RECENT EVIDENCE ON TAXPAYERS RESPONSE TO THE RATE INCREASES IN THE 1990 S FRANK SAMMARTINO DAVID WEINER *

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1 TAXPAYERS RESPONSE TO THE RATE INCREASES IN THE 1990S RECENT EVIDENCE ON TAXPAYERS RESPONSE TO THE RATE INCREASES IN THE 1990 S FRANK SAMMARTINO DAVID WEINER * * & * Tax Analysis Division, Congressional Budget Office, Washington, D.C Abstract - Recent studies have reported a disproportionate increase in reported incomes for high-income taxpayers following the Tax Reform Act of 1986 (TRA 86). Because marginal tax rates for this group were lowered substantially in TRA 86, several authors have concluded that reported incomes for this group are very responsive to changes in marginal tax rates. This paper examines similar evidence for the marginal tax rate increases of the 1990s. We tabulate recent cross-sectional and panel data to follow changes in reported incomes for the period The data suggest that there may have been a significant response to the rate increases as reported incomes for high-income taxpayers especially income from wages and salaries fell from 1992 to 1993 following the 1993 tax increase. The changes, however, may not be a permanent response to the tax rate changes, but may instead reflect a shift of income into 1992 in anticipation of the 1993 rate increases. By 1995, the decline in income for the highestincome group was completely recouped. We also find that there is significant heterogeneity in the response of taxpayers facing the same change in marginal tax rates. Thus, while the paper does not dismiss the potential for a permanent response to the recent rate increases, it does suggest that acrosstime comparisons, like those made here and previously for TRA 86, will not yield a stable relationship between marginal rates and reported incomes. INTRODUCTION Recent studies using tax return data have found evidence of a significant increase in reported incomes of highincome taxpayers in the years following the enactment of the Tax Reform Act of 1986 (TRA 86). That evidence is consistent with a large response by high-income taxpayers to the reduction in marginal tax rates enacted in TRA 86. Evidence comes from both comparisons of repeated cross sections of tax returns and from panel data that have followed the same taxpayers over a number of 683

2 TIOL TAX JOURL VOL. L NO. 3 years. The cross-sectional data show a significant increase in the share of income received by the top one percent and even smaller segments of the highest income taxpayers following TRA 86. Panel data show a larger increase in adjusted gross income (AGI) and taxable income for taxpayers experiencing the largest percentage increase in their netof-tax rate (one minus the marginal tax rate). While consistent with a large response to lower marginal tax rates, the observed increase in incomes for high-income taxpayers also is consistent with other, widely investigated, explanations for increasing dispersion in the distribution of income. These include increasing returns to education, increased use of technology that favors more highly skilled workers, growing international competition, and the decline in unionism. Moreover, even if the changes in reported incomes for the highest income taxpayers represent a response to TRA 86, they may have less to do with the change in marginal tax rates than with other complex structural features of the Act. In this paper, we investigate whether there have been changes in the share of income and average income reported by upper-income taxpayers that are consistent with a response to the tax increases enacted in the Omnibus Budget Reconciliation Act of 1990 (OBRA 90) and the Omnibus Budget Reconciliation Act of 1993 (OBRA 93). The tax changes in both of those Acts were simpler than in TRA 86, with the increases in marginal tax rates mostly confined to higher-income taxpayers and with few changes in the tax structure. Moreover, as the trend toward increased dispersion in overall incomes seems to have continued through the early part of the 1990s, any decrease in income concentration at the very highest income levels would not be attributable to the same influences shaping the overall distribution of incomes. Our preliminary analysis of both crosssectional samples of tax returns and a panel of returns that extends from 1985 through 1994 suggests that, while there does appear to be some influence of the OBRA 90 and OBRA 93 tax changes on the reported incomes of the highest income taxpayers, the size of any measured response depends upon the time period over which the changes are measured and varies considerably among taxpayers with the same change in the net-of-tax rate. While the analysis is mostly suggestive, it does cast doubt on the potential for estimating a simple, stable relationship between changes in marginal tax rates and changes in aggregate measures of income such as AGI or taxable income, on the basis of the OBRA 90 and OBRA 93 experience. THE RESPONSE OF TAXPAYERS TO TRA 86 Among many other changes, TRA 86 replaced the previous multibracketed individual income tax schedule with a transitional five-bracket schedule in 1987 and a two-bracket schedule, with rates of 15 and 28 percent, for all subsequent years. Although the Act reduced the maximum income tax rate from 50 to 28 percent, it contained provisions to recapture the benefits of the 15 percent bracket and personal exemptions from higher-income taxpayers that resulted in a tax rate of 33 percent over the recapture, or phase-out, range. The Act eliminated the capital gains exclusion, taxing gains at the same rate as other income. It also lowered the top corporate income tax rate from 46 to 34 percent, leaving the top rate on corporate income above the maximum rate on individual income. 684

