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FORUM ON THE BEHAVIORAL RESPONSE TO TAXATION

ECONOMETRIC ISSUES
IN ESTIMATING THE
BEHAVIORAL RESPONSE
TO TAXATION:
A NONTECHNICAL
INTRODUCTION
ROBERT K. TRIEST

Abstract - Reliable estimates of how tax

incentives affect behavior are an
essential input into the formation of tax
policy. However, one encounters a
number of difficult econometric
problems in estimating the magnitude
of the behavioral effects. This paper
provides a nontechnical introduction to
some of the more prominent problems,
particularly the endogeneity of marginal
tax rates and the problem of identifying
tax effects, and discusses two estimation
techniques used in recent studies:
difference-in-differences and instrumental variables using panel data.

the choice between work and leisure,

the choice of occupation and fringe
benefits, the choice of deferred versus
immediate compensation, the decision
of how much to save and consume, the
decision of how to allocate ones savings
across assets, the decison of whether to
rent or own a house, and the decision
of how much to donate to charity. Both
positive and normative analysis of
taxationeverything from revenue
estimation to social welfare evaluation
depends critically on the magnitude
of the responses. Economic theory
provides a framework for modeling
behavioral responses and understanding
their implications and importance, but
tells us little about the expected
magnitude of the responses and in
some contexts does not even tell us the
direction of the response. The magnitude of behavioral responses is inherently a topic for empirical investigation.

INTRODUCTION
Understanding how individuals, families,
and households adjust their behavior in
response to taxation is one of the most
important tasks facing public finance
economists. Taxation affects many
aspects of individual behavior, including

Unfortunately, econometric analysis of

how behavior responds to taxation is
much like the tax code itself: complex
and often controversial. At any given
moment in time, the marginal tax rate
that an individual faces depends on her

Research Department, Federal Reserve Bank of Boston,

Boston, MA 02106-2076.

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taxable income, which in turn depends

on her economic status and behavior. So
it becomes difficult to disentangle
differences in behavior across individuals, which are induced by taxation, from
those due to other determinants of
behavior. Over time, changes in the tax
code provide an exogenous source of
variation in marginal tax rates, but in
this case, it becomes difficult to disentangle the behavioral effect of tax code
changes from those due to other
changes in the economic environment
occurring at the same time. The purpose
of this paper is to provide a nontechnical discussion of these and other
econometric issues that arise is estimating behavioral responses. I first provide
an overview of the major econometric
problems facing researchers investigating the effect of taxation on behavior,
and then discuss some of the estimation
techniques used in recent studies. The
paper ignores many econometric
problems encountered by applied
researchers in order to focus on the
problems that are largely unique to the
study of the behavioral response to
taxation. A few studies are cited as
examples, but this paper is not meant to
be a review of the literature and the list
of references is far from comprehensive.

cross section of individual tax return

data. Using ordinary least squares (OLS)
to estimate a linear regression of
contributions on individuals federal
marginal tax rates and disposable
incomes would likely result in serious
econometric problems and would not
be an appropriate technique for
estimating the coefficients.
A Fundamental Identification Problem
Perhaps the most serious problem is that
the marginal tax rate is a function of
taxable income. As Feenberg (1987)
points out, identification of the tax
effect in this case depends on our being
sure of the exact way in which income
should enter the econometric specification. If we allow for only a linear income
effect in the specification when, in
truth, contributions vary with the square
(or some other nonlinear function) of
income, then the coefficient on the tax
price will generally be biased. Because
the tax price is a nonlinear function of
taxable income, it will likely be correlated with the omitted nonlinear income
term, producing classical omittedvariable bias. The tax-price coefficient
would be picking up some of the effect
of the nonlinear income effect in this
case.

