Is Raising Marginal Tax Rates on Higher Income Individuals a Good Idea? Becker

 

Newly elected French President Francois Hollande campaigned on a promise to raise the marginal tax rate to 75% on individuals making more than 1 million euros. President Obama wants to increase marginal tax rates on high-income individuals to their level before the Bush tax cuts.  Obama defines “high” as anyone making over $250,000 per year. Neither the modern history of high tax rates, economic analysis, or their consequences for the budget deficit and income redistribution indicates that raising taxes on higher income individuals are a good idea.

A few decades ago, tax rates on higher incomes were at least 70% not only in high taxing Scandinavian countries, but also in the United States (where the top rate was 91% in 1960) and many other countries where government spending took a relatively small share of GDP. The widespread avoidance and evasion of such high taxes through sophisticated accounting methods, reduced work effort, and even in countries like Sweden through outright barter for services and goods, led to a world wide revolution toward flatter and much lower tax rates. The bi-partisan tax accord in the US in the 1980’s reduced the top income tax rate to 28% (the top rate was 33% for a fraction of high income persons), and even Sweden lowered its top income tax rate to about 55%. Since aside from the Great Recession, GDP has grown quite rapidly during the decades subsequent to the tax reduction movement, why is there growing pressure to raise tax rates again on the so-called “rich”?

From the academic side, support for raising taxes on higher income individuals mainly comes from evidence on individual behavior over the lifecycle. This evidence suggests that labor supply does not respond very much to changes in after-tax earnings (see a good survey of this issue in Meghir and Phillips, “Labor Supply and Taxes”, 2010). Yet evidence on aggregate labor supply, such as the differences in hours worked among countries with different levels of taxes, suggests that workers spend considerably more hours working when marginal tax rates on their incomes are lower.

A recent article in the Journal of Economic Literature tries to reconcile the micro and macro based conclusions by arguing that the micro evidence gives a biased picture of aggregate labor supply responses (see Keane and Rogerson, “Micro and Macro Labor Supply Elasticities: A Reassessment of Conventional Wisdom”, June 2012). One of the factors in their reconciliation comes from the importance of on the job investments in human capital. These investments bias downwards the micro estimates of labor supply elasticities that are based on variations in hours worked over the lifecycle. This bias is especially large at younger ages where most of these investments occur since the true earnings at these ages is much larger than the observed wages at these ages because younger workers are raising their future wages through investments in their human capital. This bias helps explain why computed elasticities of labor supply are usually greater for older workers.

A second important bias shows up especially in the difference between the labor responses of men and women. It has long been known that women respond more to higher tax rates on their (family) earnings because many women then leave the labor force entirely rather than simply adjusting their hours worked. As Keane and Rogerson show, such decisions to enter or leave the labor force can greatly increase the aggregate labor response to changes in tax rates.

These and other corrections to simple interpretations of the micro evidence on labor responses to changes in tax rates clearly suggest that aggregate labor responses to tax rates may be quite large. Moreover, as welfare economics shows, raising tax rates by only a few percentage points on a sizable tax rate base- as in President Obama’s proposal- will tend to have large costs in efficiency even when the elasticity of response to the tax increase is relatively small.

 I would not argue, however, that the evidence conclusively proves that the higher taxes proposed would do significant damage. Suppose then to be conservative that there is only a 50-50 chance (I believe the true probability is much more than 50-50) that the tax increases proposed by Hollande and Obama would sizably reduce hours worked and the effort put into work relative to the magnitude of the tax increases, and would cause sizable loses in efficiency relative to the additional revenue raised. Would such probabilities justify much higher tax rates?

To answer this question, one has to consider the potential benefits and costs of raising taxes on higher income individuals, and determine whether expected benefits exceed expected costs. If higher taxes on the rich only slightly affected their work effort (the usual assumption in revenue calculations), tax revenue would rise, but not by a lot since the great majority of revenue comes from taxes on the other 98% of taxpayers. With only a little increase in revenue under the most favorable conditions about labor supply responses, such tax increases would do little to close the budget deficit, and not much additional revenue would be available to redistribute to lower income families.

Higher taxes on the so-called “rich” would likely reduce after tax income inequality. The sizable growth in earnings and income inequality since 1980, especially at the high-income end, is one of the forces behind the movement toward higher taxes on the “rich”. In particular, many people are upset about CEOs getting high bonuses and stock options even when there companies are doing badly, or bankers getting their very high options and bonuses even after they made such bad decisions that contributed to the financial crisis. I have sympathy with these concerns, but the way to attack these problems is not to raise the taxes on everyone earning more than $250,000. For professionals and small business owners, not workers in the financial and banking sectors, constitute the great majority of persons in that higher income bracket. The best way to meet these concerns is by further improving corporate governance, and by formulating effective rules-based banking regulations that discourage the too big to fail banks from taking on excessive risks, and hence unjustified compensation.