3 TAXPAYERS RESPONSE TO THE RATE INCREASES IN THE 1990S Potential Effects on Taxable Income Slemrod (1990, 1995) suggests that, through changes in the timing of transactions and through rearrangement of household portfolios, taxpayers can still be very responsive to changes in tax rates even if they do not respond in ways that affect the level of economic activity, such as through changes in labor supply or saving. For example, faced with an increase in tax rates, higher-income taxpayers, in particular, may be able to change their reported taxable income by increasing the share of compensation that is paid in the form of tax-free or tax-deferred fringe benefits (such as health insurance, pensions, or company perks), converting ordinary income to capital gains, substituting tax-exempt bonds for taxable bonds or growth assets for dividend-producing assets, and increasing spending on tax-deductible items such as charitable contributions or home mortgage interest. Thus, even though a substantial body of empirical evidence suggests that overall hours of work are not very sensitive to wage rates, and hence to changes in marginal tax rates, taxable income may still be very sensitive to changes in tax rates. 1 Evidence 1 from Cross Sections Feenberg and Poterba (1993) found evidence of a significant jump in the share of income received by the top one-half 1 percent of taxpayers following TRA 86. The share of AGI going to that group rose from 8 percent in 1985 to 12 percent in 1988, before declining to 11 percent in Moreover, they found that most of the increased share of income for the highest-income taxpayers was even more concentrated among a smaller subset of taxpayers the top one-quarter of one percent. They concluded that the rapid growth in reported incomes at very high income levels may not be part of a general trend toward a widening distribution of income, but may reflect other factors, including a tax-reform-induced change in the share of economic income that is reported as taxable income. Those results came, in part, from using a current law definition of AGI that reflected the changes in the tax base enacted in TRA 86 the elimination of the partial exclusion for capital gains, in particular, would tend to show an increase in incomes for higher-income taxpayers. Slemrod (1996) found a smaller but still substantial change in the high-income share when he recalculated Feenberg and Poterba s results using a 2 constant definition of AGI that was not affected by the changes made in TRA 86. He further tested the hypothesis that the 2 high-income share responds to changes in tax rates by regressing the share of income received by the top onehalf percent of taxpayers on their tax rate relative to the tax rate for the rest of the taxpaying population, the maximum tax rate on capital gains, and a measure of overall dispersion in income, for the period He found that, for a regression of the wage and salary share that excluded the years , the income dispersion variable was the dominant factor, while the tax rate variable was not statistically significant. When the years were included in the regression, however, the tax variable was an important and statistically significant factor in explaining the higher share of income going to the top one-half percent. Evidence from Panel Data Feldstein (1995) used a panel of tax returns to study the issue of taxpayers response to changes in marginal tax rates following TRA 86. He grouped people by the marginal tax rates they 685

4 TIOL TAX JOURL VOL. L NO. 3 faced in 1985, and then compared the changes in income to the changes in marginal tax rates between 1985 and 1988 within those groups. He estimated elasticities of reported taxable income with respect to changes in the net-oftax rate by comparing the groups to each other. For each pair of groups in the comparison, he assumed that income would have changed proportionally if there had been no behavioral responses to changes in marginal tax rates, and thus calculated an elasticity as the ratio of the differences in the percentage change in income to the differences in the percentage change in the net-of-tax rate. Those estimates produced an elasticity of taxable income with respect to the change in the marginal tax rate of between 1.00 and A more recent study by Auten and Carroll (1994) found similar results after making several improvements to Feldstein s methodology. 2 First, they used 1989 instead of 1988 as the comparison year. Because 1988 was the first year of the permanently lower TRA 86 tax rates for individuals, taxpayers had an incentive to push income forward into 1988 (other than capital gains), which would tend to overstate the size of the increase in income before and after TRA 86. Second, they substantially increased the sample size by augmenting the panel data used by Feldstein. Third, the authors estimated regression equations to control for some observed demographic and economic differences among taxpayers, that could explain differences in income growth. Theses changes reduced the estimated elasticity of taxable income with respect to the net-of-tax rate. The estimates, however, still suggested that the change in the tax rate had a sizable and statistically significant effect on the change in reported income. Although not part of the estimated regression equations, Auten and Carroll reported that attempting to control for demandside influences by including variables such as occupation and region tended to reduce the estimated elasticities. Competing Explanations for Unequal Income Growth A fundamental objection to these studies is they do not adequately control for the many factors, other than tax changes, that have influenced the shape of the income distribution over the sample period. There have been many attempts to measure and explain the increases in income inequality that occurred over the past 20 years. A number of researchers have focused on changing demographic factors such as the increasing labor force participation of women and the changing age and demographic structure of families, although these factors do not seem to explain much of the change in the dispersion of family incomes. 3 Others have looked at labor market factors to try to explain the disparity in earnings growth, investigating influences such as increased international trade, technological change that favors those with more education, and changes in the strength of unions as explanations of why wages of highly skilled workers increased relative to wages of low-skilled workers during the 1980s. 4 Special factors may apply to the most highly paid workers. The 1980s saw an increase in the salaries of superstars in many professions, where payments to outstanding performers far exceeded the compensation of others in the profession. 5 The Effect of Other Features of TRA 86 A second problem with the existing studies is the difficulty of disentangling the response of taxpayers to lower marginal tax rates from their response 686

