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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[NEH]

Terry, As for Money, Power and its ability to Corrupt; you really don't think that a Plutocracy is going to allow the Legal remedies, etc. and other Institutions to stand free and clear of their control...

Getting nervous there affl? ;) By exposing the actions hidden in the Dark and Shadows to exploit the vulnerabilities of the Republic and Institutions to the bright light of day? "Chutzpah and Marxist Pap"? Come now, you can do better than that.

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This article is far too narrow in scope and does not address biases in the field. The analysis does not address measures that many small businesses at the lower end of the threshold use to avoid paying taxes such employing additional help or buying equipment. It does not examine the benefit that the very rich will have in living in a country with sustainable debt levels. The very rich own much the government debt at issue and would be quite upset if it becomes utterly worthless in the near future. Finally the vast majority of economists, whether in the private sector, government or education field, ultimately derive their income from explaining, reassuring or enabling the wealthy to retain their wealth. Is it any wonder that unpaid bloggers have had a far better track record predicting and explaining economic events in the last seven years.

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[Terry Bennett]

NEH - Actually, I do have faith in the law in our time. Sure, in some third world country a wealthy person can buy his own army (A prominent crony capitalist in The Philippines once told me he had 30,000 men at the ready), but I don't lose any sleep over such a scenario here. We regularly expose, prosecute, and punish the wealthy/powerful. Think Blagojevich, in our hosts' backyard. Edwards got off unincarcerated, but not uninjured. Granted, I'm disappointed at the lack of severed heads from the last banking scandal, but overall I do think most wealthy people are aware of constraints on their behavior. In fact, because they don't need it and have more enjoyable lives to lose, they are probably less likely to take legal risks, i.e., commit crimes.

[TANSTAAFL]

Bennett makes a good deal more sense than NEH. It is no coincidence that he writes better, too.

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[NEH]

Terry, As for Blagojevich he's in my "front yard". We also have Ryan, etc., etc. and the likes of the IBI keeping a close eye on the Legal system. Both State and Federal. I guess you haven't lived and grown up in Modern America and the realm of "Money, Power, Corruption and Machine Politics". Actually, it's called "Real Politik"... ;)

[Terry Bennett]

TANSTAAFL - Thanks for the reassurance. Sometimes I wonder if he and I are talking about the same country. I'll try to keep up the standards.

NEH - I'm a lifelong hick from the rolling mountains of Atlantic City, where the Chicago machine is at most a rumor, so perhaps you are correct that I'm missing an important part of the picture. Nonetheless, as I feel my piece of the elephant I come away with the sense that corruption is rather junior on our current list of problems. Further, I do not see where arbitrarily giving the poor more power would somehow make things better. The saving grace of our country is liberty, and the social mobility that it allows. If for some reason you want power, and money is power, go earn money. Plenty of people have done exactly that in our time. Power is not ensconced in a protected class here. The blood of tyrants need not be shed; we merely need to out-earn them, and if it's important to you to see different people running the show, go generate wealth and have at it.

[Tax Hater]

I don't believe in tax

[Luke Terry]

I believe that raised tax is okay only if it does not become too taxing or difficult for the tax payers. I do believe that people with higher income should be paying higher taxes. If you are earning millions anyway, you surely have a couple dollars to spare. But then with the different tax brackets, in some cases, people who get promoted to a higher position end up having to pay more because of the increase in their tax. This is a problem I wish would be addressed

[Charlie Day]

There's no reason why those who make more shouldn't be required to pay more in taxes. They earn enough to more than sustain themselves and it's not fair that they pay less. It's an odd logic that guides the idea that cutting taxes for the wealthy will somehow stimulate the economy since it'll make them spend more. If anything, studies have shown poorer people spend well beyond their means relative to their incomes. It seems like the rich are due for another set of Occupy protest, hopefully this guy will be leading them: http://lawblog.legalmatch.com/2012/07/20/your-right-strip-naked-airport/

[NEH]

Terry, Atlantic City ehh... The secret of a well functioning Republic and the Health and Wellbeing of a Nation and its People lies in advancing and maintaining the Balance of Power between the various Socioeconomic Classes that exist and the Art of Compromise. Not the policies of "We hold the Power, so let the Devil take the hindmost".

[Terry Bennett]

Charlie,

There IS a reason. Our country is founded on liberty and justice for all, not just the poor. The government is everyone's burden. It seems so easy for other people to be flippant with my rights and my money. Need an extra trillion for some responsibility you'd like the government to take off your back, like saving money for retirement or health care? Sure, just let those other guys pay for it - they can afford it. How did I get to be the bad guy, just because I work hard? Why should I be penalized so you can have things you didn't pay for?

Luke, you'd make a good panhandler. Hey Mister, you make a lot of money, you surely have a couple dollars to spare, so I don't have to work so hard.

The worst part is that the people who are encouraging the forced extraction of this magnanimity from the rich do not then want to give the rich any credit for the gift. As was posted above by Matt, the top 5% of earners do already in fact pay almost 3/5ths of the taxes, and does anybody say thank you to these people who bear this burden that we should rightly be bearing side by side with them? The argument being offered is, "Please reach into your pocket a little deeper sir, since you are so blessed and others are needy." Then when the deed is done, there's not a kind word to be said toward the donors. On the campaign trail Al Gore perfected his pronunciation of "the rich" to the point that he sounded like he was going to puke when he said it.

As I said above, we have a federal budget of X, and a population of Y eligible voters. Anybody who is paying less than X/Y in taxes is on welfare. Instead of investing your energies trying to sell the supposed fairness of taking even more money from someone else to underwrite your unearned and undeserved standard of living, the noble thing to do would be get a job and pay your fair share.

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[Tien Huynh]

As we all know, the increasing of income tax does not mean that it will increase the revenue of government. It might reduce the revenue; as the income tax is so high, many businesses would reduce amount of work or job, many people would reduce amount of working hours, and there would be more tax cheaters. These are problem that many people think when the income tax is increased. However, the problem is not quite true. As we know, people who earn more than $250,000 a year mostly are business, CEO, and Ph.D degree people. These people have fixed income. Service business, for example, cannot reduce amount of workers just because of the increasing of income tax when its business is in good condition and growing fast . If the business reduced the work forces, who would help it maintain the business? I agree that "Americans are accustomed to working hard and to achieving and maintaining a high level of expenditure on consumer goods", and there is no way they want to work less or reduce work. Even with higher income tax, people can compensate it with high income earning. The income tax from people who make over $250,000 a year does not mean of raising the government revenue significantly , but it helps government having more money in investing other program and stimulus economy.

[New Mike]

OK, so far Terry Bennet is the winner. You have assembled the best argument I have read to date! Kudos.

I got here by the query "who gains when taxes go up" in order to shake out an idea I had. Where does the larger percentages of money go via government spending. Like the military, roads, utilities, construction etc. Historically have those same industries gained from higher taxes? Are they historically the same industry? Just a thought I had. Really trying to get my head around it.

Also the idea that we can raise the tax to 70% before deleterious effect would occur lead me to ask, why would we do that? Are you saying that government is better at managing money than those who made it in the first place.

Why can't private enterprise be more the answer than government? Are we instantly assuming that government is better at stimulating an economy? That as more money goes into it the more people have better services? I seek clarity. This is coming from a previously die hard Keynesian. I do think we need to pay something, as Terry said government is all of our burden. Just how much do you want to pay is the question. If we can get maximum ROI from government then great. If it's better to let the private sector do it then great too.

Going to 70% just because you can is nuts. That right there made me think the Austrians might have a good point.

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