So the gain in tax revenue from higher taxes on richer individuals would not be great even in the chance that these taxes only slightly discourage their hours worked and effort at work. But the cost to the economy in the chance that higher taxes greatly discourage their effort (relative to the magnitude of the tax increase) is likely to be substantial in terms of fewer hours worked and less work effort by high income individuals, reduced incentives to start businesses, less investments in their human capital, investing abroad rather than in the US or other countries that raised these taxes, and even migration abroad, especially in countries like France where many talented Frenchmen are already working in Britain, the US, and other countries.

So I conclude that even with considerable uncertainty about how much higher taxes on higher-income individuals would reduce their work effort and their investments, the expected gain from raising these taxes is likely to be negative. The trend toward lower marginal tax rates during the past 50 years was perhaps mainly the result of interest group pressure from higher income individuals, but it also receives support from a benefit-cost analysis of the expected effects of tax increases on behavior.

 

 

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[Mitchell K.]

Becker writes the following:
"The trend toward lower marginal tax rates during the past 50 years was perhaps mainly the result of interest group pressure from higher income individuals, but it also receives support from a benefit-cost analysis of the expected effects of tax increases on behavior."

He glosses over an aspect of the important point he makes concerning the cost-benefit analysis on the potential loss of efficiency and the potential gain in revenue associated with a tax increase; by increasing the tax rate, the government runs the risk of losing revenue not just by affecting productivity but by also encouraging "widespread avoidance and evasion of such high taxes through sophisticated accounting methods."

Lowering tax rates has been advocated not only as a method of encouraging growth but also as a way to increase revenue. Obviously, such an approach has limits (one cannot hope to increase revenue collection if the tax rate is reduced to zero!). However, the recognition of the nonlinear relationship between tax rates and tax revenue (as signified by the so-called Laffer curve) is one major reason why presidents Kennedy and Reagan championed tax cuts. Interest group pressure from high-income individuals does not really explain the support amongst most Republicans and some Democrats for reducing the marginal tax rate for the highest income earners.

In fact, the interest group pressure from the wealthy seems to have the opposite sign; the notably wealthy people in America (Warren Buffett, Bill Gates, etc.) tend to argue for higher taxes! As Posner mentions in his companion posting, Americans are frequently competitive and many compete for social standing via wealth acquisition. Amongst the extremely rich, the competition for status often manifests itself through competing over who donates more to high-profile charitable causes and how loudly they advocate tax increases.

[alamedarj]

Hi Becker, I'm following your blog posts. I found some spam comments here. In my own opinion, I think that is not a good idea many lives will be affected. In our country, this is not applicable - rising taxes high.

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[NEH]

Interesting that there has been little comment on the issues of Offshore Banking, Black Banking and the rise of Creative Accounting practices. Dare we call it a "Fraud"? If these avenues were closed down and shut off, there may very well be no need to raise the Marginal Tax Rate on the "Plutocrats".

[Adi Venkata]

The issue is not the marginal tax rate. The issue is tax loopholes and the number of exemptions. Unless government reforms exemptions & loopholes, they can go to 90% or even 99% tax rate without making much difference.

I would suggest that govt limit exemption claims to $40,000 or 10% of gross income. What this does is to reduce avenues of exemption claims at the high income range. This along with 2 other factors - return to clinton era tax rates and reduction in govt spending as put forth by Pres. Obama or even the Simpson Bowles commission will create a better fiscal situation. Once public debt dips below 40% of GDP, please reduce top tier tax rates ...

[Michael Gemmink]

In response to Becker: The most effective way to cut down inequality is to remove tax loopholes, which happen to modify behavior inefficient ways. Tax loopholes add nothing to the system but give advantages to those who can afford accountants who can find them. Then make capital gains taxes equivalent to income tax, which give an edge to those in finance. Economic theory would suggest that if the capital gains tax would increase investment would decrease, but this can be up for in government investment in infrastructure brought in by the additional revenues.

In response to Mitchell K: The United States is on the left side of the Laffer curve which means that raising taxes would increase revenue, but each increase in taxes will bring in less revenue than the previous increase by the law of diminishing returns. The Laffer for maximum government revenue is thought to be somewhere at 70%. No where near the top tax rate in the United States. Perhaps the most clear cut evidence for this is that the Bush tax cuts brought in no additional revenue.