AN OVERVIEW OF THE ECONOMETRIC

PROBLEMS

In addition to income, tax rates are

strongly influenced by marital status and
the presence of dependent children in
the household, but these factors are
likely to themselves be determinants of
charitable contributions and other taxrelated activities. Feenberg (1987) notes
that, as polynomial and interaction
terms in income and other variables that
determine both charitable contributions
and marginal tax rates are added to the
specification, the tax price will become
nearly collinear with the other variables.
It is in this sense that the tax price
model is identified only through

Taxation often lowers the relative

price of a tax preferred activity. For
example, for someone who itemizes
deductions, the price of giving a dollar
to charity is one minus the individuals
marginal tax rate.1 For simplicity, initially
consider the case where we posit that
an individuals annual contributions to
charity are a linear function of the tax
price (one minus the individuals
marginal tax rate) and after-tax income,
and suppose we wish to estimate the
coefficients of this relationship using a
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functional form assumptions. In

practice, of course, researchers have
little a priori information about what the
functional form of the specification
should be, so this is a serious problem.

be biased due to the influence of the

omitted state effects.
The importance of controlling for the
determinants of state policy formation
depends on the type of policy being
analyzed. In the charitable contributions
case considered by Feenberg (1987), it
seems reasonable that variation over
states in the tax treatment of contributions is largely independent of other
determinants of contributions. However,
in other contexts, this assumption may
be less innocuous. For example, state
variation in welfare program generosity
has been used to identify the effects of
welfare programs on family structure.
Moffitt (1994) and Hoynes (1997) find
that econometric estimates of the effect
of welfare programs on female headship
decisions are very sensitive to controlling
for unobserved state varying determinants of headship decisions, suggesting
that state welfare program generosity is
a function of factors that also affect
headship decisions.

Separately identifying the income and

tax price effects requires that there be
some source of variation in tax rates
that is independent of other explanatory
variables that are in the regression (or
should be in the regression). One source
of variation in tax prices that is plausibly
not a direct determinant of charitable
contributions or other tax-related
activities is state of residence, and this is
the source of Feenbergs (1987) solution
to the identification problem. States
differ considerably in the structure of
their income taxes, and in whether they
impose an income tax at all, so this
provides the needed independent
variation in tax prices.
As Feenberg (1987) notes, two key
assumptions underlie the use of state
taxes for identification: (1) that individuals respond to state taxes in the same
way that they respond to federal taxes,
and (2) that state tax laws are independent of other determinants of the
taxpayers behavior being modeled. The
latter assumption might be problematic
in some contexts. State policies are not
set purely randomly, but instead reflect
the values and circumstances of voters
in each state. These values and circumstances may also directly influence
taxpayers behavior and need to be
controlled for in the econometric
analysis. One can do so by introducing a
set of state-specific dummy variables
into the regression, but doing so
effectively destroys the ability of the
state tax variation to identify the tax
price effect. However, if one does not
control for the state varying factors that
are correlated with their tax policies,
then the estimated tax price effect will

Another potential solution to the

identification problem is to use data
spanning a period of time over which
the tax code changed. In this case, the
tax reforms provide the needed variation
in tax prices. However, some of the
problems involved in using state tax
variation to identify tax effects also
apply in this case. Changes in the
economic environment occurring as the
tax reforms are implemented may
influence the behavior being modeled
and will bias the estimated tax effects
unless controlled for in the regression.
The difference-in-differences methodology discussed later in this paper is
designed to control for nontax effects
that coincide with tax reforms.
When investigating the effect of
taxation on hours of work, identification
of the tax effects may be a less severe
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problem than it is in other cases.

Taxation affects the incentive to work by
reducing taxpayers after-tax wage and
nonearned income. As long as one is
willing to maintain the assumption that
taxation affects hours of work only
through these channels, and does not
affect pretax wages, then one can use
the variation over taxpayers in pretax
wages to identify the tax effects.
However, these assumptions may be
questionable. Remuneration for work
effort comes in the form of current
earnings, fringe benefits, and deferred
compensation, but only current earnings
are typically used in computing the
wage rate used in labor supply regressions. The desired mix of current taxable
earnings and other forms of remuneration is influenced by the structure of the
tax system, and so tax reforms may
affect the observed pretax wage rate.
Partly because of this, some researchers
have elected not to rely on the traditional labor supply specification in
examining how taxation affects hours of
work.2

