Tax Deduction Matters: Elasticities of the Laffer Curve, Taxable Income, and Tax Revenue

Abstract

This study uses a simple dynamic general equilibrium model to demonstrate that the tax deductions affect the three elasticities: that of the Laffer curve (the Laffer elasticity, hereafter), taxable income, and the tax revenue. This study first decomposes the Laffer elasticity, which consists of the elasticity of taxable income and the tax revenue elasticity. The contributions of this paper are twofold. First, to quantitatively evaluate the importance of tax deductions, this study calculates the analytical solutions of these elasticities with respect to labor and capital income under the steady state in the general equilibrium model with exogenous deduction and a social security tax. Second, using Japanese data, this study conducts a numerical simulation with plausible parameter values. Furthermore, this study finds that the simulation results are consistent with the empirical literature on public finance: an unstable peak of the Laffer curve, a wide range of estimates for the elasticity of taxable income, and tax revenue elasticity greater than 1. The policy implication of these results is that tax rates that maximize tax revenues are unstable, depending on parameters and deductions.