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[Terry Bennett]

Apart from the "potential benefits and costs of raising taxes on higher income individuals", has anyone considered the moral irrectitude?

In an egalitarian society, such as I think it is extremely important for us to be, the FAIR way to apportion government burden is to divide the budget by the total number of eligible voters. If that number is too big - and a rough guess right now puts it in the low 5 figures per year - the majority of voters can decide to reduce the numerator, spending. The obvious effect of such a system would be to drastically reduce, by broad consensus, the size of government.

A progressive tax creates an externality - a cost that someone else pays. The poor freeride on the taxes paid by the rich. Of course the 99% are going to vote to raise taxes on the 1%. They want government services but they don't want to pay for them. This is disparate treatment, a systematic attack on a class, and all the rest. I am quite weary of hearing about somebody else's "fair share", from a person whose sense of fairness is fatally clouded by his lifelong sense of entitlement. In the eyes of the law, I demand to be seen as equal to any other citizen. How can any of us make that stand if we are unwilling to pay OUR FAIR SHARE of the cost of the government we vote to create?

[Tax Letters]

To its a bad idea..

[Retired_Early]

Here is one anecdotal micro economic example, me. Two time successful entrepreneur with net worth of about $10 million, single. Have been "retired" for past 10 years at an early age. Every time I get an offer to go back and do another startup I do the following mental calculation; if I started a new company and it was successfully sold in next few years each dollar of capital gains would be taxed at about 28%, depending on level of success might be even higher taxes. If some accident or illness were to cause my early demise then each marginal dollar earned would be subject to 55% estate tax federal (and more state if I lived in state with estate tax). So from a potential venture 83% or more could end up with the government. So when looking at opportunities I say to myself, I can go back to work either for government or, if I left bulk of estate to non-profits, then for charity. Every time, and there have been quite a few opportunities, my answer is why bother? In my two companies I created over 200 jobs and products that yielded massive boost in end user productivity. So, thanks to combination of taxes on capital and estate tax regime I'll keep clipping my coupons and enjoying the beach. I don't know the answer but I do know that in this case the expected tax regime keeps me out of productive economy.

[NEH]

Retired_Early, And then there are real Entrepreneurs who have said, "Why don't I retire early because I can? Simply because lying on the beach living off the Fat of the Land would drive me crazy. I like the challenge and it gives meaning to my life and I like building companies. The money and wealth from the profits is only secondary." Now these are the types of Entrepreneurs the Nation ought too be fostering. Enjoy that Margarita or Beer on the Beach.

Terry, And so when has the desire to create, "... the establishment of Justice, ensure Domestic Tranquility, provide for the Common Defense and promoting the General Welfare..." become a form of Entitlements? As for a "per capita tax", it's less than equitable. That's why Congress, when it first instituted an Income Tax, developed the "Progressive Scheme" to equitabally distribute the tax burden and to control an increasingly powerful Plutocracy...

[Matt]

Becker, I love your blog! However I am confused by this statement:

"the great majority of revenue comes from taxes on the other 98% of taxpayers"

According to the National Taxpayers Union (http://ntu.org/tax-basics/who-pays-income-taxes.html), the top 1% of earners pay 36.73% of federal income tax revenue. The top 5% pay 58.66%.

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[Terry Bennett]

Dear NEH,

In defense of Retired_Early, it appears that he (or she) is not living off the Fat of the Land, but rather off the money he earned in exchange for the value he created. He gave a plausible and rational explanation for his dissuasion from further entrepreneurial effort. It is no surprise that you want him to emulate Boxer (perhaps 'N' stands for Napoleon?), but in practice how would you propose to distinguish the heart of one entrepreneur from that of another in deciding which to "foster"? I would also point out, there is no suggestion that any fostering by government had anything to do with his success.

Not all people can be entrepreneurs. Most don't have the temperament. I hope we can all agree that these appropriately gifted people benefit society when they take their risks and generate their economic activity, both by employing others who are likely incapable of employing themselves and by making better products and services available for people to consume. George Will is fond of noting that when you subsidize something, you get more of it. The corollary is that if you penalize something, such as entrepreneurship, you get less of it.

People say they want jobs, and there's a surefire way to create them. Suppose for every person you employ, the government were to give you a credit against your own taxes. Unemployment would vanish overnight, because the entrepreneurs of our country would come out and work their magic. The supposed downside of this, the sole reason we won't do it today and eliminate our economic problems, is that if we did it the entrepreneurs would get rich, and Lord knows we can't have any more of that. Once again, Schadenfreude economics thwarts reason. And once again, my advice is to realize that the rich are the ones who have the money, and get over it.

