The effects on the 1986 Tax Reform Act on labor supply and taxable labor income

How will a cut in marginal tax rates affect labor supply? This question arises every time new tax legislation is introduced. However, there is little agreement on the incentive effects of a cut in marginal taxes. There is evidence that the decrease in marginal tax rates following the 1986 Tax Reform Act (TRA86) had large effects on taxable income among high income taxpayers. Even among middle-income taxpayers there was a non-negligible change. Unfortunately, we do not know whether these effects were the consequence of decreased tax avoidance (with no significant change in real behavior) or a consequence of an increase in labor supply.;I consider how labor supply for taxpayers changed between 1985 and 1988, and I compare their change in labor supply with the change in reported taxable income. I use two separate data sets to analyze this problem: (1) Individual Tax Model File Public Use Sample, compiled by the Internal Revenue Service and (2) Survey of Income and Program Participation.;I find that taking deductions has a positive and significant effect on hours worked, while marginal tax rate has a negative effect on hours worked, although less so in 1988 than in 1985. The decline in labor tax rates appears to have little impact on the labor supply of lower income households. However, among households in the top income quartile, while taxable income rose 10 percent, hours of work rose by only 5.0 percent. It appears that while part of the increase in taxable income was due to increased labor supply, but most was due to decreased tax avoidance activities.;The basic labor supply model assumes that utility is a function of labor and income. Using a model developed by Slemrod (1994), I introduce tax avoidance to the budget constraint, which allows a taxpayer to decrease taxable income at some cost. A taxpayer has an incentive to increase avoidance until the marginal cost of avoidance is equal to the marginal tax rate. A decrease in marginal tax rates may then have two effects. First, it should increase labor supply through the effective increase in wage. Second, it should decrease the optimal level of avoidance.