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The Agenda

NRO’s domestic-policy blog, by Reihan Salam.

A Millionaire’s Bracket is a Bad Idea, Particularly for the Left



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Annie Lowrey of The Washington Independent is one of my favorite economics reporters. Her work on youth unemployment alone merits praise. But I’m definitely not a fan of her call for a new top income tax bracket, a stance that will surprise almost no one. Annie writes:

 

Democrats could, for instance, offer to create a new tax bracket for the top one percent of earners (those making more than about $410,000) or for any earners making more than $1 million. That tax bracket could pay the top marginal rate before the tax cuts, 39.6 percent, or some rate between the current 35 percent and 39.6 percent in 2011 and 2012. Then, two years from now, Democrats could end the Bush-era tax cuts for all families making more than $250,000 and individuals making more than $200,000, bringing that bracket up to 39.6 percent and pushing taxes on the highest earners up again.

Why would this be a good idea? Politically, it seems workable, since Americans by and large want to soak the rich to help pay down the debt. For the past 20 years, the top income tax bracket has started around $370,000, adjusted for inflation, and top marginal tax rate has stayed between 35 and 39.6 percent. But since the mid-1990s, the richest have gotten richer, earning a higher and higher share of all income while paying the same income tax rate as more moderate-income workers.

She goes on to cite the Tax Foundation:

The Tax Foundation notes: “[B]etween 2000 and 2007, pre-tax income for the top 1 percent of tax returns grew by 50 percent, while pre-tax income for the bottom 50 percent increased by 29 percent.” And the total proportion of taxes paid by very wealthy Americans has declined, as they earn more and more from investment vehicles on which they pay capital gains, rather than income, taxes. The income tax is, of course, progressive. But it could be more so.

That same article from the Tax Foundation also notes the following:

In 2007, the top 1 percent of tax returns paid 40.4 percent of all federal individual income taxes and earned 22.8 percent of adjusted gross income. Both of those figures—share of income and share of taxes paid—are significantly higher than they were in 2004 when the top 1 percent earned 19 percent of adjusted gross income (AGI) and paid 36.9 percent of federal individual income taxes.

This strikes me as fairly important. If the top 1 percent is responsible for 40.4 percent of revenue from federal individual income taxes, a new top rate will presumably increase revenue volatility, as income at the top of the distribution tends to fluctuate with the business cycle. 

Of course, revenue volatility is not the end of the world. Another important question is whether this strategy will raise much revenue. Alan Viard of AEI addressed this question in 2007:  

 

Even after bearing such a large share of the tax burden, the top 1 percent still retained 14 percent of national after-tax income in 2004. Their average household income was $1,260,000 before tax and $868,000 after tax.

Nevertheless, raising significant amounts of revenue from this group would require large hikes in marginal tax rates. Consider the task of raising an additional $1 trillion over fiscal years 2008 through 2017, which would cover the costs of AMT repeal or reform, with some extra money for other priorities. That would be an increase of only 3 percent over the $34.5 trillion revenue projected under current law.[11]

Extrapolating from CBO estimates for smaller rate increases indicates that this money could be raised with an across-the-board rate increase of 2.2 percentage points. But if the increase applied solely to taxable incomes above $1 million ($500,000 for singles), marginal rates would need to rise 22 percentage points from their current 35 percent, to 57 percent. If the net were widened to include everyone in the top bracket (couples with taxable incomes above $349,700), the necessary increase would be 13 percentage points, from 35 to 48 percent. Even if the rate increase also applied to the next highest bracket (couples with taxable incomes above $195,850), the required increase would still be 10 percentage points.[12] Such rate increases would put marginal rates back to levels not seen in decades; the top rate has been below 40 percent since 1987.

Annie is definitely not calling for a marginal tax rate of 57 percent. Rather, she sees 39.6 percent as an upper bound. It is safe to say that this proposal, in the best case scenario, will raise very little revenue, as Viard goes on to explain:

Economic analysis indicates that the best taxes are those paid by people who can best afford to pay and those that involve little distortion per dollar of revenue. Unfortunately, there is usually a tradeoff between these criteria. On the one hand, rate increases at the top fall on those with the greatest ability to pay. On the other hand, they turn out to have large distortions per dollar of revenue.