code. Tax reforms that change avoidance opportunities may change the way
in which behavior responds to marginal
tax rates. The ways in that avoidance
opportunities affect real behavioral
responses to taxation are little understood at present and provide an
important area for future research.
Endogeneity of Marginal Tax Rates
A second important econometric
problem faced by researchers investigating the behavioral effects of taxation is
that the marginal tax rates faced by
taxpayers depend on their own behavior. For example, as a workers hours of
work increase, taxable income will also
increase, and eventually the worker will
shift into a bracket with a higher
marginal tax rate (in the case of a
progressive tax system where marginal
tax rates increase with income). Workers
who work more hours than are typical
of others with the same wage rate,
unearned income, and other characteristics that influence labor supply will also
face higher marginal tax rates than are
typical. As a result, the additive error
term in a labor supply regression will be
positively correlated with the marginal
tax rate, and OLS is a biased estimator
of the coefficients of the regression.
Similar problems result in other taxrelated analyses. For example, as an
individuals charitable contributions
increase, taxable income decreases, and
the individual will eventually drop into a
bracket with a lower marginal tax rate.

Another reason for caution in assuming

that taxation affects hours of work only
through the traditional wage and
income effects is that this ignores the
way in which tax avoidance affects labor
supply decisions. Triest (1992) estimates
a labor supply model in which the tax
price of deductible expenditures (one
minus the marginal tax rate) directly
enters the labor supply specification for
those who itemize deductions and finds
that deductibility has a potentially
important effect on labor supply.
Heckman (1983) and Slemrod (1998a)
provide theoretical models of the labor/
leisure choice that incorporate more
comprehensive forms of tax avoidance.
As Slemrod (1998b) also points out,
behavioral responses to taxation will
generally depend on the avoidance
opportunities permitted under the tax

A commonly adopted solution to the tax

rate endogeneity problem is to use an
instrumental variables estimator. One or
more suitable instruments must be
found that are correlated with the
marginal tax rate, but not correlated
with unobserved determinants of the
behavior being analyzed (the error term
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table contributions, the marginal tax

rate applying to the first dollar of
contributions is often used as an
instrument for the tax price. Because
the rate applying to the first dollar of
contributions does not depend on the
amount that an individual decides to
contribute, it does not bear the same
obvious link to the the value of the
regression error term that the finaldollar tax rate does. However, more
subtle endogeneity problems may still
remain. The first-dollar tax rate depends
on all of the components of taxable
income except the charitable contributions deduction. If the unobserved
determinants of contributions are
correlated with other deductions or
income sources, for example, then the
first-dollar tax rate may itself be
correlated with the unobserved determinants of contributions. Recognizing this
possibility, Feenberg (1987) uses the tax
subsidy rate on contributions (evaluated
over a fixed sample of returns) in the
taxpayers state as an instrument for the
tax price of charitable contributions.
This solves both the endogeneity and
identification problems.

hood estimator rather than two-stage

least squares to reduce the degree of
bias, and also develop methods appropriate for the construction of confidence
intervals when instruments are weak.
Behavior of Taxpayers Facing Nonlinear
Budget Constraints
Complex tax schedules sometimes
create unusual incentives for taxpayer
behavior, which estimation strategies
must take into account. For example,
consider the case of a progressive
income tax with a marginal tax rate
which increases with income in discrete
jumps (as the U.S. system does over
much of its range). A worker who is at a
point where an extra hour of work will
push him into a bracket with a higher
marginal tax rate faces a lower after-tax
wage for that additional hour than he
did for the previous hour. Some workers
who wish to work additional hours at
the higher after-tax wage may not be
willing to work additional hours at the
lower after-tax wage rate. This will tend
to lead to desired hours of work being
more heavily concentrated at the kink
points between tax brackets than they
are elsewhere on workers budget
constraints. A clear example of this is
provided by Burtless and Moffitt (1984),
who show that there was a sharp spike
in the distribution of earnings of Social
Security recipients in the late 1960s near
the amount exempt under the earnings
test. Social Security benefits were
reduced by 50 cents for every dollar
beyond the exempt amount, resulting in
a sharp drop in the after-tax wage rate
at that point.

