Introduction
Massachusetts voters will determine in November whether the state constitution should be changed to change the state’s flat rate individual income tax system to a graduated rate system by imposing a 4% surtax on income exceeding $1 million. The issue before Massachusetts voters is substantial, having far-reaching repercussions for the state’s economy.
So yet, most of the focus has been on the expected $2 billion in revenue that the surtax will create. The potential economic consequences of the surtax, on the other hand, have received less attention. This absence is particularly noteworthy because the surtax on the November ballot differs from other tax bills in that, if enacted, any changes to the new 9 percent top marginal rate will necessitate a constitutional amendment, which can take years to complete. In other words, if policymakers misread people’s reactions or the tax hike has unanticipated economic implications, it might take years to alter the rate or reassess the policy, and the damage could be long-lasting—even if the policy is reversed, but especially if it isn’t. As a result, it is in both politicians’ and voters’ best interests to be fully educated about the measure’s potential consequences.
While there is limited literature on the transition of an individual income tax system from a flat rate (where everyone pays the same proportion of their taxable income) to a progressive rate (where higher earners pay a larger percentage of their income than lower earners), many more studies have looked at the relationship between various income tax measures and their macroeconomic impact (Gross Domestic Product, unemployment rates, levels of private investment, etc.). The academic literature on the relationship between the macroeconomy, taxes, and people’ behavioural responses to rate cuts or increases in the United States and overseas is summarised in this study. We find substantial evidence to support the notion that moving from a flat to a graduated income tax system, and from a lower to a higher marginal rate, has a negative impact on economic growth.
Interestingly, several of the research cited in this study were done using national income tax data. However, this does not rule out the conclusions of the studies being applicable at the state level. Many of the studies, in fact, indirectly look at the impact of taxes on relatively closed economies—those where production components are confined within a country’s boundaries. Subnational economies, in contrast to national economies, are significantly more open. Because it is considerably simpler to avoid the effects of a specific state policy by transferring labour or capital to another state, it is logical to suppose that the empirical findings of a national study could be exacerbated at the state level.
Individual income taxes cause spatial migration and innovation output reactions that stifle the return on innovation, with high earners being more sensitive to higher rates.
Review of the Literature
Gentry and Hubbard (2002) investigated the chances of upward mobility under a more progressive tax structure. The authors looked at the chance of switching to a better job in the face of increasing tax rates and greater tax rate progressivity in particular. The authors of the study look at data from the University of Michigan’s Panel Study of Income Dynamics (PSID), a longitudinal study undertaken every year. A longitudinal research varies from regular surveys in that it questions the same people every year for a long time. The PSID is used by Gentry and Hubbard to determine whether respondents will relocate to a “better job” in the future year. The respondent’s definition of a better job is left to their discretion, but it is commonly believed to be one that offers a promotion or higher income. From 1979 through 1993, the authors looked at national PSID answers.
The authors used TAXSIM, a tax modelling programme from the National Bureau of Economic Research, to develop their measurements of tax variables, such as a household’s expected future marginal tax rate and the progressivity (or convexity) of a tax system. The study takes into account federal and state income tax payments, as well as the federal and state governments’ varying marginal income tax rates.
The baseline results were concerned with the possibility of an employed head of home moving to a better position in the coming year. Gentry and Hubbard discovered that for every percentage point reduction in the marginal tax rate, the likelihood of an employed male head of household moving to a better job in the following year increased by 0.158 percentage points. In other words, a “five-percentage-point reduction in the marginal tax rate boosts the probability of switching to a better job by 0.79 percentage points,” according to the authors. The average likelihood of changing jobs was 9.87 percent. As a result, a five-percentage-point reduction in the marginal tax rate increased the inclination to relocate by 8%. Female heads of home were significantly more likely (8 percent more likely) to relocate to a better job in the subsequent year under the same conditions. The impact of marginal tax rates on the chance of switching to a better job was shown to be highly statistically significant.
Gentry and Hubbard discovered that every percentage point decrease in their measure of tax structure convexity increased the probability of shifting to a better job by 0.277 percentage points. “In terms of economic importance,” the authors write, “this estimate implies that a one-standard-deviation decrease in the marginal tax convexity measure (3.12 percentage points) would raise the turnover propensity by 0.86 percentage points.” A drop in the average progressivity of a tax system leads to an 8.71 percent rise in the probability of moving to a better job when applied to the average inclination to move to a better job.