5 TAXPAYERS RESPONSE TO THE RATE INCREASES IN THE 1990S to other features of tax reform. TRA 86 was a complex change in the tax structure for both individuals and corporations. In addition to reducing marginal tax rates, TRA 86 attempted to broaden the tax base and eliminate many tax shelter opportunities. These changes were likely to have caused shifts in the way taxpayers received and reported income. For example, the restriction on passive losses is likely to have increased reported income from partnerships. The reduction in the top individual income tax rate below the corporate tax rate, together with other tightening in corporate tax rules, is likely to have influenced the well-documented increase in reported income from S- corporations. Fullerton (1996) suggests that perhaps it was these structural changes rather than the response to lower tax rates that may have boosted the reported incomes of high-income taxpayers, and thus accounted for the effects found by Slemrod (1996). In this paper, we look at the response of taxpayers to the tax rate increases enacted in OBRA 90 and OBRA 93. Those increases were mostly confined to higherincome taxpayers, which is where we focus our attention. In some ways, the OBRA 90 and OBRA 93 increases offer a cleaner test of the response to changes in tax rates. Because the trend toward increased dispersion in overall incomes seems to have continued through the early part of the 1990s, any reduction in the income of high-income taxpayers could not be attributable to the same forces shaping the overall income distribution. Finally, neither Act made significant changes to the overall tax structure. THE OBRA 90 AND OBRA 93 TAX INCREASES OBRA 90 increased federal income, payroll, and excise taxes, with the last accounting for about half of the projected additional revenues. The Act increased income taxes for upperincome taxpayers through three provisions: a higher top tax rate, a revised phaseout of personal exemptions, and a limit on itemized deductions. OBRA 90 added a new phaseout of personal exemptions starting above an AGI floor. The phaseout began at AGI of $150,000 for joint filers ($100,000 for single filers) and proceeded at a rate of two percent per additional $2,500 of AGI. Itemized deductions were reduced by 3 percent of the amount by which a taxpayer s AGI exceeded $100,000, up to a maximum reduction of 80 percent of the originally allowable deductions. Deductions for medical expenses, casualty and theft losses, and investment interest were not subject to the reduction. The Act also raised the alternative minimum tax rate from 21 to 24 percent and increased the maximum taxable wages subject to the 1.45 percent tax for Hospital Insurance (Part A of Medicare) from $53,400 to $125,000 for Increases in income tax rates for highincome taxpayers were the largest single revenue item in OBRA 93, accounting for $115 billion of the projected $241 billion in additional revenues between 1994 and OBRA 93 added new tax rate brackets of 36 and 39.6 percent, increased the tax rate and exemption amount for the alternative minimum tax, and made permanent the limitation on itemized deductions and the personal exemption phaseout. OBRA 93 also eliminated the wage cap for the Hospital Insurance (HI) payroll tax, raising the tax rate on earnings for workers whose earnings were above the previous wage cap. 687

6 TIOL TAX JOURL VOL. L NO. 3 The Act also greatly expanded the earned income tax credit (EITC) for lowincome workers, increased the maximum taxable percentage of Social Security benefits from 50 to 85 percent for middle- and upper-income beneficiaries, reduced the deductible portion of business meals and entertainment expenses, increased the top corporate income tax rate to 35 percent, and raised the motor fuels excise tax. Changes in Marginal Tax Rates Under the provisions of TRA 86, taxpayers faced a statutory marginal tax rate of either 15 or 28 percent. Because the benefits of the 15 percent tax bracket and personal exemptions were phased out by means of a 5 percent surtax on taxable income above a floor, however, the marginal tax rate on taxable income in the phase-out range was increased from 28 to 33 percent. For income above the phase-out range, the marginal tax rate was 28 percent. OBRA 90 repealed the surtax and imposed a statutory rate of 31 percent on all income (except capital gains) above limits virtually identical to the beginning of the old phase-out range. It also imposed new and, at the time, temporary phase-outs of personal exemptions and itemized deductions, which raised marginal tax rates by about one to two percentage points in the phase-out range. Most taxpayers were unaffected by the rate changes and remained in either the 15 or 28 percent bracket. Those in the old phase-out range facing an effective marginal tax rate of 33 percent saw their rate fall to 31 percent, but with the new phase-out of exemptions and deductions, they were left with nearly the same marginal tax rate as before. Higher-income taxpayers, with incomes above the phase-out range, saw their marginal tax rate increase from 28 to 31 percent. The increase in the taxable maximum for the HI payroll tax added another 1.45 percentage points to the marginal tax rate on earnings 2.9 percentage points counting both the employee and employer portion of the tax for earnings in the newly taxable range. OBRA 93 further increased marginal tax rates for high-income taxpayers. The new income tax brackets of 36 and 39.6 percent together with the limitation on itemized deductions, the phase-out of personal exemptions, and the removal of the HI payroll tax wage cap raised marginal tax rates on earnings from about 31 to about 42 percent for the highest-income taxpayers. The Act increased the differential between the rate on gains and the rate on other income by keeping the tax rate on capital gains capped at 28 percent, although rates slightly above that applied because of the phaseouts. Changes in marginal tax rates on earnings for other taxpayers were much smaller. Marginal tax rates for taxpayers with AGI between $100,000 and $200,000 a portion of whom were affected by the higher income tax rates saw their marginal tax rate on earnings rise from 32 to 34 percent. The small number of Social Security beneficiaries with earnings whose income placed them in the phase-in range for the higher taxation of benefits saw substantial increases in marginal tax rates on earnings. 6 Is There Evidence of a Substantial Response to OBRA 93 by High-Income Taxpayers? In a recent paper, Feldstein and Feenberg (1996) calculated that taxable income for high-income taxpayers in 1993 (those with incomes over 688

