Estimating the Gains from Wage and Capital Income Tax Cuts

Abstract

Niels Kleis Frederiksen examines the effects of the broad reductions in the labour income taxation undertaken in many industrialised countries in order to enhance labour force participation. He aims at evaluating whether these tax cuts are likely to lead to supply side adjustments which can justify the fiscal cost. Drawing from the literature on the marginal cost of public funds, the author outlines a methodology that allows to compare the effects of different policy options. The key insight is that the efficiency impact of a tax change is equal to the change in net revenue resulting from the behavioural response and can be measured by a “revenue recovery ratio” (the fraction of the initial revenue loss that is offset by behavioural changes). The paper focuses on the choice between wage and capital income tax cuts. The results suggest that policy makers should devote more attention to reforming capital income taxation rather than implementing across-the-board cuts in labour income taxes. Once behavioural responses are taken into account, the size of the fiscal externalities generated by lowering capital income taxes may be relevant. This is due to the large dimensions of the tax bases affected this category of taxation (household savings, business capital formation, residential housing investment and pension/life insurance asset accumulation). The result is independent of the international tax competition arguments.