Reductions in the Top Marginal Income Tax Rate from the Tax Reform Act of 1986

The Tax Reform Act of 1986 lowered the top marginal income tax rate rate from 50% to 28%. Auten and Carroll (1999) use a difference-in-difference design to estimate the effect of the reform on taxable income. They estimate an elasticity of taxable income with respect to the after-tax keep rate of 0.57.

MVPF SUMMARY

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Hendren and Sprung-Keyser (2020) translate this into an implied MVPF of the 1986 top tax rate reform. They arrive at an MVPF that is quite high, but note the statistical imprecision of the estimates lead them to be unable to reject a confidence interval that includes an MVPF near 1 and an MVPF near infinity.

To compute the MVPF, they use the equation

where

where

is the Pareto Parameter of the income distribution and

is the elasticity of taxable income with respect to the keep rate, 1-t. Throughout, Hendren and Sprung-Keyser (2020) measure t as the sum of the federal income tax rate and a 5% state income tax rate assumption. In practice, the reforms are discrete changes in tax rates, t. To account for this, Hendren and Sprung-Keyser (2020) compute the fiscal externality above separately for the pre- and post-reform tax rates, and then take an average of the two FEs. Appendix F of Hendren and Sprung-Keyser (2020) provides further details and references.

The key additional parameter beyond the elasticity of taxable income is the Pareto parameter of the income distribution. Atkinson et al. (2011) find a value of 2 for 1986. Combining with the elasticity of taxable income of 0.57 implies an MVPF of 44.27, with a wide confidence interval of [1.037,\infty]. This means Hendren and Sprung-Keyser (2020) cannot reject a null hypothesis of an MVPF close to 1, nor an infinite MPVF.