People’s interaction with the tax system is one of the most fundamental aspects of economic life. A large empirical literature studies people’s reactions to tax policy, with recent increased interest in how people understand, reason and learn tax code (Saez et al. 2012, Bernheim and Taubinsky 2018, Stantcheva 2021). Several articles emphasize the role of learned skills, such as nurturing and peer-to-peer transmission of information, but less is known about the role of innate traits and unlearned skills.
In a new study (Bastani and Waldenström 2021), we analyze whether individuals with different cognitive abilities react differently to a large and salient discontinuity in the Swedish marginal tax rate schedule (an increase in the marginal tax rate of 20 points percentage). Our data come from population administrative records on taxable income and cognitive abilities of military enlistment at age 18.
People with high potential react better to taxes
Figure 1 captures a fascinating stylized pattern. Ranking taxpayers by their taxable income relative to elbow location, we observe a statistically significant clustering in the income distribution (left panel) and a simultaneous spike in mean cognitive ability at the elbow (right panel ). In other words, smart people are more likely to group at the kink.
Figure 1 Grouping and average cognitive ability at the income tax knee point
To note: Taxable income in 2012-2016 in tranches of thousands of Swedish kronor (EUR/SEK=10).
To examine whether there are systematic differences in tax responses across ability levels, we divide the population into ten equally sized deciles of cognitive ability (from the lowest 1 decile to the highest 10 decile), and then estimate clustering within each capability decile.
Figure 2 reveals that people in the higher cognitive ability deciles tend to be more sensitive to income tax. Ability decile 10 has an excess mass at the knee point that is twice as high as in the general population and almost three times higher than in the lowest ability decile. The increase is almost monotonous. We call this model the fiscal responsiveness capacity gradient at the breaking point and it is the main conclusion of our study.
Figure 2 The capability gradient in fiscal responsiveness
To note: Excess mass and 95% confidence intervals (+/- 1.96 times the standard error, bootstrap with 500 repetitions) at the knee point estimated separately for each decile of the distribution of male cognitive abilities (for all males from our main sample) and for labor income earned between 2012 and 2016 (grouped data). The dotted line represents the estimated (mean) clustering in the overall male population
Income transfer among the high-potential self-employed
How can we explain this capacity gradient in fiscal responsiveness? We begin by dividing wage earners into salaried and self-employed, distinguishing between incorporated and unincorporated business owners. Figure 3 reveals a slight tendency for a capability gradient among employees, which, as we show in the article, is partly determined by labor supply responses. More significantly, however, we find a clear gradient among incorporated business owners, but no ability gradient among the unincorporated self-employed (even though they are the most clustered, as shown by estimates high excess mass).
What explains the steep ability gradient among incorporated business owners? A key distinction between these groups is that corporate owners can reclassify some of their highly taxed labor income as less taxed capital income. Moreover, the incentive to reclassify income increases discontinuously at the breaking point due to the sharp increase in the marginal income tax rate (capital income is taxed at a proportional rate). Our analysis shows that high-potential incorporated business owners who cluster neck and neck are much more likely than high-potential unincorporated business owners to have significant capital income, which suggests that income transfer is the main explanation for the ability gradient in tax responsiveness among auto-entrepreneurs. -employee.
picture 3 Capacity gradients among employees and self-employed
Men have a stronger ability gradient than women
We also investigate whether there are gender differences in the ability gradient. Since we do not observe women in military tests, we use high school GPA as an indicator of cognitive ability. Figure 4 shows that there is no ability gradient for women, while the ability gradient for men is still visible when using this alternative measure of cognitive ability. Closer examination reveals that this finding is not driven by gender differences in self-employment.
Figure 4 Ability gradients in males and females
Conclusions and policy implications
Our study is one of the first to document that individuals with high cognitive ability respond more strongly to tax incentives than individuals with low ability, suggesting an ability gradient in tax responsiveness. Our empirical analysis links cognitive abilities measured at age 18 to recorded earnings 20 to 50 years later, highlighting the importance of skills acquired before entering the labor market for taxpayer behavior and the relevance these skills throughout working life.
The results highlight a fundamental conflict in tax design. Governments want to tax people with high potential more and people with high elasticity less. However, if high-potential individuals are also high-elastic individuals, the effectiveness of using progressive taxation of labor income to achieve ability-based redistribution may be questioned.
An important lesson for policymakers is that taxes on labor and labor capital must be carefully calibrated to achieve desired distributional goals, especially in the context of dual tax systems. Our article points out that the Achilles’ heel of complex tax systems with ambitious distributional targets is that they invite high-potential individuals to avoid the progressiveness of the tax code through careful tax planning. More generally, generous opportunities for tax avoidance can harm the long-term legitimacy of the tax system and affect tax compliance and social standards (e.g., Slemrod et al. 2019, Sarin and Summers 2020, De Neve et al. 2021).
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