Tax Reform and Automatic Stabilization

Syracuse University Center for Policy Research Working Paper No. 21

50 Pages Posted: 13 Apr 2011

See all articles by Thomas J. Kniesner

Thomas J. Kniesner

Claremont Graduate University - Department of Economic Sciences; Syracuse University - Department of Economics; IZA

James P. Ziliak

University of Kentucky - Department of Economics

Date Written: January 1, 2001

Abstract

A fundamental property of a progressive income tax is that it provides implicit insurance against shocks to income by dampening the variability of disposable income and consumption. The Economic Recovery Tax Act of 1981 (ERTA) in combination with the Tax Reform Act of 1986 (TRA86) greatly reduced the number of marginal tax brackets and the maximum marginal rate, which limits the stabilizing effect of the tax system on household consumption when pre-tax income fluctuates. We examine the effect of the federal income tax reforms of the 1980s on the associated degree of automatic stabilization of consumption. The empirical framework derives from the consumption insurance literature, where the ideal outcome is spatially equal changes in households’ marginal utilities of consumption, and permits partial insurance, which we use to identify how the degree of consumption insurance has changed since ERTA and TRA86. Our data come from interview years 1980–1991 in the anel Study of Income Dynamics. We find that in certain cases the tax reforms of the 1980s actually increased the automatic stabilization inherent in the United States income tax. Overall, ERTA and TRA86 reduced consumption stability by about 50 percent. More recent tax reforms, most notably increased EITC generosity, have restored or enhanced consumption insurance. A welfare analysis indicates that the cost of moving to the post-TRA86 system is sizable for relatively risk averse households facing large income risk, but is much more modest for the typical household.

JEL Classification: H21

Suggested Citation

Kniesner, Thomas J. and Ziliak, James P., Tax Reform and Automatic Stabilization (January 1, 2001). Syracuse University Center for Policy Research Working Paper No. 21. Available at SSRN: https://ssrn.com/abstract=1808041 or http://dx.doi.org/10.2139/ssrn.1808041

Thomas J. Kniesner (Contact Author)

Claremont Graduate University - Department of Economic Sciences ( email )

Claremont, CA 91711
United States

Syracuse University - Department of Economics ( email )

Syracuse, NY 13244-1020
United States

IZA

P.O. Box 7240
Bonn, D-53072
Germany

James P. Ziliak

University of Kentucky - Department of Economics ( email )

Lexington, KY 40506
United States

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