Researchers need to be concerned with

how strongly correlated their instruments are with the tax price. Bound,
Jaeger, and Baker (1995) show that,
when instruments are only weakly
correlated with an endogenous explanatory variable, even a small correlation
between the instruments and the error
term of the regression can induce a
serious bias in the direction of OLS. In
practice, there is often reason to suspect
some correlation, although perhaps
small, between potential instruments for
the tax price and the regression error
term. If the instruments also explain
little of the variation in the tax price,
then we may need to worry about bias.
Staiger and Stock (1997) suggest using
a limited information maximum likeli-

In some cases, taxation results in the

price of a good decreasing as consumption of it increases. For example, as
consumption of a tax deductible good
increases (starting from a point of no
deductible expenditures), at some point
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it becomes optimal to itemize deductions rather than take the standard

deduction, and the tax price of the
good drops from one to one minus the
marginal tax rate. More familiar
examples come from analysis of how
taxation affects the price of leisure time,
the after-tax wage rate. The Earned
Income Tax Credit results in the effective
marginal tax rate dropping, and the
after-tax wage increasing, as one exits
the claw back region where the credit
is reduced as income increases. So, as a
workers leisure time increases (and
hours of work decrease) just enough so
that he goes from being ineligible for
the credit to being in the claw back
region, the price of leisure decreases.
Economic theory implies that taxpayers
will not find it optimal to locate at such
points. If the taxpayer is at a point
where he or she has willingly bought
the good at a given price, but can now
buy additional units at a lower price, it is
always optimal to do so. This implies
that there will be some region around
such kink points in the budget constraint that individuals will avoid. As
Moffitt (1990) demonstrates, small
changes in tax rates may result in large
changes in individuals behavior in this
case, because taxpayers may be induced
to jump from one side of the nonconvex
kink to the other. If one does not take
this possibility into account in investigating the behavioral effects of taxation,
one might incorrectly infer that the
jump in behavior is the result of a large
tax price elasticity rather than the
nonconvexity in the budget set.

brackets that differ from their utility

maximizing positions. Moreover, by
making explicit the assumptions
regarding the preferences underlying
the behavioral response to taxation, the
methodology allows precise predictions
to be made regarding the changes in
excess burden and behavior that would
result from potential tax reforms.
However, the methodogy has been
criticized for its complexity and strong
assumptions. Heckman (1983) has
criticized it for making overly strong
assumptions regarding researchers
knowledge of the budget constraints
and choice problems facing taxpayers,
and MaCurdy, Green, and Paarsch
(1990) criticize the restrictions on
possible estimated behavioral responses
that it imposes. Recent research has
tended to use less structural methods to
investigate behavioral responses to
taxation, but it is still important to take
into account the nonlinear nature of the
budget constraint in interpreting results
and simulating the effects of potential
tax reforms.
Timing Issues
Slemrod (1995) argues that the behavioral response to taxation can be divided
into three tiers according to the sensitivity of the response. The three levels of
the hierarchy, ranked from most to least
responsive, are timing responses,
avoidance responses, and real responses. Real responses have a direct
impact on individuals well being, but
the timing of transactions can often be
easily modified in such a way as to
reduce taxes paid without having a large
impact on the benefit ultimately derived
from the transactions. An important
task facing researchers is to determine
how much of the observed behavioral
response is due to a shift in the timing
of activities in response to tax incentives

Burtless and Hausman (1978) pioneered

econometric methodology that cleanly
accounts for utility maximization of
taxpayers subject to complex nonlinear
tax schedules.3 This methodology also
takes into account the possibility of
measurement error in tax rates induced
when taxpayers are observed in tax
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and how much is due to a more

permanent change in the level of the
activities.

rate variation is due to transitory factors,

estimated behavioral responses will
likely overstate the behavioral response
to a permanent change in tax rates.

