The Economic Effects of Increasing Marginal Income Tax Rates—Posner

Increasing income taxes can, as Becker argues, reduce the amount of work. But when the issue is increasing marginal income tax rates, the likelihood of a significant effect on work depends critically not only on the amount of the increase but also on where the margin is set. The Obama Administration proposes by allowing some of the Bush tax cuts to expire on schedule to increase the marginal income tax rate of persons whose taxable income exceeds $250,000 a year from 35 to 39.6 percent. The top 1 percent of American earners have household incomes in excess of about $330,000; their taxable income is less; so probably not much more than 1 percent of taxpayers would be affected by the proposed tax increase. The effect on most of these taxpayers would be small. Suppose a person earning $300,000 in taxable income pays $75,000 in taxes currently. If his marginal rate (the rate for taxable income above $250,000) rises from 35 to 39.6 percent (for simplicity I’ll round this up to 40 percent), then his total income tax bill will rise from $75,000 to $77,500 (because on the last $50,000 of his income he will pay an extra 5 percent in tax). Will this increase in his total federal income tax bill, of 3.3 percent, cause him to work less? I would like to see evidence that it would. 

Because of tax avoidance opportunities, it seems that very few people pay more than about a quarter of their income in federal income tax. Suppose someone has an income of $10 million on which he currently pays $2.5 million in income tax. The Administration’s tax increase would raise his income tax by $487,500 ([$10 million - $250,000] x .05), or slightly less than 20 percent. Would that affect how hard he works? I’m skeptical. 

Income tax on earned income (as distinct from capital gains and dividends, which I’ll discuss shortly) does increase the cost of work relative to leisure, which is the basis for concern that increasing income tax rates, especially marginal rates, will cause a shift from work to leisure (and, as emphasized by Becker, to nonpecuniary work such as household production). But there is another effect: by lowering disposable income, an increase in income tax may cause a person to work harder iin order to maintain his previous standard of living. The net effect on income of a higher tax is therefore uncertain. 

The Administration’s tax plan would raise the capital gains tax from 15 to 23.8 percent and the tax on dividend income from 18 percent to 43.8 percent. These would be substantial increases but except for the 3.8 percent (a new Medicare tax) would merely return these tax rates to what they were in the Clinton years, the 1990s, actually a more prosperous time than the 2000s even before the financial bust of September 2008 and the ensuing general economic downturn. I don’t know what effect on work these tax increases would have, because I don’t know how direct the relation is between either capital gains and work or dividends and work. 

Americans are accustomed to working hard and to achieving and maintaining a high level of expenditure on consumer goods. In addition, people who earn high incomes tend to be highly competitive and to rate themselves by their income relative to the income of peers. Because of the absence of an aristocracy and the presence of a generally philistine attitude toward culture, money is the key index to prestige and social standing in the United States and, for many Americans, to a feeling of self-worth. These features of American society lead to me to be skeptical in general about the effect on work and therefore income of increasing marginal income tax rates to the levels contempated by the Administration. 

The more important question is the revenue effect of the proposed tax increases, if they are put into effect. Increasing taxes can actually reduce government revenues if the increase induces people either to work less or, more likely, to report less income, either by increasing lawful deductions (implying an added demand for services of lawyers and accountants) or by cheating. And an effective tax increase, one that reduces after-tax incomes, is hardly a recipe for promoting recovery from a severe economic slump. So I am not enthusiastic about increasing taxes now, especially since the Treasury remains able to borrow at extraordinarily low interest rates to finance the federal deficit. Nor is this just short-term borrowing; the 10-year Treasury rate as of three days ago was 1.5 percent. 

The real significance of the proposed tax increases is political. Income inequality is growing in the United States and there  is increased resentment at what seem the outlandish incomes of the rich and the increased frequency of crime and sharp practices by businessmen (whether that frequency actually has increased is unknown). A tax increase limited to high earners might assuage this resentment somewhat.

Comments

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[Rcfwilmette]

On behalf of liberals and progressives, I am glad to welcome Judge Posner to our group.

[William]

Here is a question I have thought about for sometime since the Debate about tax rates always involves comparisons to the 90s. Did the "Bush-era" tax rates actually prevent the economic downturn from being more catastrophic than it was? That is, would things have been worse if the tax rates were never reduced? Everything I understand about taxes states that it is true that at some point you reach a tax rate that actually reduces government revenue meaning that lowering taxes will increase the government's revenue. If that is true, it seems to me that it is possible that without the Bush-era reduced taxes, the "Great Recession," as many people called, it could have been the "Second Great Depression."

