The Effect of Base-Broadening Measures on Labor Supply and Investment: Considerations for Tax Reform

Summary

One source of interest in a tax reform that broadens the base and lowers the rate is the potential increase in growth, as labor supply and investment respond to lower marginal tax rates. Yet, studies of a signature reform in the past, the Tax Reform Act of 1986, found little effect on growth. The act was revenue and distributionally neutral, which is a goal of some recent tax reform proposals. One reason advanced for the limited effects on growth is that the effects of provisions that broaden the base to finance lower statutory rates increase effective marginal tax rates for some taxpayers.

This report shows how options to broaden the tax base by placing limitations on itemized deductions can potentially work counter to the growth effects of reducing marginal tax rates, primarily through reducing labor supply. It also shows how these effects—along with other base-broadening provisions, such as slowing depreciation—limit the effects on investment and savings and can eventually reduce the size of the capital stock in the economy. The effects on labor supply and the capital stock are considered in turn.

To examine the potential effects of base broadening on effective tax rates facing labor, the analysis examines provisions to eliminate itemized deductions for state and local taxes, for charitable contributions, and for both. It also examines provisions to eliminate itemized deductions altogether or to impose dollar caps ($17,000 and $25,000). Eliminating itemized deductions would raise effective marginal tax rates by almost two percentage points on average and is estimated, using common behavioral responses, to reduce labor supply by 0.2% to 0.6%. These effects are significant compared to projected effects in the Tax Reform Act of 2014 (H.R. 1, 113th Congress), where labor supply was projected to increase by 0.4% to 0.8%. More limited restrictions to itemized deductions result in smaller reductions in labor supply.

Similar to the analysis for labor supply, the potential effects of base broadening on effective tax rates for capital investment are examined. The analysis includes two itemized deduction restrictions: disallowing the deduction for state and local taxes and disallowing all itemized deductions. Eliminating these provisions increases the effective marginal tax rate on business income, interest income, dividends, and capital gains. It also included the effects of three provisions that affect how quickly an investment is recovered. One is to move to the alternative depreciation system that forms the baseline for measuring the benefits of accelerated depreciation. The other two provisions are to depreciate two types of intangible investments, research and development and advertising, over a 10-year period. The analysis also considered repeal of the production activities deduction (which allows a 9% deduction from taxable income for certain domestic production, such as manufacturing) and indexation of interest deductions and payments for inflation.

Moving to the alternative depreciation system had the greatest effect, reducing the long-run capital stock (using a range of behavioral responses) by 0.8% to 1.6%. It more than offset the effect of a 10 percentage point corporate rate reduction. Indexing interest deductions and payments for inflation had the next largest effect, 0.5% to 1.1%. Repealing itemized deductions for state and local taxes reduced the capital stock by 0.1% to 0.2%, and repealing all itemized deductions reduced it by 0.1% to 0.3%. Repealing all itemized deductions offset about a third of the effect of reducing the statutory corporate tax rate by 10 percentage points.

An inevitable characteristic of a revenue-neutral tax reform is a tendency to balance out positive and negative effects on labor supply and growth. Revenue-neutral tax reform may have other virtues, but given the inevitable trade-off of such an approach, a major impact on growth may not be one of them.