Should Taxes Depend on Age?
Current law uses many factors beyond income to set a person's tax liability--marital status, number of children, mortgage size, charitable giving, and so on. Age is one variable conspicuously omitted. Yet in a wonderful but still unpublished paper titled "Should Taxes Be Independent of Age?" my Harvard colleague Michael Kremer suggests that younger workers should face lower income tax rates than older workers.
To understand Kremer's argument, start with a simple premise: An income tax discourages people from working and thus prevents the economy from reaching its full potential. Tax cuts reduce this disincentive, encourage people to work harder, and expand the economic pie.
Yet tax cuts do not affect everyone the same. For instance, suppose that the government were to cut the tax rates that apply to the first $50,000 of earnings. Taxpayers with incomes below $50,000 would have a greater incentive to try to make more money because each dollar of earnings would be taxed at a lower rate. But that is not true for someone earning above $50,000. This person would view the tax cut as infra-marginal--the reward for additional work would not improve.
How much incentives are improved by such a tax cut, therefore, depends on the ratio of low-income to high-income taxpayers. That ratio, in turn, varies by age. Few 20-year-olds make more than $50,000 a year, so this tax cut would encourage almost everyone in that age group to work harder. Yet because many more 40-year-olds are in the high-income group, the tax cut would boost incentives for far fewer of them.
Not only is it easier to improve incentives for young workers, but they are also more likely to respond. Middle-aged workers are often locked into jobs that give them little choice about how much they work. Young workers are still choosing career paths and have more flexibility. As a result, their labor supply elasticities are larger. Kremer estimates that young workers are about four times more responsive to work incentives than the middle aged.
The bottom line: If the government wants to get the most economic gain for each dollar of lost tax revenue, tax cuts for younger workers are better than tax cuts for the middle-aged. That is hard for me, as a 48 year old, to admit. But I don't see any holes in Kremer's logic.
Update and Technical Clarification: Some of the comments on this post reflect a confusion about Kremer's argument (undoubtedly my fault), so let me try to be more precise.
Consider the marginal tax rate at an income of x. This is the amount of extra tax a person would owe if he earned $1 more, so his income went to x+1. If we reduce just this marginal tax rate, it will have an incentive effect only for people making x. But the tax cut will lose tax revenue for all those people making more than x, who get an inframarginal tax cut but experience no incentive effect from the tax change. If f(x) is the density for the distribution of income, and F(x) the cumulative distribution, the ratio of marginal to inframarginal taxpayers at income x is f(x)/[1-F(x)]. This ratio, Kremer shows, is age-dependent. It is larger for younger workers. As a result, reducing the tax rate at any income x will incentivize more workers per unit of lost tax revenue if the tax cut is applied to younger workers only.
Kremer's second claim is that the young have larger labor supply elasticities. This is a different argument for why taxes should be age-dependent which points in the same direction as the first. The first argument is more technical and, as a theoretical matter, more novel. However, the two points are complementary: Tax cuts incentivize more young workers, and young workers respond more to incentives.
Kremer's analysis concludes that the young should face a lower tax rate at any given level of income. Thus, the fact that the young have lower tax rates because they have lower income does not mean that the Kremer recommendation is being implemented in the world. To follow Kremer's advice, we would need to make the tax schedule a function of age.