As to the last paragraph I think more appropriately hits the nail on the head. Raising taxes on the "rich" is more about punishment than anything else. A true policy debate would not focus on phrases like "fair share" and the "rich", it would focus on whether raising taxes puts will increase revenue or are the rates already as high as they can go, that is, which side of the Laffer Curve are we on? This I think would be a legitimate debate.

[Thomas Rekdal]

I share Judge Posner's skepticism about the disincentive effects of the Obama taxes on work effort, but I do not share his expectation (or is it hope?)that such taxes may assuage class resentment over income inequality. More likely it will simply strengthen the false belief that squeezing the rich is the solution to our fiscal problems. This is like encouraging people to bring water pistols to a forest fire.

Our real problem is massive overspending, particularly massive overspending on the elderly, and until the public is prepared to accept the pain that reduced spending or substantial taxes will cause, there is no "way forward." Indeed, there is no hope at all.

Some political problems are so difficult there is no real solution. Like slavery, our debt dilemma may be one of them. We may just have to wait for the bond market to break the deadlock. And make no mistake, after it is through ravaging Europe, it will surely come for us.

[Richard Mason]

Although it is incidental to the main point, I would comment that for Americans, fame is a source of prestige and self-worth at least as potent and probably more potent than money.

I think most Americans would rather be the football quarterback than the owner of the football team; would rather meet the quarterback; would be more likely to accord the quarterback reverence and respect if they met him; and so on.

Of course, celebrities often have good incomes caused by or correlated with whatever made them famous, but their social prestige is greatly disproportionate to that.

Unlike the distribution of income, the distribution of fame is said to be becoming more equal with time (cf. Warhol, 1968).

[Happy to Pay My Taxes]

I agree with Judge Posner's analysis for the most part. However, I wish that Obama had taken the page from Bowles-Simpson and coupled the not-unimportant Populist appeal of "income equality" and "everyone-pay-your-fair-share" [I'm down with these] with long-term entitlement reform.

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Tax is the country's economic resources, but too many tax increases our burden.

[A concerned citizen]

The analysis that Judge Posner presents here is solid, and I agree with nearly every word of it. However, he misses a significant economic point that is promoted by nearly every economics professor in their most basic economics course: namely, the notion of opportunity cost.

While I share the belief that raising the marginal tax rates on the rich will have a very small (virtually negligible) deleterious effect on their productive behaviors (it may even have a positive effect if they decide to work more to make up for the decrease in their after tax income!), I have to question the wisdom of the allocation of those additional taxed resources in promoting wealth. Hayek, in particular, makes this point several times and won his Nobel Prize for his work on this subject. Those dollars that are taxed will be spent on something whether they are taxed away from the people who earned them or not. Absent a vested, monetary incentive to spend those dollars in an economically efficient manner (as opposed to just a technically efficient manner), there's simply no guarantee that wealth will actually be generated, just that things will be done.

The point I'm making essentially boils down to the following. We have clear and demonstrable evidence that the private individuals who are going to be taxed additionally can take resources and transform them into higher valued resources: their salaries. They would not be paid such high salaries (and therefore be subject to the highest marginal tax rate) if this were not the case. However, we lack this clear and demonstrable evidence in the case of political actors. This last point cuts against what is "known" by the vast majority of people, but the vast majority of people are not economists. The lesson is perhaps best summed up in the Tale of the Roman Emperor and what I'm advocating is simply letting the second singer sing.

Given relative certainty on one hand and relative uncertainty on the other, personally I am inclined to side with the certainty. Let those who earned the dollars keep the dollars and spend them in a competitive environment that is subject to monetary profit and loss as opposed to political profit (reelection) and loss (impeachment/defeat).

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I am glad to welcome Judge Posner to our group

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A decrease in disposable income would have some effect on equilibrium prices in the economy, who knows what the net effect will be.

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[EJR (U of Chicago AB '82)]

"A tax increase limited to high earners might assuage this resentment somewhat". Huh???

Why is the fear of resentment a basis for tax policy? Why stop at "tax the rich"; why not "shoot the rich"? That should really reduce resentment (although probably not for the rich).

This is the kind of dopey, egg-head thinking that most reasonable, working Americans reject.

A policy promoting wealth re-distribution (as an end in itself) is immoral. Dick Posner should know better.