Taxpayer Responses over the Cycle: Evidence from Irish Notches Enda Patrick Hargaden Department of Economics University of Michigan IFS Labour Market Conference March 1, 2016 Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 1 / 51
Introduction and Motivation Why would cyclical variation be interesting? Standard theory shows that the behavioral response optimally determines: 1 Tax rates 2 Extent of redistribution 3 Enforcement levels Should these vary over the cycle? Some have argued a Keynesian cyclicality story on the expenditure side. Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 2 / 51
Introduction and Motivation Why would cyclical variation be interesting? Standard theory shows that the behavioral response optimally determines: 1 Tax rates 2 Extent of redistribution 3 Enforcement levels Should these vary over the cycle? Some have argued a Keynesian cyclicality story on the expenditure side. Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 2 / 51
Introduction and Motivation Which way does cyclical variation swing? Arguments for increase in responsiveness during a recession: If firms are struggling to survive, they may search harder for cost savings With income effects, employees may value a euro more during a recession Arguments for decrease: There may be fewer opportunities to hide income when GDP is smaller It is harder to adjust hours during a recession, by e.g. switching jobs Wage rigidity could be a factor in downturns Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 3 / 51
Introduction and Motivation Which way does cyclical variation swing? Arguments for increase in responsiveness during a recession: If firms are struggling to survive, they may search harder for cost savings With income effects, employees may value a euro more during a recession Arguments for decrease: There may be fewer opportunities to hide income when GDP is smaller It is harder to adjust hours during a recession, by e.g. switching jobs Wage rigidity could be a factor in downturns Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 3 / 51
Introduction and Motivation What does this paper have? Administrative employee tax return data, and a set of notches Unprecedentedly volatile developed economy Insight into “frictions”, i.e. the determinants of reporting tax disadvantaged incomes Focus on the inter-temporal component of taxpayer response A new method ( bunching in differences ) to investigate the responsiveness Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 4 / 51
Introduction and Motivation Preview of Results The evidence of taxpayer response is much weaker during the recession. Pre-2008 ‘treatment effects’ are about three times as large as post-2008. Much of the difference reflects non-random attrition from labor force. ◮ Reduced employment in sectors (e.g. construction) that exhibit above-average ability to report tax-advantaged incomes creates composition effect/composition bias. However, it’s more than just a composition effect. ◮ Holding the labor force constant, people are less responsive to the incentives. Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 5 / 51
Introduction and Motivation Overview of Talk 1 The theory of notches 2 Taxpayer responses and the elasticity of taxable income 3 Data description and introduction to methods 4 Empirical evidence of cyclical variation 5 Determinants of tax avoidance 6 Inverse probability weighting estimates ⋆ Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 6 / 51
Theory of Notches Question: What exactly are notches? Post-tax income Y 1 Y 2 Pre-tax income Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 7 / 51
Theory of Notches Question: What exactly are notches? Post-tax income Y 1 Y 2 Pre-tax income Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 7 / 51
Theory of Notches Question: What exactly are notches? Post-tax income Y 1 Y 2 Pre-tax income Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 7 / 51
Theory of Notches Question: What exactly are notches? Post-tax income Y 1 Y l Y 2 Y u Pre-tax income Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 7 / 51
Theory of Notches Question: What exactly are notches? Post-tax income Strictly dominated region Y 1 Y l Y 2 Y u Pre-tax income Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 7 / 51
Understanding Taxpayer Responses Understanding Taxpayer Responses Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 8 / 51
Understanding Taxpayer Responses Taxpayer Response and Taxable Income Debate over which margin of adjustment: hours, gross income, evasion/avoidance? Feldstein (1995) shifted the focus to taxable income (ETI). Many margins of adjustment, all captured by taxable income. Under certain circumstances, this measures the welfare costs of taxation. Readily available empirical source. Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 9 / 51
Understanding Taxpayer Responses Bunching at notches to identify taxpayer response Notches provide very strong incentives, and clean tests of ability to avoid taxes. Extent of level-bunching can identify ETI (Saez, 2010). The larger the bunching, the larger the ETI. Chetty et al (2011) and Kleven & Waseem (2013) bunching in Denmark and Pakistan. Almunia & Lopez-Rodriguez (2014), Auten & Carroll (1999), Bastani & Selin (2014), Gruber & Saez (2002), Jenderny (2015), Kopczuk & Munroe (2015), Marx (2012), Onji (2009), Ramnath (2013), Sallee & Slemrod (2012), Slemrod et al (2015), Yelowitz (1995). Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 10 / 51
Understanding Taxpayer Responses Slemrod & Kopczuk: ETI as a policy choice ETI is not an immutable parameter. For a cost, we can influence it. Dependence on tax system: compare Denmark and Greece. Increased enforcement will lower responsiveness — ETI can be lowered (at a cost). Subtle point: I find a very low responsiveness for Ireland. Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 11 / 51
Understanding Taxpayer Responses Policy and academic implications of the paper Time-varying responsiveness affects: 1 Optimal enforcement varies with the phase of the cycle: fund HMRC in good times. 2 Stimulus package identification bias. Small aside: tax cuts likely less stimulating than hoped. Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 12 / 51
Understanding Taxpayer Responses Policy and academic implications of the paper Time-varying responsiveness affects: 1 Optimal enforcement varies with the phase of the cycle: fund HMRC in good times. 2 Stimulus package identification bias. Small aside: tax cuts likely less stimulating than hoped. Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 12 / 51
Data Description Data and Empirics Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 13 / 51
Data Description Sample from Universe of Irish Tax Returns I have access to an administrative panel of employee tax returns with demographics and details on their employer. Employers must file an income statement for each employee Dataset is a panel (2006–2013) of 10% of all employees, representative of full sample Demographic information on employee (age, sex, nationality) Some business information on employer (legal form, number of employees, detailed sector) Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 14 / 51
Data Description Trends in the data Earnings distribution in Ireland, 2006-2013 40,000 30,000 Frequency 20,000 10,000 0 20,000 40,000 60,000 80,000 100,000 Total Annual Pay (€) Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 15 / 51
Data Description Trends in the data Irish and US Business Cycles 120 Real Output (2005 Q1=100) 115 110 105 100 2006 2008 2010 2012 2014 Year Ireland USA Sources: Central Statistics Office, FRED Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 16 / 51
Data Description Trends in the data Irish and US Unemployment Rates 15 Unemployment Rate (seasonally adjusted) 12.5 10 7.5 5 2.5 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Ireland USA Sources: Central Statistics Office, BLS Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 17 / 51
Data Description Trends in the data Employment in Ireland 120 Employment by Sector (2006 Q2 = 100) 100 80 60 40 2007 2008 2009 2010 2011 2012 2013 2014 Year Total Non-construction Construction Source: Central Statistics Office/QNHS Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 18 / 51
Data Description Trends in the data Limitation of the data The notches are not applicable to people who are (i) married; (ii) jointly filing; and (iii) both spouses working. Will attenuate results. Likely becomes less of a problem over time. Marriage rate Employment rate Hargaden (University of Michigan) Irish Tax Notches March 1, 2016 19 / 51
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