7 TAXPAYERS RESPONSE TO THE RATE INCREASES IN THE 1990S $200,000) was less than it would have been if their taxable income had grown at the same rate between 1992 and 1993 as taxable income in the next highest income group (those with incomes between $50,000 and $200,000). Because OBRA 93 did not increase tax rates for most taxpayers in the second highest income group, they postulated that this result provided evidence of a long-term behavioral response by high-income taxpayers to OBRA 93. Based on this finding, they concluded that OBRA 93 raised less than half the revenues expected from the tax increases for high-income taxpayers. Changes in Income Dispersion after 1989 A relative decline in income for the highest-income taxpayers in 1993 would not be attributable to the same forces that have shaped the overall income distribution after The trend toward greater dispersion in income that prevailed during the 1980s appeared to have come to an end by Census data from the Current Population Survey show that the share of income received by both the top 20 percent (incomes in excess of $65,124 in 1995) and the top 5 percent of families (incomes in excess of $113,000 in 1995) peaked at 46.8 and 18.9 percent, respectively, in By 1991, those shares had declined to 46.5 and 18.1 percent, not a very large change but notable as the first time either share had fallen since In the recovery that followed the recession, however, the share for both the top 20 percent and the top 5 percent began to climb. Although the percentages are not comparable before and after 1992 because of major changes in the way in which the Census collects and processes the data, they do suggest increasing income dispersion from 1991 through 1994, with some leveling off by All in the Timing? There is evidence, however, that suggests that a drop in expected taxable income for the highest income group could have been a short-term response to the expected change in tax rates, rather than a permanent effect. By the end of 1992, high-income taxpayers had good reason to anticipate that taxes would increase in 1993 following the presidential election. The simplest method to avoid some of the tax increase would have been to accelerate January 1993 bonus payments into December Other possible strategies included exercising stock options at the end of 1992 or postponing charitable contributions until All of these activities would have raised taxable income in 1992 and reduced it in Quarterly wage data from the National Income and Product accounts are consistent with a shift of roughly $20 billion of wages from the first quarter of 1993 to the fourth quarter of This shift alone could account for most of the apparent decline in taxable income for the highest income group, although this was offset somewhat by a smaller shift from the first quarter of 1994 to the last quarter of 1993 to avoid the higher HI payroll taxes that went into effect in Evidence from monthly Treasury data on withheld taxes is also consistent with a shift of income from the first quarter of 1993 to the last quarter of Evidence from Recent Cross Sections of Tax Returns We first investigate whether there has been any shift in the share of income 689

8 TIOL TAX JOURL VOL. L NO. 3 reported by the highest-income taxpayers coincident with the OBRA 90 and OBRA 93 tax changes by looking at cross-sectional tax return data. We look at the share of income reported by approximately the one percent of taxpayers with the highest incomes in For comparison purposes, we include the same calculation for We start with tabulations of returns from the IRS master files for 1995, the most recent available data. Those data classify tax returns by the level of AGI. To find comparable groups of taxpayers in prior years, we take the number of tax returns in each income group in 1995 and index that number backward by the growth in the adult population to find the equivalent fraction of tax returns in previous years. We use the growth rate in the adult population rather than the growth rate in the number of returns to control for changes in the number of returns filed each year that may be related to changes in the tax law. Thus, for example, the master file data for 1995 show that there were million returns with AGIs of $200,000 or more just over 1 percent of total returns filed in that year. We deflate that number by the growth rate in the population between 1994 and 1995 to find the equivalent number of taxpayers in the top one percent of the population in Because the growth rate in the number of returns has closely followed the growth rate in the population in recent years, the share of returns is very close to one percent in all years from 1989 through We use the definition of AGI that applied in 1995 in all years. For years prior to 1993, we recalculate the portion of Social Security benefits included in AGI according to the OBRA 93 rules. For 1990 and 1989, we also add back the portion of passive losses that were deductible in those years. For 1985, we recompute AGI by adding back excluded capital gains, two-earner and IRA deductions, and passive losses, along with other adjustments. The share of AGI reported by the top one percent of taxpayers does indeed decline both in 1991 and 1993 following the OBRA 90 and OBRA 93 tax increases (Figure 1). However, the onehalf percentage point decline in 1993 was preceded by a more than one percentage point increase in This pattern is consistent with the type of income shifting from 1993 to 1992 discussed earlier, but also may reflect the rebound from the recession in The decline in the income share from 1992 to 1993 is almost completely recouped by The share for the highest income group stayed about constant between 1993 and 1994 before increasing by more than one-half percentage point in Realized capital gains are a particularly volatile source of income and tend to be concentrated among higher-income taxpayers. Thus, it is useful to follow trends in income over time without regard to capital gains. The share of AGI less realized gains reported by highestincome taxpayers tends to follow the same pattern as their share of AGI, except that the decline between 1992 and 1993 is somewhat more pronounced (Figure 1). Realized gains were particularly strong in 1993, increasing by about 18 percent from their level in 1992, measured in constant dollars. Recall that, in addition to incentives to shift income from 1993 to 1992, highincome taxpayers also had an incentive to shift income taxable as wages to capital gains, because of the increase in the difference between the tax rate on wages and the tax rate on gains. 690

