Tax Reform & the Effective vs Marginal Rate Debate: Evidence from New Research

A new tax reform idea was floated in this NYTimes article:

One possible change would tax the entire salary earned by those making more than a certain level — $400,000 or so — at the top rate of 35 percent rather than allowing them to pay lower rates before they reach the target, as is the standard formula.

I’m pretty confident this will be considered, but, as stated, tax liabilities for someone earning $399,999 will increase very sharply if she earns one more dollar. As such, they will probably have to gradually phase this in.

Beyond the politics of it, an implicit idea behind this proposal involves the effective versus marginal rate debate, i.e. do people make decisions based on marginal tax rates (as economists frequently assume) or based on effective tax rates. Koichiro Ito of Stanford has a compelling paper that provides “strong evidence that consumers respond to average price rather than marginal or expected marginal price.”

If distortions and efficiency costs from taxation result from behavioral responses, and average or effective tax rates (rather than marginal tax rates) determine behavior, then the difference in efficiency costs between (1) these proposed tax reforms and (2) increased top marginal rates may not be as big as many people seem to think.