Finally, the analysis discovered evidence of a statistically significant link between wage growth and tax progressivity. The authors found that lowering tax convexity by one percentage point boosted the three-year real growth rate in wages from 9.1 percent to 10.5 percent.
Feldstein and Wrobel (1998) investigated whether state and local governments can redistribute income effectively through taxation and transfers. Their findings back with the economic theory that, in the long term (under perfect mobility), an individual’s pretax wages adapt to equalise his or her after-tax real income across all jurisdictions. When people realise their after-tax income is higher in another jurisdiction, they relocate to locations where their real net earnings are higher. Although there are no perfect mobility conditions (though mobility has certainly improved post-pandemic), Feldstein and Wrobel uncover real-world impacts that closely match the stylised theory.
The authors’ findings backed up the hypothesis that more progressive state tax arrangements can’t promote long-term income redistribution. Migration raises the pretax real incomes of high earners while lowering the pretax real incomes of lower earners in jurisdictions where high earners are taxed more heavily.
A more progressive tax system, rather than achieving long-term income redistribution, confuses economic decisions and lowers total real earnings. A change in a state’s tax structure’s progressivity encourages migration and alters resource distribution within the state. Firms are driven to reduce the number of higher paying positions and increase the number of lower paying ones as pretax incomes of highly skilled persons rise and wages of low skilled individuals decline.
The point estimates of Feldstein and Wrobel are a little sloppy, but they show a rapid adjustment of gross earnings to changes in the progressivity of state and local tax systems in the 1980s. They conclude that because “individuals can avoid unfavourable taxes by migrating to jurisdictions that offer more favourable tax conditions, a relatively unfavourable tax will cause affected individuals to migrate out until the gross wage for their skill level is raised to a level at which the resulting net wage is equal to that available elsewhere,” “a relatively unfavourable tax will cause affected individuals to migrate out until the gross wage for their skill level is raised to a level at which the resulting net wage is equal to Furthermore, because salaries react quickly to changing tax settings, data suggests that states cannot redistribute income for more than a few years.
Exogenous tax changes—those motivated by causes other than economic stabilization—and economic growth are studied by Romer and Romer (2010). The authors defined a tax change as any action “that really changed tax liabilities from one quarter to the next” for the purposes of the study. To account for endogenous factors that could influence tax rates and economic conditions at the same time, Romer and Romer ruled out solutions that would return the economy to normal growth. Only exogenous motivations—policy rationales that were less likely to effect rates and economic production at the same time, such as the reduction of inherited debt, long-term economic growth, or ideology—were examined by the authors.
The authors were able to assess the impacts of tax adjustments on the economy without the influence of confounding variables that could disguise or exaggerate the impact of the policy change by adjusting for endogenous tax changes. The authors examined the narrative record of tax proposals from the executive and legislative arms of the federal government between 1947 and 2006 in order to identify these tax changes, and then utilised their findings to filter empirical data for statistical testing. The authors came to the conclusion that “tax hikes are very contractionary,” blaming the negative impact on the economy on the considerable negative impact of tax increases on investment.
After three years, an exogenous tax increase of 1% of GDP resulted in a 3 percent fall in GDP, according to the study (12 quarters). A decline in personal consumption expenditures and private domestic investment was blamed for much of the GDP drop. The authors discovered that increasing taxes by 1% of GDP results in a two-year drop in personal consumption expenditures and private domestic investment. Personal consumption expenditures were anticipated to fall by 2.6 percent nine quarters after the adjustment. Similarly, private domestic investment was predicted to have fallen by 12.6 percent ten quarters after the tax rise.
The relationship between income tax progressivity and gross production was investigated by Rhee (2012). The author’s research was prompted by his observation that theory alone cannot predict whether tax system progressivity will result in increased income equality. According to him, the issue must be empirical because the relationship is a function of income distribution, labour supply elasticity of various income groups, migration, and the tendency to save or consume, among other factors.