The behavioral response of taxpayers to

changes in the marginal tax rate that
they face is likely to depend on whether
the change in the marginal rate they
face is temporary or permanent.
Marginal tax rate changes might be
temporary due either to the change in
the tax law being temporary or due to
transitory movements in the taxpayers
income. The latter possibility has
especially disturbing implications for the
use of cross-sectional data in measuring
behavioral responses. Taxpayers with
transitorily high incomes will tend to
face temporarily high marginal tax rates,
while taxpayers with transitorily low
incomes will tend to face temporarily
low marginal rates. Taxpayers facing
temporarily high marginal tax rates have
an incentive to shift income receipts to
years in which they face lower marginal
tax rates and to shift deductions to the
current year, when the value of the
deduction is temporarily high. Conversely, taxpayers facing temporarily low
marginal rates have an incentive to
concentrate income receipts in the
current year, when they are taxed less
heavily, and to defer deductions to years
in which they face higher marginal tax
rates. Even if a taxpayers behavior
would be unchanged if there were a
permanent change in the marginal rate
she faces, there might still be a sizable
transitory response to a temporary
change in tax rates. More generally, the
behavioral response to a temporary tax
change is likely to be greater than the
behavioral response to a permanent
change. Unfortunately, using crosssectional data, it is generally impossible
to tell to what degree variation in
marginal rates across taxpayers is due to
transitory rather than permanent
factors. To the extent that the marginal

The degree to which timing matters will

differ across the type of behavior being
analyzed. Making substantial changes in
ones hours of work might require a
change of jobs, and so this likely
responds fairly slowly to changes in tax
law. Capital gains realizations, on the
other hand, are often cited as a form of
behavior that can respond very quickly
to tax changes. Individuals may be able
to reduce the present value of their
expected tax burden by realizing gains
during a period in which they face a
temporarily low marginal tax rate with
relatively little change in the composition of their asset portfolio.
RECENT APPROACHES TO ESTIMATION
Recent research on the behavioral
effects of taxation has tended to use
either panel data or several cross
sections of data spanning a period of
time encompassing a tax reform.
Changes in tax law provide an exogenous source of variation in tax rates,
which can be used to help solve the
identification problem discussed above.
However, the researcher needs to be
able to distinguish between changes in
behavior caused by the change in tax
law and changes in behavior induced by
other changes in the economic environment that coincide with the tax reform.
The key to sorting out the tax effects
from other factors is that tax reforms
generally do not treat all groups of
individuals in the same way. Some
groups experience larger marginal rate
changes than do others, and sometimes
marginal tax rates increase for some
groups while they decrease for others.
Two closely related methods for using
the variation in tax rates generated by
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reforms to estimate the behavioral

effects of taxation, difference-indifferences and instrumental variables,
are discussed below.

after TRA 86 (Hca). Eissa assumes that

the nontax factors affected both the
high- and low-income women in the
same way, so that the effect of the nontax factors on labor supply can be
removed by taking the difference
between the preTRA 86 (198385) and
postTRA 86 (198991) values of hours
of work. Women are classified as high or
low income on the basis of household
income excluding their own earnings.
High-income women, defined as those
at the 99th percentile of the income
distribution, on average experienced a
drop in their marginal tax rate of 14
percentage points as a result of TRA 86
and are the treatment group. Lowincome women, defined as those at the
90th percentile of the income distribution, on average experienced a drop in
their marginal tax rate of only seven
percentage points and are the control
group.4 Under the assumption that
women treat their asset income and
husbands earnings as given, the
classification of women to the treatment
and control groups is exogenous.

Difference-in-Differences
The difference-in-differences estimation
technique has increasingly been used in
work examining the ways in which
taxation and other government policies
affect behavior. This methodology treats
tax reforms as natural experiments that
can be used to identify the effect of
taxation on behavior. Because some
taxpayer groups experience larger
changes in marginal tax rates than do
other groups, those who are subject to
relatively small changes in marginal rates
can serve as a quasicontrol group and
those who experience larger changes
function as a treatment group. The
change in the behavior of the control
group can be used as a measure of how
underlying nontax factors affected
behavior. Comparison of the change in
behavior of the group experiencing the
large tax rate change with the change in
behavior of the group experiencing the
smaller change can then be used as an
indicator of how the tax reform affects
behavior.

Eissa (1995) takes the difference

between hours of work postTRA 86
and preTRA 86 for each group to
eliminate nontax related changes, which
affect labor supply during the period
being analyzed. An important assumption underlying this step is that the nontax factors affected both groups equally.
The difference in the change in hours of
work between the two groups, the
difference-in-differences (Hta Htb)
(Hca H cb), then indicates the degree
to which the larger cut in marginal tax
rates applying to high-income women
affected their hours of work. If the tax
reform had no effect on hours of work,
the difference-in-differences would be
zero, while a positive value of the
difference-in-differences indicates that
the tax reform resulted in increased
work hours by high-income women.

