Public Economics

November 1 and 2, 2012
Raj Chetty of Harvard University and Justine Hastings of Brown University, Organizers

Sara LaLumia, Williams College; James Sallee, University of Chicago and NBER; and Nicholas Turner, Department of the Treasury

New Evidence on Taxes and the Timing of Birth

LaLumia, Sallee, and Turner use data from the universe of tax returns filed between 2001 and 2010 to provide new evidence on the extent to which taxpayers are willing to shift births from the beginning of January to the end of December in order to claim child-related tax benefits in an earlier tax year. Filers have an incentive to shift births into December, through induction or cesarean delivery, because child-related tax benefits are not prorated. The researchers find evidence of a positive but very small effect of tax incentives on birth timing, which contrasts sharply with previous research. In addition, they leverage variation in birth timing and the relationship between household structure and tax incentives to provide novel evidence of tax evasion. As compared to those with an early-January newborn, low-income filers with a late-December newborn are substantially more likely to report income that maximizes their benefits from the Earned Income Tax Credit. This difference, which is driven entirely by self-employment income not subject to third-party verification, is inconsistent with real labor supply differences and is likely driven by strategic misreporting.

John Sabelhaus, Federal Reserve Board

Early Withdrawals from Retirement Accounts in the Great Recession

Pre-retirement withdrawals from retirement accounts are a double-edged sword. On the one hand, early withdrawals reduce retirement resources. On the other hand, early withdrawals allow individuals to smooth over demographic and economic shocks, and many people would not voluntarily contribute to retirement accounts in the first place if they knew they could not get access to their funds in an emergency. Sabelhaus uses data from Statistics of Income individual tax returns and the Survey of Consumer Finances to study retirement account contributions and withdrawals in the years leading up to, during, and following the Great Recession. He finds that pre-retirement withdrawals increased only modestly between 2004 and 2010, but withdrawal rates are high in all of those years. Early withdrawals are strongly correlated with demographic and economic shocks.

Jason DeBacker and Alex Yuskavage, Department of the Treasury, and Bradley Heim and Anh Tran, Indiana University

The Lasting Impact of Enforcement: An Analysis of Corporate Tax Aggressiveness Following Audit

DeBacker, Heim, Tran, and Yuskavage study how legal enforcement changes subsequent corporate behavior. Using confidential IRS data, they find that corporations increase their tax aggressiveness after an audit for a few years and then reduce it gradually. In the long run, audited corporations become more tax aggressive than before the audit, reducing their effective tax rate by around 14 percent. This finding is in contrast to the usual expectation that subjects should behave better after experiencing legal enforcement, at least for some time. The authors show that this U-shaped impact indicates a strategic calculation of firms, including Bayesian updating of audit risk. This adverse effect on illicit activities calls for reexamining both existing theory and current policy of legal enforcement.

Eytan Sheshinski, Hebrew University

Limits on Individual Choice

Individuals behave with choice probabilities defined by a multinomial logit (MNL) probability distribution over a finite number of alternatives that includes utilities as parameters. The salient feature of the model is that probabilities depend on the choice-set, or domain. Expanding the choice-set decreases the probabilities of alternatives included in the original set, providing positive probabilities to the added alternatives. The wider probability "spread" causes some individuals to further deviate from their higher valued alternatives, while others find the added alternatives highly valuable. For a population with diverse preferences, there exists a subset of alternatives, called the optimum choice-set, which balances these considerations to maximize social welfare. Sheshinski analyzes the dependence of the optimum choice-set on a parameter that specifies the precision of individuals' choice (the degree of rationality). He shows that for high values of this parameter, the optimum choice-set includes all alternatives; for low values, it is a singleton. Numerical examples demonstrate that for intermediate values,

Lorenz Kueng, Northwestern University

Tax News: Identifying the Household Consumption Response to Tax Expectations using Municipal Bond Prices