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10 TIOL TAX JOURL VOL. L NO. 3 Changes in income shares for any particular group reflect changes in income for other groups. To compare changes in reported incomes across different income groups, we look at the change in average AGI less gains relative to the average in 1989, all in 1995 dollars (Figure 2). The middle-income group represents the approximately 19 percent of taxpayers with income below the top 1 percent (taxpayers with income of $50,000 $200,000 in 1995), with the remaining 80 percent of taxpayers collected in the lowest-income group (taxpayers with income of less than $50,000 in 1995). A few simple observations emerge. Clearly, there is much more year-to-year volatility in the average income for the highest-income group, but, aside from 1990, the direction of changes is the same for the three income groups in each year. While other income groups experienced small declines in average income in 1991 and 1993, and small increases in 1992, 1994, and 1995, their average income did not drop nearly as much as the highest-income groups, nor did they have a significant increase in average income in Finally, despite the year-to-year fluctuations, average income for the highest-income group grew significantly more between 1989 and 1995 than for the rest of the population of taxpayers. Decomposing the Cross-Sectional Changes What is behind the year-to-year changes in average income for the highestincome group? The data suggest that changes in wage and salary income are the most important factor. Earnings accounted for 87 percent of the increase in AGI excluding capital gains between 1991 and 1992 and 63 percent of the decrease from 1992 to 1993 (Table 1). Although average earnings declined further in 1994, that decline was more than offset by an increase in other sources of income. Average earnings surged again in 1995, accounting for 97 percent of the increase in income in that year. The dominant role of changes in wage and salary income contrasts with the findings reported by Slemrod (1996) for the increase in the income of the top one percent of taxpayers between 1984 and Earnings were an important part of the income shift for high-income taxpayers, but they were not the overwhelming factor. Over that period, the increase in wage and salary income accounted for about 44 percent of the total increase in AGI. Increases in income from small business corporations (S-corporations) and partnerships were also important, accounting for 17 and 15 percent of the increase. Average earnings in 1992 for the top one percent of taxpayers were almost ten percent above their 1989 level, measured in constant dollars (Figure 3). Although average earnings fell in 1993 and 1994, by 1995, they had risen to eight percent above average earnings in In contrast, average earnings for other groups were fairly flat, declining in 1990 and 1991 and rising slightly from 1993 through Thus, neither the sharp increase in average earnings for the top group in 1992 nor the drop in 1993 and 1994 was shared by other income groups. Neither, it appears, was the large increase in Despite the volatility in average earnings, the composition of income for the top one percent of returns was not very different in 1995 than it had been in Earnings were 72 percent of AGI excluding capital gains income by the end of the period compared with

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12 TIOL TAX JOURL VOL. L NO. 3 TABLE 1 CHANGE IN CONSTANT LAW AVERAGE AGI REPORTED BY THE TOP ONE PERCENT OF RETURNS, BY TYPE OF INCOME (1995 DOLLARS) Average in Change from Prior Year AGI AGI less gains 495, ,029 20,200 10,029 47,377 26,115 46,706 40,221 17,365 25,846 4,113 3,766 37,849 20,044 Capital gains Interest Dividends Pensions Other 258, ,638 47,063 36,545 36,509 10,006 6,820 30,229 2,335 2,031 1,383 6,191 16,797 21,262 6,334 4,868 4,748 6,632 35,037 6,485 8,786 1,392 2,815 12,549 16,258 8,481 5,160 2, , ,731 14,089 19,369 17,805 4,662 3, ,312 Share of Change in AGI from Prior Year (Percent) Capital gains Interest Dividends Pensions Other Capital gains Interest Dividends Pensions Other Share of Change in AGI Less Gains from Prior Year (Percent) Source: 1995 Master File Tabulations and Congressional Budget Office Tabulations of the Individual SOIs. percent at the beginning (Table 2). The only noticeable change in the composition of income was a decline in the share of income from interest and dividends, possibly a reflection of a different set of taxpayers in the highestincome groups by the end of the period, but more likely the result of declining interest rates and dividend payouts. Preliminary Results from the 1985 Sales of Capital Assets Panel While the cross-sectional data can provide an overall picture of what has happened to the highest-income group over time, it does not necessarily tell the story of what has happened to the highest-income taxpayers over time, since, in any given year, the population of taxpayers in the highest-income group changes. In order to follow the same taxpayers over time, we use a panel of taxpayers from the 1985-based Sales of Capital Assets Study. This panel follows a subset of returns in the 1985 Statistics of Income (SOI) cross section forward over time. The latest available data for the panel are for tax year There were 102 million returns filed in The SOI cross-sectional sample contained 121,000 returns, and the panel we use is a subsample of the SOI with approximately 13,000 returns. We restrict our analysis to the set of returns for which the panel contains a return for each year from 1985 through 1994, a sample of roughly 8,000 taxpayers. The results from the panel strictly hold only for the set of taxpayers who filed returns in 1985 and all years through

