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How taxpayers will respond to tax changes, and in particular higher tax rates, is often a matter of debate in policy circles. The answer to this question matters primarily because of its implications for tax revenues, but it also has implications for the welfare effects of taxes.
Will raising rates on high-income taxpayers lead to higher revenues? In public finance economics, this question is studied by estimating the elasticity of taxable income (ETI). This elasticity captures the changes in reported taxable incomes as tax rates change. It is perhaps not surprising that existing research finds that this elasticity is much higher near the top of the income distribution, as higher-income taxpayers expend greater resources on reducing their tax burdens. In a new National Bureau of Economic Research working paper, we evaluate this elasticity by focusing on corporate executives and how their compensation responds to tax rates.
Over the last several decades, there has been dramatic growth in executive compensation, largely through the growth of stock options and other incentive-based pay. In an earlier paper, we find that this change in the form of executive compensation can be linked to tax changes. For example, Section 162(m) of the Internal Revenue Code, enacted in 1993, limited the tax deductibility of any non-performance-based pay over $1 million. This made cash compensation relatively more heavily taxed than stock options, which are inherently performance-based.
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But in general, there are other advantages to equity-based compensation as well, such as the ability to avoid being taxed in high tax years — when they are subject to top marginal tax rates. By substituting away from cash (salary) toward equity-based compensation, executives can defer taxation on their income in high tax years because equity-based compensation is taxed only when realized (such as through exercise of stock options). If current tax rates are high, then the share of stock options in the compensation package increases significantly, while the share of salary and other cash compensation decreases. This result implies that there are more substantial long-run responses beyond the exercising of stock options documented in earlier papers.
These types of responses of taxable income can be thought of as income-shifting responses. In other words, executives respond to anticipated tax rates by shifting income to periods of lower tax burdens. In addition to income shifting responses, executives may also have “real” responses in terms of reduced labor supply, both at the extensive and intensive margins. In this new paper, we use measured differences between the tax rates on current and deferred income to estimate ETI and decompose the total elasticity into real responses (reductions in total reported income due to a reduction in labor supply) and income shifting across tax bases and over time. Decomposing this overall response, we find that much of the behavioral response to taxation comes from the income shifting response, rather than the real response.
Finally, we assess how our ETI estimates, which account for income shifting, change our understanding of the change in welfare from a change in the tax rate relative to the welfare effects using traditional estimates of the ETI, which do not distinguish between real responses and income shifting. Accounting for income shifting implies that the reduction in welfare from an increase in taxes is almost half the size of the reduction in welfare implied by ETI without accounting for income shifting, because some of the income shows up in later periods.
At the time of writing this paper, the Tax Cuts and Jobs Act has been passed, which removes the exemption for incentive-based pay under the old Section 162(m), effective as of 2018. The new rule extends the $1 million deduction limit to all pay, including stock options, severance benefits and deferred compensation. Over the course of the next several years, it will be interesting to document the implications of this change on the structure of executive compensation, given that firms no longer have a tax advantage to paying out compensation as stock options, although executives can still benefit from the option of being able to defer income and taxation.
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