This methodology is perhaps best

explained by working through a
concrete example of its use. Eissa (1995)
investigates how the Tax Reform Act of
1986 (TRA 86) affected the labor supply
of married women using repeated crosssectional data from the Current Population Survey (CPS). Her estimate of the
effect of TRA 86 is based on comparisons of the average hours of work of
four different groups of married
women: high-income women in years
before TRA 86 (Htb), high-income
women in years after TRA 86 (Hta), lowincome women in years before TRA 86
(Hcb), and low-income women in years
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Eissa (1995) also implements the

difference-in-differences technique in a
regression framework that allows for
changes in the characteristics of the
control and treatment groups over time.
In this case, an hours of work regression
is run, using individual-level observations from the CPS pooled over years,
on individual characteristics, a dummy
variable for postTRA 86 years, a
variable indicating the woman is a
member of the high-income group, and
a variable interacting the postTRA 86
indicator with the high-income dummy
variable. The coefficient on the post
TRA 86 dummy variable captures
changes over time that affect labor
supply of both the control and treatment groups, the coefficient on the
high-income dummy variable captures
differences in the hours of work of the
high-income group relative to the lower
income group, and the coefficient on
the interaction of the two indicator
variables measures the extent to which
the high-income group increased its
labor supply more than the lower
income group as a result of TRA 86. This
last coefficient is capturing the same
effect as the difference-in-differences.

studied, then the estimated tax effect

will be biased. Researchers using
difference-in-differences techniques are
aware of this possibility, and often take
steps to address it. Eissa (1995), for
example, investigates whether the labor
supply of the two income groups she
analyzes exhibited different trends in the
years prior to TRA 86. Another approach
is to add an additional source of
variation in tax rates. For example, in a
study of the effect of tax incentives on
purchases of health insurance, Gruber
and Poterba (1994) use differences in
tax prices between employed and selfemployed workers as well as differences
across workers due to differing marginal
tax rates and differences over time due
to implementation of TRA 86. Taking
account of all three sources of variation
simultaneously results in a difference-indifference-in-differences estimator.
The difference-in-differences method
depends on a suitable variable being
available to classify observations into the
control and treatment groups. Heckman
(1996) criticizes Eissas (1996) use of
income as a grouping variable, noting
that although husbands earnings are
relatively unresponsive to taxation, this
is not true of capital income. Some
women may switch groups as a result of
the tax reform, leading to biased
estimates of the effects of the reform on
behavior. Heckman argues in favor of
invoking economic theory to link tax
effects to changes in the after-tax wage
and using variation in wage growth
across exogenously defined groups for
identification.5 However, for most other
forms of behavior that are affected by
taxation, this identification strategy in
not an option.

A critical assumption in difference-indifferences studies is that changes in the

economic environment over time have
the same effect on the behavior of the
groups experiencing different changes
in tax rates. In practice, this is often a
controversial assumption. Because the
magnitude of tax rate changes often
vary with income, income or income
related variables are often used in
grouping observations in difference-indifferences studies. But the welldocumented trend of growing income
inequality suggests that different
income groups may have been affected
in different ways by nontax forces. If
these differences in the nontax forces
across groups affect the behavior being

Panel data, where the same individuals

or households are followed over time,
provide an alternative means of identification. Feldstein (1995) uses data from a
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panel of tax returns to estimate the

response of taxable income to the TRA
1986. Because he observes the same
taxpayers both before and after the Act,
Feldstein can use preTRA 86 marginal
tax rates in grouping taxpayers into
categories experiencing different
changes in marginal tax rates. This
avoids the problem of the composition
of the groups changing over time.

unobserved determinants of behavior

are also affected by the transitory factor.
A similar critique applies to using postreform income or tax rates as instruments. Moffitt and Wilhelm investigate
using several alternative instruments for
the change in tax rates, including
educational attainment, broad occupational categories, and illiquid asset
holdings. Carroll uses a proxy for
permanent income, income averaged
over several years, as an instrument.
These instruments are less likely than
prereform income or tax rates to be
sensitive to transitory disturbances, and
so are more likely to be uncorrelated
with the change in the unobserved
determinants of behavior.