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14 TIOL TAX JOURL VOL. L NO. 3 TABLE 2 SHARE OF CONSTANT LAW AVERAGE AGI REPORTED BY THE TOP ONE PERCENT OF RETURNS, BY TYPE OF INCOME (1995 DOLLARS) AGI AGI less gains , , , , , ,942 Average , , , , , , , ,128 Capital gains Interest Dividends Pensions Other 258, ,638 47,063 36,545 36,509 10, ,737 96,409 44,728 34,514 37,892 3, ,941 75,147 38,394 29,647 33,144 2, ,977 81,632 29,607 28,254 35,959 15, ,720 90,112 24,448 25,503 35,246 14, ,599 90,459 23,690 25,789 32,516 28, , ,265 28,352 29,337 32,294 21,178 Share of AGI (percent) Capital gains Interest Dividends Pensions Other Capital gains Interest Dividends Pensions Other Share of AGI less gains (percent) Source: 1995 Master File Tabulations and Congressional Budget Office Tabulations of the Individual SOIs A Closer Look at Those Affected by the Rate Changes Thus far we have looked at income changes for those at the top end of the distribution, not all of whom would have experienced the same OBRA 90 and OBRA 93 rate changes. Moreover, a number of other taxpayers with incomes below the cutoff for the highest-income group also saw an increase in marginal tax rates. With the panel, we can look more closely at those taxpayers affected by the rate changes. Figure 4 shows changes in average AGI (excluding gains) from 1989 for taxpayers at different marginal tax rates. Taxpayers are classified by their marginal rates under the OBRA 93 tax schedule based on the average of their taxable income between 1989 and (We consider alternative ways of grouping taxpayers in Appendix A.) We exclude taxpayers who were age 62 or over by 1994 to eliminate the effects of retirement on the results, although the patterns are very similar in the full sample to those reported for taxpayers under age 62. (Appendix B shows the sample size for the full sample and for those under age 62 in each marginal tax rate category.) Classified in this manner, taxpayers in the top bracket those whose tax rate increased to 31 percent following OBRA 90 and 39.6 percent following OBRA 93 show a similar pattern to the highincome group in the cross section. Income fell sharply in 1991, rose in 1992, and then declined in What is different, however, is that income continued to fall in Recall that, in the cross-sectional data, incomes for the highest-income group grew from

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16 TIOL TAX JOURL VOL. L NO. 3 to 1994, and then increased rapidly in As we will see, the decline in income for the highest marginal tax rate group in the panel is attributable to a decline in average earnings, a result consistent with the cross-sectional data. In contrast to taxpayers in the top bracket, taxpayers whose marginal tax rate increased from 31 to 36 percent following OBRA 93 show average income generally rising from Average income for those taxpayers also increased sharply in 1992, rising about 15 percent above their average income in 1989, but declined only modestly in Although not facing a decrease in the net-of-tax rate as large as the 12 percent reduction for those in the 39.6 percent bracket, these taxpayers also saw their net-of-tax rate fall by about 7 percent between 1992 and Decomposing the Panel Changes Table 3 breaks down the change in AGI from 1989 through 1994 for the 39.6 percent marginal rate group in the same way as Table 1 did for the highestincome group in the SOI cross section. Consistent with the results from the cross-sectional data, changes in earnings explain much of the year-to-year change in income for this group, TABLE 3 CHANGE IN CONSTANT LAW AGI REPORTED BY RETURNS IN THE 39.6 PERCENT BRACKET, AGE LESS THAN 62 IN 1994, BY TYPE OF INCOME (1995 DOLLARS) AGI AGI less gains Average in , , ,154 44, ,566 59,877 Change from Prior Year , , ,246 46, ,551 30,380 Capital gains Interest Dividends Schedule C income Schedule E income Pensions Other 406,074 54,308 46,774 16,080 35, , ,271 4,407 19,117 3,664 1,366 2,123 30, ,531 27,216 4,689 5, ,838 26, , ,983 32,881 5,754 3, ,904 1,080 2,155 26,216 57,828 6,834 4,146 3,773 7, ,618 73,892 24,171 3,231 7,059 1,396 30, ,521 Share of Change in AGI from Prior Year (Percent) Capital gains Interest Dividends Schedule C income Schedule E income Pensions Other Capital gains Interest Dividends Schedule C income Schedule E income Pensions Other Share of Change in AGI less Gains from Prior Year (Percent) Source: Congressional Budget Office Tabulations of the 1985 based SOCA Panel