Although theoretical models often emphasize fiscal foresight, most empirical studies neglect the role of news, thereby underestimating the total effect of tax changes. Measuring the path of expected future tax rates from the yield spread between taxable and tax-exempt bonds, Kueng finds that consumption of high income households increases by close to 1 percent in response to news of a 1 percent increase in expected aftertax lifetime income, consistent with the basic rational-expectations life-cycle theory. Using novel high-frequency bond data, Kueng develops a model of the term structure of municipal yield spreads as a function of future top income tax rates and a risk premium. Testing the model using the presidential elections of 1992 and 2000 as two natural experiments, he shows that financial markets forecast future tax rates remarkably well in both the short and long run. Combining these market-based tax expectations with consumption data from the Consumer Expenditure Survey suggests that households who have lower income, less education, or are more credit constrained respond less to news. However, the same households also respond one-for-one with large news shocks, consistent with rational inattention. Overall, these results suggest that ignoring anticipation effects biases estimates of the effect of fiscal policy downward.

Justine Hastings, and Christopher Neilson and Seth Zimmerman, Yale University

Determinants of Causal Returns to Postsecondary Education in Chile: What's Luck Got to do with it?

Hastings, Neilson, and Zimmerman use new administrative data from Chile from 1985 through 2010 to estimate the causal returns to a college degree as a function of field of study, quantitative requirements, selectivity, measures of school quality, and student socio-economic status. Their data link high school records to entrance exam records to college applications, admission, matriculation, and finally short and long run labor market earnings from tax records. Because the Chilean admission system for most universities is centralized and test score based, they are able to exploit thousands of regression discontinuities to estimate the causal impacts of interest. They find large and positive returns to field of study particularly in health, technology and business. They also find large positive returns for majors and universities with high quantitative requirements, and high selectivity in admissions. Gains along university-degree dimensions are not fully captured by differences in tuition across institutions and degrees. They do not find differential outcomes for students coming from low versus high SES backgrounds. Their results support the claim that persistent frictions exist in supply of institution-degrees relative to demand for skills, or in demand response to returns through informed student choice. Both suggest a role for public policy in decreasing frictions which they discuss in the conclusion.

John Friedman and Raj Chetty, Harvard University and NBER, and Soren Leth-Petersen, Torben Nielsen, and Tore Olsen, University of Copenhagen

Active vs. Passive Decisions and Crowd-out in Retirement Savings Accounts: Evidence from Denmark

Do retirement savings policies -- such as tax subsidies or employer-provided pension plans -- increase total saving for retirement or simply induce shifting across accounts? Friedman, Chetty, Leth-Petersen, Nielsen, and Olsen revisit this classic question using a panel dataset with 50 million observations on savings for the population of Denmark. They find that a policy's impact on total savings depends critically on whether it changes savings rates by active or passive choice. Policies such as tax subsidies that rely upon individuals to take an action to raise savings have small impacts on total wealth. In contrast, policies that raise savings automatically even if individuals take no action -- such as employer-provided pensions or automatic contributions to retirement accounts -- increase wealth accumulation substantially. Intuitively, price subsidies only affect the behavior of active savers who optimize their portfolios with respect to policy, whereas automatic contributions increase savings of passive individuals who do not re-optimize. The authors estimate that approximately 85 percent of individuals are passive savers. The 15 percent of active savers who respond to price subsidies do so by reallocating savings across accounts. These individuals also offset changes in automatic contributions and have higher wealth/income ratios. Overall, these results imply that automatic contributions may be more effective at increasing total retirement savings than price subsidies for three reasons: 1) subsidies induce relatively few individuals to respond; 2) they generate substantial "crowdout" conditional on response; and 3) they do not influence the savings behavior of passive individuals, who are the least prepared for retirement.

Michael Dinerstein and Pablo Villanueva, Stanford University; Caroline Minter Hoxby, Stanford University and NBER; and Jonathan Meer, Texas A&M University

Did the Fiscal Stimulus Work for Universities?

