# How Taxes Affect Economic Behavior

By Henry J. Aaron; Joseph A. Pechman | Go to book overview

giving an average of ½ - x) per unit change in holdings. Also by assumption 2, ΔA = (ρ/x - 1)A, where A is the amount of initial holdings. When these results are combined and when we sum over individuals, the total efficiency gain from spreading risk efficiently would be

,

where v is the total amount of risky securities outstanding.

Appendix D: Derivation of Efficiency Gains and Revenue Effects of Selected Tax Reform Proposals

In this appendix, we derive the efficiency gains and the revenue effects of the tax reform proposals discussed in the text.

Reduction in the Corporation Tax

The principal efficiency effect of reducing the corporation tax rate is to lower the distortion favoring debt over equity finance and the associated costs. The size of the initial excess burden is in proportion to - (1 - αb)]2. In appendix B, αb was estimated to be 0.75, and it is assumed that this value will remain unaffected by the change in the corporation tax rate. A 1 percent reduction in τ would then lead to a 4.1 percent drop in the excess burden, or a gain of \$132 million a year.

The size of the excess burden from the distortion of investment decisions is proportional to {[τ - (1 - αb)]/(1 - τ)}2 (rz - γr)2. If τ drops by one percentage point, D will drop by 2.1 percent according to the triangular approximation in figure 1. This change, together with the change in τ, implies that the excess burden on investment will fall by 3.4 percent, or \$39 million a year. The total efficiency gain from a cut in the corporation tax rate is therefore \$171 million a year.

In 1975, a cut of one percentage point in the corporate rate would have reduced revenues by \$406 million, assuming corporate behavior did not change. The resulting \$406 million reduction in corporate revenues would accrue to shareholders. If their average marginal tax rate was 0.157,103. taxes on shareholders would increase by \$64 million a year. But

____________________
103.
This is the figure used by Martin Feldstein and Lawrence Summers in "Inflation, Tax Rules and the Long-Term Interest Rate," BPEA, 1: 1978, pp. 61-99.

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