17 TAXPAYERS RESPONSE TO THE RATE INCREASES IN THE 1990S 699

18 TIOL TAX JOURL VOL. L NO. 3 TABLE 4 CHANGE IN AVERAGE WAGES FOR RETURNS IN THE 39.6 PERCENT BRACKET RANKED BY 1994 WAGE DIVIDED BY AVERAGE WAGES (1995 DOLLARS) Quartile First Second Third Fourth All Share of Returns (Percent) Average , , , , ,241 Average , , , , ,505 Share of Share of Source: Congressional Budget Office Tabulations of the 1985 based SOCA Panel Wage Divided by Average (Person Weighted) Wage Divided by Average (Weighted by Average Wage) although changes in income reported on Schedule E (partnership, small business corporation, rent, royalty, and estate and gift income) were also important. Earnings accounted for 84 percent of the increase in noncapital gains income between 1991 and 1992 and for 56 percent of the decrease in income between 1992 and Schedule C income follows a similar pattern to that for earnings, except for 1992, when Schedule C income declined while earnings rose sharply. Schedule E income rose in all years except Changes in average earnings follow the same pattern observed in the crosssectional data, although the year-to-year fluctuations for the highest marginal tax rate group are more pronounced (Figure 5). Average earnings in 1992 for the top marginal rate group were 20 percent above the average wage in 1989, measured in constant 1995 dollars. Average earnings fell from 1992 to 1993, but were still well above the 1989 average in that year. Average earnings for taxpayers in the 36 percent bracket also increased sharply in 1992 and fell in Their average wage was up in 1994, however, compared to a decline in the 1994 average wage for the highest-income group. A smaller fraction of earnings of taxpayers in the 36 percent bracket would have been subject to the increase in HI taxes that took effect in How Uniform Are Changes Within a Class? The analysis thus far has grouped all taxpayers facing the same change in marginal tax rates together and then has followed the change in average income of the group over time. There is a wide range of changes in income within each marginal rate group, however. We explored the distribution of changes in earnings for the subset of returns whose marginal tax rate increased to 39.6 percent. The returns in the 39.6 percent marginal rate group were ranked according to the ratio of their 1994 earnings to their average earnings between 1989 and This analysis only included returns with wage income present in each year. Table 4 shows the distribution of changes in wage income, measured in constant 1995 dollars. The ratio of 1994 average earnings to average earnings is 0.95 for the entire 39.6 percent marginal rate group. That is, overall 1994 earnings were five percent 700

19 TAXPAYERS RESPONSE TO THE RATE INCREASES IN THE 1990S below average earnings for the period. The ratios vary within the 39.6 marginal rate group, however. The average ratio for the 25 percent of returns with the smallest ratio was 0.36, while the top 25 percent of returns with the biggest change in average earnings had an average ratio of about 2.5. Interestingly, if the sample is weighted by population weights rather than by earnings, the mean ratio of 1994 earnings to the average is greater than one. Thus, in the sample, more taxpayers in the top marginal rate group saw an increase in their earnings, even though average total earnings fell. The distribution of ratios suggests that a model explaining the change in income as a function of changes in marginal tax rates will need to account for the wide range of income changes for taxpayers facing the same marginal rate. Conclusions Changes in income for taxpayers facing the greatest increase in marginal tax rates are consistent with a response to both the anticipated and actual OBRA 93 rate increases. This is particularly true for income from wages and salaries. Earnings in 1992 were well above the average for prior years in both the cross section and the panel for taxpayers affected by the rate changes. Taxpayers unaffected by the rate changes did not have a similar increase in earnings. Income from wages and salaries for the highest-income group fell sharply from 1992 to 1993, and by a lesser amount in Evidence from the cross section shows that the post-obra 93 decline in income was reversed in We wait to see if this trend is confirmed when panel data for 1995 become available. We would stress that the evidence presented here is merely suggestive, and, without a better understanding of how earnings for higher-income taxpayers are determined, it is difficult to generalize from these results the potential effect of future tax changes. ENDNOTES The views expressed here do not necessarily reflect the opinions of the Congressional Budget Office. We would like to thank Len Burman, Richard Kasten, Rosemary Marcuss, Diane Lim Rogers, and John Sabelhaus for helpful comments, and Sean Schofield for helping to compile the data. 1 These results are summarized in U.S. Congressional Budget Office (1996). 2 Slemrod (1996) discusses some important caveats to Feldstein s results. 3 See Gottschalk and Danziger (1993). 4 See Levy and Murnane (1992). 5 See the discussion in Levy (1995). 6 Because OBRA 93 increased both the rate at which the EITC increased with additional earnings and the rate at which it phased out when income exceeded certain amounts, some workers eligible for the EITC saw an increase in the marginal tax rate on earnings, while others saw a decrease. On average, the changes were small, but tended to increase marginal tax rates. Marginal tax rates on earnings for taxpayers with incomes below $30,000 not all of whom were eligible for the EITC increased by about one percentage point. See U.S. Congressional Budget Office (1994) for a discussion of the revenue provisions of OBRA 93 and their effects on marginal tax rates. 7 See U.S. Bureau of the Census (1996). 8 See Parcell (1995). 9 This follows the procedure used by Feenberg and Poterba (1993) and McCubbin and Scheuren (1988). 10 Most of the taxpayers in this group faced a tax rate of 28 percent prior to OBRA 90. Some of them were in the TRA 86 phase-out range, and thus faced a marginal tax rate of 33 percent, but they represent a relatively small fraction of the returns and dollars included here. REFERENCES Auten, Gerald, and Robert Carroll. Behavior of the Affluent and the 1986 Tax Reform Act. In Proceedings of the Eighty-Seventh Annual Conference on Taxation. Columbus: National Tax Association Tax Institute of America,