Between 1979 and 2004, Rhee looked at the average tax rate and progressivity of the individual income tax in each state in the US. Rhee (2012) determined that there was no statistically significant contemporaneous association between average tax rate and growth after looking at each state’s average tax rate, income tax progressivity, and output. In the same year, there was no statistically significant link between progressivity and output growth rate.
The author wondered if the progressiveness of a tax system could have a delayed effect on output. Because companies, employees, and consumers may take time to digest changes in the tax system, the impact of a tax may take several years to manifest in a person’s behaviour. According to Rhee’s statistical research, the lagged progressivity index and gross state product growth rate have a strong negative association. Economically and statistically, the relationship is considerable. Individuals’ responses to the changing tax system increase the absolute value of the negative connection for three years of progressivity lag, after which continued adjustments lessen.
Finally, the author considered whether migration had an effect on the change in gross state product described earlier. There was no substantial association between a state’s net migration rate and its average tax rate or progressivity index, according to Rhee. The relationship between an income group’s migration and a state’s tax progressivity was not investigated. Net migration rate data, according to Rhee, may conceal an offsetting effect. To put it another way, states with highly progressive tax regimes may see out-migration of high-income people offset by in-migration of lower-income people. Other migration studies have found that high-rate progressive taxes had the biggest impact on high-earners’ location decisions, particularly for entrepreneurs, who are the most susceptible to higher tax rates.
Cloyne (2013) expanded on Romer and Romer (2010)’s work by examining the narrative record of tax changes in the United Kingdom from 1955 to 2009. Cloyne, like Romer and Romer, adjusted for endogenous tax changes and only looked at exogenous tax changes—those unrelated to rate changes and macroeconomic output. The author’s main finding is that a one-percentage-point reduction in taxes as a percentage of GDP improves GDP by 0.6 percent within a quarter of the tax adjustment, and by 2.5 percent after three years.
Cloyne also looked at the impact of tax cuts on household spending and investment, and discovered that his findings were comparable to Romer and Romer’s (2010). A 1% reduction in tax rates as a percentage of GDP results in a 1.3 percent increase in consumption one quarter after the policy change. Two years following the tax shock, the highest impact on consumption is a 2.9 percent change. In terms of investment, a 1% reduction in tax rates as a percentage of GDP increased investment by 1.2 percent on average. Investment climbed by 4.6 percent on average two years after the tax change.
The impact of a similar one-percentage-point tax change on the labour market is also examined in the study. Cloyne discovered that the actual salary changed significantly over time, with a 1.2 percent increase on impact and a 3.3 percent increase after 11 quarters.
Mertens and Olea (2013, 2017) examine the connection between federal marginal individual income tax rates and earnings. They wanted to know “to what extent do marginal tax rates affect individual work and investment decisions?” Mertens and Olea discovered that the incomes of those in the top 1% of the income distribution respond the most to changes in tax rates. The scientists also discovered that lower-income earners’ incomes respond to changes in tax rates, albeit with less vigour than the top 1%. Nonwage income (from S corporations, partnerships, sole proprietorships, rents, dividends and interest, and realised capital gains) is particularly tax-sensitive.
Mertens and Olea also discovered that lower marginal tax rates resulted in higher real gross domestic product and lower unemployment rates. The number of total hours worked increased when marginal tax rates were reduced. This was attributable to the employment of previously unemployed individuals (by a large margin) as well as an increase in the number of hours worked by those who were already working (the intensive margin).
The writers made a point about the difference between average and marginal tax rates and how they affect real economic activity. Even if the overall tax rate remains constant, increases in marginal tax rates result in approximately proportional income responses, according to their findings. They found little evidence, on the other hand, that earnings change when average tax rates fall but marginal rates remain unchanged.
Finally, the authors calculated the impact of tax reforms that lowered average marginal tax rates (AMTR)[1] just for the top 1% or bottom 99 percent of the income distribution. They discovered that lowering the AMTR for the top 1% leads to higher real GDP, reduced overall unemployment, a favourable effect on earnings in the bottom 99 percent, and more income disparity in the near run.
Mertens and Olea discovered that a 1% reduction in the AMTR of the top 1% resulted in a 0.26 percent rise in real GDP in the first quarter and 0.30 percent increase in the first year. One year following the modification, the unemployment rate fell by 0.17 percentage points as a result of the same average rate cut. Similarly, a 1% reduction in the AMTR of the top 1% of income earners resulted in a 1.51 percent gain in income for same group within a quarter. Within the first year, the rate of income increase had risen to 1.57 percent.
