Germany , elasticity of taxable income , deductions , tax expenditures , sufficient statistic , administrative data
Abstract:
The elasticity of taxable income (ETI) is often interpreted as a sufficient
statistic to assess the welfare costs of taxation. Building on the conceptual
framework of Chetty (2009), we show that this assertion does no longer hold
for tax systems with deduction possibilities if (i) deductions generate externalities
and (ii) deductions are responsive to tax rate changes. While the first
condition should arguably hold for almost any imaginable tax deduction, we
provide a thorough empirical examination of the second condition. Relying
on rich German panel data from administrative tax records, we exploit several
tax reforms that were implemented in Germany between 2001 and 2008. Our
baseline estimates indicate an overall ETI of 0.49 and an elasticity of deductions
with respect to the net-of-tax rate of -2.80. Given that the majority of
deductions in the German income tax system generate externalities, our nonzero
deduction elasticity suggests that the ETI is not sufficient to calculate
the welfare cost of taxation.
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