Deadweight Loss of a Tax Increases with the
Square of the Tax Rate
•The deadweight loss or excess burden of a dollar of tax revenue measures
the dollar value of all the bad decisions made because of taxation beyond the
dollar of revenue collected.
•Higher tax rates both reduce the quantity of economic activity and increase
the average value of the lost economic activity.
•This makes the deadweight loss of a tax rate, t, proportional to t2.
There is Substantial Uncertainty about the
Elasticity of Taxable Income
•The elasticity of taxable income measures the
responsiveness of the tax base with respect to changes in tax
rate.
•The economic literature generally agrees that high income
taxpayers have the most responsive, highest elasticity of
taxable income.
•0.5 is a central tendency for the elasticity of taxable income
in the literature for the income levels facing tax rate increases
under the Administrations’ budgets.
•There is considerable uncertainty about the value of the
elasticity of taxable income.
The Marginal Cost of Public Funds Depends on the
Marginal Tax Rate and the Elasticity of Taxable Income
Elasticity of taxable income
0.3
0.5
0.7
Marginal Cost Marginal Cost Marginal Cost
of a Dollar of of a Dollar of of a Dollar of
Public Funds Public Funds Public Funds
Marginal
tax rate
43%
$ 1.51 $ 2.30 $ 4.81
47%
$ 1.67 $ 3.04 $ 16.72
55%
$ 2.22 $ 12.00 Infinity
Source: Dr. Raj Chetty, Dept. of Economics Harvard University and NBER
Source: Dr. Raj Chetty, Dept. of Economics Harvard University and NBER
Minnesota is a Small Open Economy


Minnesota has 0.08% of world population.
Minnesota GDP is about 0.33% of world GDP.
◦ 1 of every 300 dollars of value produced in the world is produced in Minnesota.
We should compare our taxation of
capital internationally, as capital is
highly mobile today.
 We should compare our taxation of
labor and savings nationally, because skilled
workers are relatively mobile today.

Mobility Limits the Effectiveness
of State and Local Redistribution
Source: Dr. Joseph Stiglitz, Columbia University and NBER, Public Sector Economics, 3rd edition. p. 758.
Mobility Limits the Effectiveness of State and
Local Redistribution
“The evidence presented in this paper supports the basic theoretical
presumption that state and local governments cannot redistribute
income. Since individuals can avoid unfavorable taxes by migrating to
jurisdictions that offer more favorable tax conditions, a relatively
unfavorable tax will cause gross wages to adjust until the resulting net
wage is equal to that available elsewhere. The current empirical findings
go beyond confirming this long-run tendency and show that gross wages
adjust rapidly to the changing tax environment. Thus, states cannot
redistribute income for a period of even a few years. The adjustment of
gross wages to tax rates implies that a more progressive tax system raises
the cost to firms of hiring more highly skilled employees and reduces the
cost of lower skilled labor. A more progressive tax thus induces firms to
hire fewer high skilled employees and to hire more low skilled employees.
Since state taxes cannot alter net wages, there can be no trade-off at the
state level between distribution goals and economic efficiency. Shifts in
state tax progressivity, by altering the structure of employment in the
state and distorting the mix of labor inputs used by firms in the state,
create deadweight efficiency losses without achieving any net
redistribution.”
Source: Feldstein and Wrobel, Journal of Public Economics, 1998.
Mobility Limits the Effectiveness of State and Local
Redistribution

Labor mobility of highly skilled individuals
“This paper examines the responsiveness of the rich to state income
taxes. We use Major League Baseball free agents who were named AllStars at some point in their career and who signed with a U.S. team for
the 1991 through 2002 seasons. This data set overcomes some of the
previous difficulties encountered in similar studies but also has
limitations representing the general rich population. We find evidence
that the wages of this subset of players do adjust to offset the burden
of state income taxes, specifically a 1% decrease in net-of-tax rate leads
to a 3.3% increase in salary.”
Source: Ross and Dunn, Contemporary Economic Policy, 2008.
Increasing Prosperity and Income Inequality:
The United States 1970-2006
Source: Maxim Pinkovskiy & Xavier Sala-i-Martin, 2009. "Parametric Estimations
of the World Distribution of Income," NBER Working Paper 15433
Increasing inequality AND substantial middle
class gains in Median Household income
Source: Dr. Terry J. Fitzgerald, Federal Reserve Bank of Minneapolis
Income Mobility and the Minnesota Tax Incidence Study
“Income received in a single year can be a misleading measure of economic wellbeing. Individual households may have unusually high or low income in a particular
year due to business losses, unemployment, or the sale of capital assets…
Because of such transitory income, a snapshot of the income distribution in a single
year shows more income inequality than a time exposure over several years. In
addition, income varies over a household’s life cycle. For these reasons, annual
income may not be an accurate measure of a household’s more permanent
economic well-being.
In spite of these shortcomings, there are two strong reasons why this study uses
annual rather than permanent income. First, an adequate record of the income of
individual households over a longer period is rarely available. Consequently, state
incidence studies have always used an annual accounting period. Second, an annual
perspective may be preferred because taxes are paid out of a household’s current
income, not out of what might be earned in the future. If the purpose of an
incidence study is to make policy decisions regarding current ability to pay taxes,
then it is reasonable to argue that the appropriate measure should be based on
annual rather than permanent income.”
Source: 1995 Minnesota Tax Incidence Study, pp. 16-18.
US Income Mobility:1996-2005
Source: Gerald Auten and Geoffrey Gee. “Income Mobility in the United States: New Evidence
from Income Tax Data.” National Tax Journal. June 2009. pp. 301-328.
US Income Mobility:1996-2005
Source: Gerald Auten and Geoffrey Gee. “Income Mobility in the United States: New Evidence
from Income Tax Data.” National Tax Journal. June 2009. pp. 301-328.
The Repeal of Inflation Indexing of Minnesota Tax Brackets




The Administration’s budget has both a 4th tier and 1st tier
10.95% rate in the long-run because the Administration’s
budget uses inflation to shift progressively more
Minnesotans into the 4th tier 10.95% rate.
Eventually, what was the 4th tier will become the 1st tier,
with the 10.95% rates being the first tier income tax rate.
This is the result of relying on inflation to provide
increasing revenues to Minnesota state government for the
executive’s goal of revenue adequacy over time through
bracket creep.
The size of personal income tax, tax expenditures would
increase under the Administration’s budget.
Budgets Always Involve Tradeoffs
There are few things wholly evil or wholly good.
Almost every thing, especially of government
policy, is an inseparable compound of the two;
so that our best judgment of the preponderance
between them is continually demanded.
- Abraham Lincoln, 1848
A central tradeoff in public budgeting is
between the value of another dollar of public
expenditures and that marginal cost of public
funds to raise that dollar of public expenditures.