The benefits of a tax cut for the top 1% of incomes, on the other hand, were not limited to the top 1% of earners. “Average incomes of the poorest 99 [percent] climb by 0.23 [percent] on impact and by up to 0.44 [percent] the following year,” the authors write.
Marginal rate decreases that exclusively benefited the bottom 99 percent of the population resulted in increased aggregate economic growth, individual income growth, and a fall in the unemployment rate. Those advantages, however, took several years to manifest. Whereas a targeted AMTR cut for the top 1% resulted in quick growth in aggregate economic activity, a targeted AMTR cut for the bottom 99 percent resulted in virtually no change in real GDP for the majority of the following year. Real GDP began to rise in the second year and peaked at 1.63 percent by the third year. Similarly, incomes of the poorest 99 percent showed little change in the short run, but three and four years after the projected AMTR drop, they plateaued at 2.1 percent increase. The unemployment rate followed a similar pattern, with minimal change in the first year but a 0.53 percentage point drop in the third.
Mertens and Ravn (2013) examined the influence of changes in the average federal individual income tax rate and the average federal business income tax rate on gross domestic product between 1947 and 2006 using a narrative research similar to Romer and Romer (2010). Using the narrative record to detect tax shocks, as in earlier studies, helps control for endogenous effects, which occur when observed tax obligations and observed GDP influence each other at the same time. The authors also made steps to account for the impact of changes in individual income taxes on changes in corporate income taxes, as well as the other way around. Previously, narrative studies focused exclusively on exogenous changes affecting total tax collections, whereas this study looked on the relationship between GDP and various types of taxes.
Mertens and Ravn discovered that the average personal income tax rate (APITR) and real GDP per capita have a negative connection. “A one-percentage-point reduction in the APITR resulted in an increase in real GDP per capita of 1.4 percent on impact and up to 1.8 percent after three quarters,” according to the study. A change in individual income tax rates that results in a 1% loss in tax revenue leads to a 2.5 percent gain in GDP, according to the multiplicative effect on the economy.
Changes in the APITR also enhance employment, cut unemployment, and increase hours worked per worker, according to the authors. In specifically, a 1% drop in the APITR is linked to a 0.3 percent rise in employment per capita in the first quarter, which is statistically significant. The growth in employment peaked at 0.8 percent five quarters after the tax cut. The number of hours worked per worker grew significantly as well, increasing by 0.4 percent in the first quarter following the tax cut. For the first year, the gain was consistently favourable. The unemployment rate declined 0.3 percent within a quarter of the tax cut and 0.5 percent within a year, indicating that those already in the labour force were able to find work. Despite the short-term improvements in employment and unemployment rates, the labour force participation rate did not change statistically significantly.
Mertens and Ravn also discovered an increase in private sector investment and a boost in private consumption. Durable goods consumption climbed by a statistically significant 3.6 percent within one quarter and 5 percent within two quarters in response to a one-percentage-point drop in the APITR, and stayed at that level for another two quarters before becoming statistically insignificant. Within one quarter of the tax decrease, the identical one percentage point cut resulted in a statistically significant 2.1 percent rise in private nonresidential investment. Within a year of the average rate drop, the rise had grown to 4%.
“If reasonably rapid job creation is a policy goal, drops in the personal income tax rate are probably the best fiscal weapon,” the authors found. Raising personal income taxes, on the other hand, is effective if the goal of tax policy change is to increase revenue. However, the cost of increased revenue is a significant loss of jobs and GDP.
On econometric grounds, Jentsch and Lunsford (2018) questioned the validity of Mertens and Ravn’s conclusions. They were sceptical if Mertens and Ravn (2013) performed the appropriate statistical tests to arrive at their conclusions in 2013. (referenced earlier). Jentsch and Lunsford were particularly concerned by Mertens and Ravn’s estimated 95 percent confidence intervals. [2] They offered a new test for Mertens and Ravn’s data, concluding that “changes in personal and corporate tax rates had no inferable influence on output, investment, employment, hours worked per worker, or the unemployment rate.”
