Micro-dynamic Behavioral Responses
As noted previously, the Tax Module accounts for certain behavioral responses for under alternative policy counterfactuals. These responses are consistent with a traditional definition of “conventional” budget estimates (which assume nominal GNP is fixed across counterfactuals) and do not represent shifts in real economic activity, which are handled by PWBM’s dynamic OLG model.
These feedback responses include business income shifting across organizational forms, labor income reclassification, and income shifting across time.
Income Shifting Across Organizational Forms
One distinguishing feature of the Tax Module is the extent of its integration. Because it includes household and business tax calculators in a unified codebase, it can model interactions between the individual income tax code and the corporate tax code that occur when tax policy changes.
One such interaction is business income shifting across organizational form. The decision of how to organize business activity depends on a number of considerations, with tax policy playing a significant role. C corporations face entity-level taxes and its shareholders are subject to payout taxes; pass-through entities do not face entity-level taxes, but owners typically face higher individual rates on distributions and must pay taxes on income in the year that it is earned. Business entity choice is responsive to the gap between the rate the business and its owners would pay under either type of entity. Consequently, the projections for each type of business income growth in the Tax Module are calibrated to reflect this tax rate differential under current law.
When the gap between these rates changes, it follows that some businesses may switch organizational form to minimize tax liability. Empirical research from economists at PWBM confirms this prediction. The Tax Module accounts for this type of income shifting by applying an elasticity to the baseline of business income, which results in a new allocation between C-corporate and pass-through firms.
This shifting affects both the business sector and the household sector in the model. For example, suppose a policy change lowered the corporate tax rate, all else equal. Depending on the magnitude of the rate cut, some amount of Schedule E and Schedule C income moves off of individual income tax returns and onto corporate tax returns to reflect reclassification from pass-through to C-corporate form. Furthermore, over time, corporate distributions from those businesses reappear on individual returns in the form of dividends and capital gains.
Labor Income Reclassification
Differential tax rates across business entity form not only create incentives to re-organize business form; they can create opportunities for taxpayers to reclassify labor income as capital income, or vice versa.
For example, a provision of the 2017 tax act offers lower effective marginal tax rates to certain owners of pass-through businesses. This provision creates an incentive for some high-income wage earners to change their employment status and form a pass-through business. Similarly, if employment taxes were lowered, owners of C corporations may find it beneficial to represent capital income as labor income by shifting payouts away from dividends and towards wages. The Tax Module incorporates this type of behavioral response. We model the number and characteristics of taxpayers switching with careful consideration to IRS regulations and the stickiness of employment contracts.
Income Shifting Across Time
Another key channel through which taxpayers respond to policy changes is the timing of income—namely, choosing when and how frequently to realize capital gains. When capital gains taxes increase, investors may respond by deferring realizations. Under current law, we assume a capital gains realization elasticity of -0.66, taken from empirical research. We also accounts for taxpayer timing of income realization with regards to temporary tax law provisions.