Capital income taxation is increasingly recognised as essential for addressing inequality, yet its effectiveness is often limited by behavioural responses. This column analyses French capital income tax reforms and finds that both capital income and labour income responses to capital tax changes play a crucial role in determining the Laffer tax rate on capital income. These findings highlight the need to fully account for all behavioural responses when designing capital income tax policies.
Capital income taxation has re-emerged as a pressing issue, particularly with rising income inequality. Recently, the Brazilian G20 presidency has prioritised examining how tax systems can address inequality, commissioning reports on the specific challenges in taxing high net-worth individuals (OECD 2024, Zucman 2024). Central to this debate is the role of capital income taxes as a tool to curb inequality and the concentration of economic power, given that capital income tends to be concentrated among the very few highest earners. However, capital income taxation also induces more behavioural responses than labour income taxation, thereby diminishing its efficiency. In France, a commission was created to evaluate the impact of the 2018 capital tax reform, which included the introduction of a 30% flat tax on capital income. While the effect of the capital tax reform on inequality has been clearly demonstrated (Paquier and Sicsic 2022), the extent of the direct causal impact on capital income remains uncertain, despite an observed increase in dividends (Evaluation Committee of Capital Tax Reforms in France 2023).
The academic literature in this area has recently grown. Several studies (Chetty and Saez 2005, Yagan 2015) have examined the effects of the 2003 dividend tax cut in the US, identifying substantial behavioural responses. Bach et al. (2024), using recent French reforms and firm- and household-level data, found evidence of retained earnings behaviours in response to dividend taxation. Several studies have highlighted tax arbitrage mechanisms, including income-shifting behaviours (see the review by Zawisza et al. 2024).
In a recent paper (Lefebvre et al. 2024), we contribute to a deeper understanding of capital income taxation, both theoretically and empirically, by estimating the ‘Laffer rate’ on capital income tax for France. The Laffer rate is the tax rate above which increasing the rate further would compress tax bases enough to reduce government revenue. We express the Laffer tax rate on capital income using direct elasticity (capital income response) and cross-elasticity (labour income response) to the net-of-tax rate on capital income. We estimate these elasticities in the empirical part of the paper, using salient capital tax reforms between 2008 and 2017. We then compute Laffer tax rates in France.
The Laffer rate on capital income depends not only on the direct elasticity of capital income to its net-of-tax rate but also on the cross-elasticity of labour income to the net-of-tax rate on capital income. Because labour income is generally higher than capital income, even a small cross-elasticity can significantly impact tax revenues. In such cases, a reform on capital tax rates could have larger effects on labour income tax revenues than on capital income tax revenues. This makes estimating both direct and cross-elasticities essential.
The sign of this cross-elasticity is theoretically ambiguous, as illustrated by two models that we detail in the paper. In income-shifting models, a tax cut on capital income could lead to a shift from labour to capital income, yielding a negative cross-elasticity that raises the Laffer rate on capital. Conversely, in two-period models where taxpayers work and save initially to consume later, both elasticities may be positive, leading to a lower Laffer rate on capital income. Hence, whether considering the cross-elasticity increases or decreases the Laffer rate on capital income cannot be assessed theoretically and can only be determined by estimating empirically the cross-elasticities of labour income to the capital net-of-tax rate.
Turning to the empirical part of the paper, we first provide graphical evidence of behavioural responses to the capital income tax increase following the abolition in 2013 of the Prélèvement Forfaitaire Libératoire (PFL), a flat tax option on capital income that taxpayers could opt for between 2008 and 2012. Comparing the income evolution of taxpayers who had previously opted for the PFL (treated group) with those who had not (control group), we observed a substantial decline in capital income among the treated group, with only a minor decrease in labour income (see Figure 1). This suggests that income-shifting responses were not dominant in explaining the cross-responses of labour income to capital tax reforms, supporting the likelihood of a positive cross-elasticity in France. This finding echoes prior work where we observed that the reform’s reduction in dividends led to decreased overall tax revenue (Lefebvre et al. 2021). This is one example where an increase of the tax rate has caused a decrease of tax revenue. This is also consistent with the findings of Bach et al. (2019).
Figure 1 Trends in capital (top) and labour (bottom) income according to household use of the PFL
Notes: The graphs show average log incomes normalized to 0 in 2011 for each group and income type.
While the 2013 reform provides valuable insights, its results may not be broadly applicable to other reforms or periods. We therefore go further than the graphical evidence by estimating elasticities of capital and labour income with respect to marginal net-of-tax rates (MNTRs) of both labour income and capital incomes. This allows us to estimate sufficient statistics to implement the Laffer formula. To circumvent the endogeneity of net-of-tax rates, we use an instrumental variable (IV) approach. 1 We obtain a direct elasticity of capital income around 0.77, which appears robust across specifications and robustness checks. Ignoring cross-response, this estimate leads to a Laffer rate on capital income of approximately 57%.
Moreover, we obtain statistically significant and slightly positive cross elasticities of labour income with respect to marginal net-of-tax rates on capital incomes. The cross-elasticity is higher for taxpayers with a high marginal tax rate on labour, where it reaches a tenth of the direct elasticity. These results suggest that the cross-elasticity is more likely explained by the impact of capital taxation on the incentive to work and save: an increase in the marginal tax rate on capital reduces the benefit of earning additional income from activity in order to save. Accounting for this cross-elasticity reduces the estimated Laffer rate significantly, to about 43%.
A key takeaway from our analysis is that the Laffer rate is especially sensitive to cross-elasticity estimates because labour income generally represents a larger tax base than capital income. This sensitivity is demonstrated in Figure 2, which shows the extent to which the Laffer rate decreases with cross-elasticities. The curve shows that considering cross-elasticity remains a key factor to compute Laffer rates.
Figure 2 Laffer tax rates as a function of the cross elasticity
To conclude, we acknowledge some limitations and propose avenues for future research. Our positive cross-elasticity estimates are derived from a period marked by multiple reforms aimed at increasing capital income tax rates. While theoretically, responses should be symmetric, additional empirical work on different tax reform designs, countries, and periods is warranted. Future research could apply our framework to estimate Laffer rates using both direct and indirect elasticities in other contexts. Finally, it is likely that a significant proportion of the behavioural elasticities that we have estimated reflects tax optimisation behaviour. Reducing tax optimisation opportunities, allowed in particular by certain tax expenditures, would then have an effect on the elasticities, and thus on the Laffer tax rates. Understanding the mechanisms through which taxpayers respond to capital tax reforms remains limited and presents a valuable direction for future investigation.
Source : VOXeu