Mertens and Ravn (2019) examined Jentsch and Lunsford’s (2018) work and noted Mertens and Ravn’s worry about the statistical test they used (2013). The authors, on the other hand, did not agree with Jentsch and Lunsford (2018)’s finding that tax cuts have no inferable effect on economic activity once a valid statistical inference approach is used.
The authors determined that their earlier results kept their statistical significance with just a small loss of precision after reanalyzing their earlier work with a range of statistically valid methods.
From 1973 through 2003, Nguyen, Onnis, and Rossi (2021) looked at the effects of changes in consumption and income (individual and corporation) taxes on income, private consumption, and investment in the United Kingdom. To create a proxy measure for tax shocks, the authors used narrative analysis. This method, like narrative analyses before it, helped adjust for endogenous variables.
Changes in income taxes, according to Nguyen et al., have “big significant, and lasting [impact] on output, private consumption, and investment” in the near run. If the average income tax rate were decreased by one percentage point, GDP would increase by 0.78 percent in the quarter after the tax reform. GDP climbed by 1.5 percent four quarters after the income tax cut. Private investment climbed by 2.7 percent in the first quarter following a one-percentage-point reduction in the average income tax rate. The full impact of tax cuts was realised in the fourth quarter, when private investment grew by 4.6 percent on average. Household private consumption climbed by 1.2 percent in the quarter following a one-percentage-point reduction in the average income tax rate. The peak change in total private consumption occurred four quarters after the income tax cut, at 1.6 percent. Changes in consumption tax rates had a little but not insignificant impact on the same variables.
Akcigit et al. (2018) looked into the effects of state and federal taxes on innovation, as well as where inventors decided to live and which organisations they opted to join. The authors used a dataset from 1920 to the turn of the century that tracked inventors, innovations, inventors’ employers, average weekly earnings, patent values, tax rates, and other variables. The empirical research “provides a sense of how enterprises and investors respond to the net return to innovation, rather than just tax rates, which are a component of that economic calculation,” according to the authors.
Personal and corporate income taxes have strong negative effects on how much innovation occurs at the state level, as measured by the number of patents filed and the number of inventors living in the state, according to the authors.
Individual income taxes, according to Akcigit et al., have a large negative impact on the likelihood of owning a patent. Taxes also influenced the likelihood of an inventor developing a highly cited patent or one that generates significant revenue for the company. In addition, inventors are much less inclined to settle in jurisdictions with higher taxes. Unlike corporate inventors, who are solely concerned with the company income tax, independent inventors are concerned with both the corporate and personal income taxes. Furthermore, the individual income tax stimulates both geographic mobility and innovative output.
Conclusion
The aforementioned studies represent a fair representation of academic research on the effects of income tax changes and the progressivity of the income tax system on individual behaviour and the broader economy. The research differ in breadth and scale, but they all agree that tax changes have a considerable impact on people’s behaviour. They also show that tax increases can bring in more income for the government, but at the expense of citizens’ economic progress and mobility. Tax cuts, on the other hand, tend to result in short-term revenue reductions while boosting long-term economic growth.
It should be emphasised that many of the above-mentioned research’ findings were interpreted in the context of a tax cut. The coefficients of interest could, however, be interpreted in terms of a tax increase due to the structure of the statistical models used in the investigations. In that instance, the interpretation would take on a whole different meaning. Similarly to how income tax reductions tend to boost particular economic activities, tax hikes have the opposite impact.
Gentry and Hubbard (2002), for example, may be rephrased as follows: a 5% rise in the marginal tax rate reduces the likelihood of switching to a better job by 0.79 percentage points from a baseline of 9.87 percent. As a result, a 5% rise in the marginal tax rate would reduce the likelihood of moving by 8%.
These findings are relevant to the current debate over the progressive income tax amendment to Massachusetts’ constitution, which is on the November ballot. The surtax may bring in additional money for the government, but the research analysed in this study imply that the effect will be short-lived and come at a cost. Voters should not overlook the policy’s potential for negative economic feedback when they weigh their position on the income tax amendment. Trade-offs abound, as these studies demonstrate. The effects of tax increases affect the entire economy and are not limited to those who pay a higher tax rate.
Learn more: Why FDI Matters for U.S. Employment, Wages, and Productivity