On to your naked conclusion that a per capita tax is less than equitable. Actually it is the very definition of equitable. The reason Congress instituted the income tax progressively is NOT that a progressive tax is equitable, but exactly the opposite. They did it precisely BECAUSE it is inequitable. They could only sell it as an externality. They said it would only apply to the very wealthy, and so the middle class put up no resistance - and got exactly what they deserved a few years later when the scheme expanded to include them.

And finally, exactly what's wrong with a plutocracy, not that we have one at all? The only power I am aware of wielding is my vote, and I still get only one no matter how wealthy I become. Whatever power the rich have, they use more benignly than the poor would. The rich would like everyone to be wealthy enough not to steal from them, and they only use whatever power they hold to keep people from invading their wallets. The poor on the other hand want to take from me the fruit of labor that I performed and they did not. I find it infinitely more honorable to work for my money and be in the first group.

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[Dereg]

A progressive tax creates an external cost - a cost that someone else pays. The poor free ride on the taxes paid by the rich.The trend toward lower marginal tax rates during the past 50 years was perhaps mainly the result of interest group pressure from higher income individuals, but it also receives support from a benefit-cost analysis of the expected effects of tax increases on behavior.

[NEH]

Terry, Your comment, "... what's wrong with a Plutocracy..." says it all. Think about it...

[Terry Bennett]

As long as people come by their wealth honestly, and it is my studied opinion that almost all Americans do, a plutocracy is a form of meritocracy. I'm not sure what is meant by "power" as I said, but if money can buy more of it, that's not necessarily bad, because anybody can go out and work hard and make more money with which to buy the level of power they desire, and anybody who then wants to take that share of power away can go out and work even harder, etc. In a straight democracy, the poor can vote to take money from those who have earned it, as was done in instituting the income tax per my original post. I find that outcome at least as ignoble as the spectre of hunger in the streets.

[NEH]

Terry, Once again, "... I'm not sure what is meant by "power"..." says it all. To raise a cliche, "Money is Power" and as such, is a clear and present danger to any Republic; its Institutions and People.

As for "Wealth", it only comes from three sources. It's either Inheritated, Stolen, or it was Earned (discounting the earned income of Drug Cartels and other international criminal activities). As for most American holders today, I think you'll find it was either Inheritated or Stolen. Could this also be viewed as an "Unearned Entitlement" for the Wealthy?

[TANSTAAFL]

"Inheritated" (sic) wealth and "Stolen" wealth are atypical minority categories of wealth in America. By far most wealth in America is earned. NEH's naked claim that most wealth in American is "either Inheritated [sic] or Stolen" is pure chutzpah. Anyone so gullible as to buy such Marxist pap deserves to have the like of NEH as their ruler, and, for that reason, must be pitied.

[Terry Bennett]

I am genuinely trying to understand, and I don't want to put words in anyone's mouth, but my position statements above obviously do not "say it all" since they don't say enough to inform me about someone else's position, and the conclusory aphorisms offered do not make it clear to me either. I am openly stating that I don't "get it", and I am apparently being criticized for not getting it, yet I am not being told anything that helps me to get it.

I'll take a stab in the dark. Let's suppose that "power" is the ability to influence a vote other than your own. If money is power, and I can use money to change another voter's mind, that is not necessarily bad. Maybe I am using my money to spread a message which will resonate with other voters and clarify an issue for them or help them to see a candidate in a new and more accurate light, and because of my money they will change their vote for the better. This applies to the votes of both fellow citizens and elected officials, and I think it is a good thing. (I also assert that in the current Presidential race, both sides have ample money to get their respective messages out, and then some, so I don't think there's an immediate problem.)

Now suppose my money is deliberately influencing somebody's vote for the worse, i.e., a bad faith use of money to accomplish a selfish or other immoral outcome. If it's a citizen, there's no law against stupidity and as long as no slander is committed, we're stuck with the votes of those who cannot see through spin, clockwise or counterclockwise, for better or for worse. If it's a directly or derivatively elected official, there is a remedy for corruption (impeachment, jail terms, etc.), and there is a remedy for stupidity (the next election).

So, if the plutocracy is growing more powerful, it's either because the voters are growing more stupid and ill-informed, in which case more power/money can help educate them, or it's because our representatives are growing more corrupt, in which case I encourage our attorneys general to get on the stick. In either case, I do not see where I am at fault for working hard and earning money.

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