To see this last point, consider a 1-percentage-point rate increase in the top tax bracket, from 35 to 36 percent. This increases the disincentives for all of the affected taxpayers by 1 percentage point, yet the revenue it raises is less than 1 percent of the affected taxpayers’ incomes. For the $500,000 couple, for example, the 1-percentage-point tax increase applies to only the last $150,300 of income, the portion that falls into the top bracket; the tax on the first $349,700 is unchanged at $94,601. Because the disincentive effects depend upon the marginal tax rate, though, they are as severe as if the couple had to pay an extra 1 percent on all of its income. (But with one caveat: the rate increase will not cause the taxpayer to reduce his income below $349,700, since the disincentive then disappears). As a result, the ratio of distortion to revenue can be very high.

An increase in the 10 percent bracket, in contrast, would prove far more effective at raising revenue, in part because the top 1 percent would pay alongside all other taxpayers without any additional disincentives. 

It is also worth noting that increases in federal income taxes at the top will be magnified by state and, in a handful of cases, local income taxes, as the Tax Foundation observed last year. If we embraced Annie’s proposal, the top effective marginal tax rate would exceed 50 percent in a majority of U.S. states. And 50 percent is widely seen as a key threshold beyond which we see a dramatic increase in tax avoidance.

My own view is that we should replace the income tax with a consumption tax. This would, as Annie suggests, tend to make our tax system less progressive, though we can address that concern by using an X-tax with progressive rates

One reason why progressives should be reluctant to raise the top income tax rate can be found in Monica Prasad’s brilliant history of neoliberal reform efforts in the U.S., Britain, France, and West Germany, The Politics of Free Markets. The University of Chicago Press’s synopsis gives some indication of the Prasad thesis: 

In The Politics of Free Markets, a comparative-historical analysis of the development of neoliberal policies in these four countries, Monica Prasad argues that neoliberalism was made possible in the United States and Britain not because the Left in these countries was too weak, but because it was in some respects too strong. At the time of the oil crisis in the 1970s, American and British tax policies were more punitive to business and the wealthy than the tax policies of France and West Germany; American and British industrial policies were more adversarial to business in key domains; and while the British welfare state was the most redistributive of the four, the French welfare state was the least redistributive. Prasad shows that these adversarial structures in the United States and Britain created opportunities for politicians to find and mobilize dissatisfaction with the status quo, while the more progrowth policies of France and West Germany prevented politicians of the Right from anchoring neoliberalism in electoral dissatisfaction. [Emphasis added.]

Consider Peter Lindert’s argument in Growing Public:

The larger the budget, the greater the political risk that larger groups will notice and take action against groups that advocate, or implement, the wrong choice. Such a rising “shadow price” of a wrong policy suggests a reason why it is the higher-budget welfare states that got certain things right. While a low-budget United States could get locked in (and is still partially-locked) into the double taxation of dividends, a higher-budget government would run greater economic and political risks by magnifying the same mix of taxes.

Does the political process really work that way in democracies? We have a few clear examples, even though most of the detailed budgetary histories remain to be written. Let us turn first to a case in which the democratic political process correctly foresaw the need to base giant social budgets largely on a pro-growth consumption tax and then to a few cases in which mistakes were followed by corrections. [Emphasis added.]

Lindert then begins a fascinating discussion of the reluctant Seocial Democratic embrace of the VAT after the Second World War. The basic takeaway is that a more steeply progressive income tax increases the political risks posed by a dramatic expansion of social budgets. That is, the left-wing is inadvertently aiding the right-wing. Some will be amused by the cosmic justice of it all. I’m more concerned about deadweight loss. 

(And on that note, I’d submit that Austan Goolsbee’s sanguine findings [PDF] have been overtaken by more recent research.) 



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