Tax Buyouts: Raising Government Revenues without Increasing Labor Tax Distortions

Marco Del Negro, Fabrizio Perri, and Fabiano Schivardi*

At a time of increasing fiscal pressures both here and abroad, it seems important to consider ways of raising government revenues without discouraging people from working. This post describes a revenue raising plan—a tax “buyout”—that does just that. The buyout would give you, the taxpayer, the option each year of paying a lump sum to the government in exchange for a given reduction in your marginal tax rate that year. In effect, you would use the lump sum payment to buy yourself a lower marginal tax rate, which would in turn give you more incentive to work. The buyout would be risk free: you wouldn’t have to decide whether to take the buyout until after you know your labor income. Why would this be good for you? If you choose to take it, you end up paying less taxes. If you don’t take it, you are just as well off as before. Why is this good for society? The lower marginal tax rate induces you to work more, so that some of the distortionary effects of taxation would disappear. Furthermore, your participation would be voluntary, so the buyout should be politically palatable.

In our paper, Tax Buyouts in the Journal of Monetary Economics, we study how tax buyouts would work in a model economy in which the price of the buyout cannot depend on workers’ ability because the government cannot observe ability. Despite the information asymmetry, we show that a simple tax buyout can make some households better off (while making none worse off) without lowering total revenues.

At first blush, this result seems counterintuitive: since the government would offer the buyout to everyone, wouldn’t those who have more to gain take the buyout, leading to a revenue loss? The first thing to notice is that with lower marginal tax rates people would work more, leading to an increase in the tax base. If this sounds a bit like “Reaganomics,” that’s because this part of the argument follows the same logic. However, different from “Reaganomics,” our plan involves not just cutting marginal tax rates, but also making people pay for it—in a lump-sum way. Wait, you say, wouldn’t people game the system by taking the buyout precisely when they expect their income to surge? (Commentators in the National Journal webpage raised some of these issues about our paper). Our answer is no. You see, the government would be fully aware that high-ability people, or people expecting promotions, are prone to take advantage of the deal and can price the buyout accordingly. But then wouldn’t keeping the “gamers” out force the government to price the buyout so high that nobody would be interested in it? Not necessarily, as we show in our theoretical model. The extra output that comes from reducing distortionary marginal taxation creates a surplus that the government can share with citizens. Therefore the government can price the buyout high enough to make positive revenues, yet low enough to attract people with high ability and high income prospects.

Actually the idea of tax buyouts is not new at all; it’s related to the idea of letting taxpayers choose among tax schedules that Alesina and Weil and Slemrod et al. studied in a static context. The contribution of our paper is to go beyond very stylized models by quantitatively evaluating the gains from buyouts in a “realistic” dynamic model economy and apply our model to the current fiscal situation. The model allows for different age cohorts and for differences in labor supply, savings rates, earnings, and wealth. It captures a number of important features of reality. In particular, we calibrate the model so that the distribution of wealth and labor earnings matches actual U.S. data for 2006, and the shape of the tax schedule matches the actual U.S. tax code.

Starting from an equilibrium with a fixed amount of government spending financed through a progressive tax income schedule, we introduce an exogenous increase in government spending (capturing the current fiscal situation) of about 20 percent. We then consider two alternative scenarios: with a tax buyout and without. In the scenario without the buyout, we find that balancing the budget requires that taxes rise from roughly 21 percent of total income to 26 percent. The baseline buyout we consider is a reduction in the marginal tax rate of at most 5 percent offered at a price of roughly $4,500, which ensures that revenues would not fall. For example, if you expect to make $100,000 next year, the buyout would save you $5,000 in taxes, for a net savings of $500. With this option, we show that total distortionary taxes would only have to rise to 24.5 percent of income—as opposed to 26 percent—to balance the budget. Distortionary taxes rise less with the buyout because more than 8 percent of the population would participate, generating additional government revenues. This transformation of government revenues from a tax that distorts labor decisions to a lump sum payment that does not is the essence of the tax buyout contract. Indeed, the labor supply effects would lead to levels of GDP almost 1 percent higher than what they would be without the buyout, reducing by approximately one third the negative effect on output of the overall tax increase. Why these relatively large macro effects? Because the buyout takers are generally high-ability agents who contribute the most to GDP. We show that these estimates are fairly stable under alternative assumptions about the elasticity of labor supply or the amount of the tax buyout offered. Interestingly, we show that even the households that do not take the buyout “today” might benefit from it in the future when their wages have increased sufficiently.

So far the buyout looks like a great deal, but there are at least two considerations that deserve attention. First, because the program benefits mostly high earners, it widens income inequality. In principle, however, the government can undo this unappealing feature by pairing the buyout with a redistribution policy (financed by the buyout itself) to assist low earners. Secondly, buyouts become very difficult to implement whenever the gap between (few) very high-ability individuals and the rest of the population is extremely large. Intuitively, the government would never be able to attract any low-income individuals into the buyout without losing huge sums of money from very high-income individuals. In fact, when there are enough households whose earning ability is substantially higher than average (so called “fat tails” of the income distribution), a revenue-neutral buyout simply may not exist: the government always loses more from the very high-ability people than it earns from those who exert more work effort and hence pay more taxes. To overcome this problem, the policymaker may have to introduce a cap to the amount of foregone fiscal revenues from high earners. This cap would obviously reintroduce some of the distortions buyouts are supposed to avoid, but there may be no acceptable alternative.

On the more encouraging side, the buyout idea could be extended in many directions that can further reduce labor disincentives. For example, varying the buyout pricing schedule for individuals of high and low work ability could be beneficial. Moreover, while we assumed the government knew essentially nothing about individuals’ work abilities, in reality the government could use what it does know about ability (education and earnings history, for example) to price the buyout. Third, it seems likely that labor supply elasticity differs among individuals: some people will respond more than others to a 5 percent wage hike. In our quantitative experiments, we assumed the same elasticity for everyone; however, individuals with high elasticity would be more likely to take the buyout, leading to higher participation rates.

*Fabrizio Perri is an associate professor of economics at the University of Minnesota and consultant at the Federal Reserve Bank of Minneapolis; Fabiano Schivardi is a professor at Universita’ di Cagliari and fellow at the Einaudi Institute for Economics and Finance.

Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).