Instrumental Variables Using Panel Data

Moffitt and Wilhelm (1998) pose the
choice of a suitable grouping variable in
terms of instrumental variables. The
difference-in-differences methodology
using panel data is essentially estimating
a regression of the change in a behavioral variable (such as hours of work or
taxable income) on the change in the
taxpayers marginal rate. The change in
the marginal tax rate is partly a function
of the taxpayers behavior and must be
instrumented for. A suitable instrument
or grouping variable must be correlated
with the change in tax rates but
uncorrelated with the regression error
term (which can be interpreted as the
change in the unobserved determinants
of the taxpayers behavior). Moffitt and
Wilhelm question whether prereform
tax rates or income are suitable instrumental (or grouping) variables. The prereform tax rate or income may be more
highly correlated with the unobserved
determinants of prereform behavior
than it is with the unobserved determinants of postreform behavior, and so
may be correlated with the change in
the unobserved determinants of
behavior. For example, as Carroll (1997)
points out, transitory increases in
income prior to a tax reform can be
expected to be followed by decreases in
income following the reform. This
regression to the mean effect would
lead to correlation between prereform
income and the regression error if the

Using panel data, in some instances,

one may be able to determine how
much of behavioral responses are due to
timing effects and how much of the
responses are permanent. Recent work
by Burman and Randolph (1994) on
capital gains realizations and by
Randolph (1995) on charitable contributions attempts to do this. Burman and
Randolph use a panel of tax returns to
estimate a model in which an
individuals capital gains realizations
depend on both his permanent tax rate
and current tax rate. They rely on the
maximum combined state and federal
marginal tax rate in the individuals state
as an instrument to identify the permanent tax effect. Because the maximum
tax rate does not vary over individuals
within the state, they argue it is unlikely
to be correlated with transitory factors.
The individuals marginal tax rate on the
first dollar of realizations is used as an
instrument to identify the transitory tax
effect.6 The first-dollar tax rate does not
depend on the individuals capital gains
realizations, and so does not suffer from
a direct endogeneity problem as the
final-dollar marginal tax rate does, but it
does vary over time for the individual.
770

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Vol 51 no. 4 (December1998) pp. 761-72

FORUM ON THE BEHAVIORAL RESPONSE TO TAXATION

The strategy of using a first-dollar tax

rate would not work in studying the
effect of marginal tax rates on taxable
income because in that case there is
essentially no exogenous income
component on which to base the firstdollar calculation. In the case of capital
gains realizations, one can argue that
some components of income are
unlikely to be correlated with the
unobserved determinants of gains
realizations and can be treated as
exogenous. Burman and Randolph and
Randolph both find that the transitory
effect of tax changes is much larger
than the permanent effect. This is very
plausiblerealizing capital gains and
giving to charity are two activities in
which taxpayers have quite a bit of
flexibility in timing. However, it is asking
a lot of the data to distinguish between
the transitory and permanent effects of
tax changes, and more research is
needed to investigate the robustness of
this strategy for estimation.

ENDNOTES

The views expressed in this paper are not

necessarily shared by the Federal Reserve Bank of
Boston or its staff.
The tax price can actually be more complex due to
the interaction of state and federal income taxes
and the tax treatment of gifts of appreciated
property.
See, for example, Eissa (1995, 1996) and Moffitt
and Wilhelm (1998).
Technical expositions of this methodology are
provided by Hausman (1985) and Moffitt (1986).
Eissa (1995) also conducted the analysis using a
second control group whose income was at the
75th percentile of the distribution.
Blundell, Duncan, and Meghir (1998) estimate a
model of how taxation affects labor supply, which
takes this approach to identification.
In addition to setting capital gains realizations to
zero, Burman and Randolph (1994) also set several
other potentially endogenous deductions and
income sources to zero before calculating the firstdollar marginal tax rate.

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