20 TIOL TAX JOURL VOL. L NO. 3 Feenberg, Daniel, and James Poterba. Income Inequality and the Incomes of Very High Income Taxpayers: Evidence from Tax Returns. In Tax Policy and the Economy, volume 7, edited by James Poterba. Cambridge, MA: MIT Press, Feldstein, Martin. The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act. Journal of Political Economy 103 No. 3 (June, 1995): Feldstein, Martin, and Daniel Feenberg. The Effect of Increased Tax Rates on Taxable Income and Economic Efficiency: A Preliminary Analysis of the 1993 Tax Rate Increases. In Tax Policy and the Economy, volume 10, edited by James Poterba. Cambridge, MA: MIT Press, Fullerton, Don. Comment on High-Income Families and the Tax Changes of the 1980s: The Anatomy of Behavioral Response. In Empirical Foundations of Household Taxation, edited by Martin Feldstein and James M. Poterba. Chicago: The University of Chicago Press, Gottschalk, Peter, and Sheldon Danziger. Family Structure, Family Size, and Family Income: Accounting for Changes in the Economic Well-Being of Children, In Uneven Tides: Rising Inequality in America, edited by Sheldon Danziger and Peter Gottschalk. New York: Russell Sage Foundation, Levy, Frank. Income and Income Inequality. In State of the Union. America in the 1990s Volume One: Economic Trends, edited by Reynolds Farley. New York: Russell Sage Foundation, Levy, Frank, and Richard S. Murnane. U.S. Earnings Levels and Earnings Inequality: A Review of Recent Trends and Proposed Explanations. Journal of Economic Literature 30 No. 3 (September, 1992): McCubbin, Janet, and Fritz Scheuren. Individual Income Tax Structures and Average Tax Rates: Tax Years Statistics of Income Bulletin, volume 8 (Winter, ): Parcell, Ann D. Income Shifting in Response to Higher Tax Rates: The Effects of OBRA 93. U.S. Treasury Department, Office of Tax Analysis, Slemrod, Joel. The Economic Impact of the Tax Reform Act of In Do Taxes Matter? The Impact of the Tax Reform Act of 1986, edited by Joel Slemrod. Cambridge, MA: The MIT Press, Slemrod, Joel. A General Model of the Behavioral Response to Taxation. University of Michigan. Mimeo, Slemrod, Joel. High-Income Families and the Tax Changes of the 1980s: The Anatomy of Behavioral Response. In Empirical Foundations of Household Taxation, edited by Martin Feldstein and James M. Poterba. Chicago: University of Chicago Press, U.S. Bureau of the Census. Money Income in the United States: 1995 (With Separate Data on Valuation of Noncash Benefits). Current Population Reports, P60-193, Table B-3. Washington, D.C.: Government Printing Office, U.S. Congressional Budget Office. An Economic Analysis of the Revenue Provisions of OBRA 93. Washington, D.C., January, U.S. Congressional Budget Office. Labor Supply and Taxes. Washington, D.C., January, APPENDIX A: THE EFFECT OF CLASSIFYING TAXPAYERS BY DIFFERENT MEASURES OF TAXABLE INCOME In this paper, we classify taxpayers on the basis of their average taxable income over the period in order to compare the changes in wages for groups at different marginal tax rates. Because taxpayers can move across different rate brackets over time from normal year-to-year fluctuations in income, or in response to changes in marginal tax rates, no single classification can accurately characterize the set of taxpayers facing a particular change in marginal tax rates. In this Appendix, we present two alternatives to classifying taxpayers by average taxable income the method used in the paper. One alternative classifies taxpayers on the basis of their 1989 taxable income, and the other according to their 1994 taxable income. The first figure compares the changes in wages from these alternative classifications for taxpayers in the 39.6 percent bracket. The three measures tell a different story for changes in wages for high-income taxpayers. Classified by their 1989 taxable income, average wages in 1994 are lower in every year and only about 70 percent of their 1989 value by 1994 (Figure A1). Classified by their 1994 taxable income, average wages are generally higher, and about 120 percent of their 1989 value in The averaging method in the paper lies between these two alternatives. We have not fully explored the reasons for these differences, but there are several possible explanations. For example, some taxpayers may have had 702