Dinerstein, Hoxby, Meer, and Villanueva investigate how stimulus-motivated federal funding directed to universities affected their expenditures, employment, tuition, student aid, endowment spending, and receipt of state government appropriations. They also investigate how these funds affected the economies of the counties in which the institutions are located. To overcome the potential endogeneity of federal funds (for instance, federal student aid rising when students become poorer),they use: 1) an instrument that applies nation-wide rates of increase in research funding by agency to universities whose initial dependence on these agencies differs; and 2) an instrument that applies the change in the maximum Pell Grant to institutions with varying initial numbers of students eligible for the maximum grant. They find little evidence that federal funds directed to universities propped up aggregate demand or generated economic multipliers in the classic Keynesian sense. However, their results suggest that federal funds induced private universities to increase research, reduce tuition, raise student aid, spend a bit more on many categories of expenditure, and slightly reduce endowment spending rates. These results are consistent with private universities maximizing objectives that require them to allocate funds over a broad array of research, instructional, student support, and other activities. For public universities, their results suggest that federal funds induced decreases in state appropriations and increases in tuition. These findings suggest that public universities used federal funds as part of a "package deal" in which they gained independence from state governments. They appear to have used their greater independence to orient their expenditures more toward research and instruction. Overall, it appears that the stimulus caused universities to increase their investments in research and human capital. It remains to be seen how those investments pay off in the long run.

Ralph Koijen, University of Chicago and NBER, and Motohiro Yogo, Federal Reserve Bank of Minneapolis

The Cost of Financial Frictions for Life Insurers

During the financial crisis, life insurers sold long-term policies at deep discounts relative to actuarial value. In January 2009, the average markup was -25 percent for 30-year term annuities as well as life annuities and -52 percent for universal life insurance. This extraordinary pricing behavior was a consequence of financial frictions and statutory reserve regulation that allowed life insurers to record far less than a dollar of reserve per dollar of future insurance liability. Using exogenous variation in required reserves across different types of policies, Koijen and Yogo identify the shadow cost of financial frictions for life insurers. The shadow cost was nearly $5 per dollar of excess reserve for the average insurance company in January 2009.

John Karl Scholz, University of Wisconsin, Madison and NBER, and Ananth Seshadri, University of Wisconsin, Madison

Health and Wealth in a Lifecycle Model

Scholz and Seshadri develop a model of health investments and consumption over the life cycle where health affects longevity, provides flow utility, and health and consumption can be complements or substitutes. They solve each household's dynamic optimization problem using data from the Health and Retirement Study from 1992 through 2008 and Social Security earnings histories. Their model matches well household out-of-pocket medical expenses, self-reported health status, and wealth. The model also does a nice job matching the evolution of health status in old age and changes in wealth between 1998 and 2008. They illustrate the importance of endogenizing health investment by examining the effects on mortality and wealth of eliminating their stylized representation of Medicare. Medicare has meaningful effects on mortality, particularly at the bottom of the income distribution.

Henrik Kleven and Camille Landais, London School of Economics, and Emmanuel Saez, University of California at Berkeley and NBER

Taxes, Wage Bargaining, and Migration: Evidence from Top-Income Foreigners in Denmark

Kleven, Landais, and Saez analyze the effects of income taxation on the international migration and wage bargaining of top earners who use the Danish preferential foreigner tax scheme. This scheme, introduced in 1991, allows immigrants with high earnings (above 103,000 Euros per year as of 2009) to be taxed at a flat rate of 25 percent for a duration of three years, rather than the regular progressive schedule with a top marginal tax rate of 59 percent. Using population-wide Danish administrative tax data, they show that the scheme doubled the number of highly paid foreigners in Denmark relative to slightly lower paid ineligible foreigners, translating to a large elasticity of migration with respect to the net-of-tax rate. There is bunching of earnings at the scheme eligibility threshold, but no hole in the distribution below the threshold. Finally, the authors find evidence of an increase in gross earnings for foreigners staying more than three years, indicating that part of the incidence of income tax for high skilled workers is borne by firms.