The Corner

More on Increasing Tax Rates On High-Income Earners

Recently I’ve been reading economists Leonard Burman and Joel Slemrod’s Taxes in America. Like pretty much everything else these two write, this book is well worth reading. In particular, it hits all the important questions about taxes in a clear and neutral manner. I highly recommend it whether you want to learn more about our tax system, its incidences, its cost, and more, or whether you want to learn how to explain complex tax issues in a simple and concise way. 

In the context of the current debate over the fiscal cliff, I was particularly interested in the chapter called “Taxes and the Economy.” Slemrod and Burman, for instance, ask questions such as “How do taxes affect the economy?” (“in many, many ways,” is the first sentence of the chapter and pretty much the answer to this question). Or “What’s the Laffer curve?” “Which is a better economic stimulus, cutting taxes or spending more?” “Why do smart people disagree about optimal tax policy?” I don’t agree with everything they say, but I nevertheless found this chapter very balanced and informative. 

In the Laffer-curve section, they bring up the work of Peter Diamond and Emmanuel Saez on the revenue-maximizing federal income-tax rate. As you may remember, Diamond and Saez have suggested an increase in marginal rates of taxation on the wealthy to somewhere between 50 and 70 percent would maximize revenue for the government. They wrote an op-ed for the Wall Street Journal on their paper, which you can read here. Their findings have been used repeatedly recently to make the case for taxing upper-income earners at higher rates in order to collect more revenue.

But there is evidence that raising taxes on the rich may not be the free lunch some claim it will be. For instance, I have explained before that in the short term, it is true that studies suggest rate increases likely won’t have much of an effect on the labor supply of the typical full-time employed man aged 30 to 50 (roughly). But for one, this finding doesn’t hold for secondary earners (such as the working wives of high-income earners.)

There are also ways for high-income earners to respond to higher tax rates that other than changing one’s labor supply. #more#For instance, economists Aparna Mathur, Silva Slavov, and Michael Strain at the American Enterprise Institute noted in a recent response published in Tax Notes to the Diamond and Saez paper that people can avoid taxes by shifting “income into non-taxable forms such as employer-sponsored health insurance and other untaxed fringe benefits, or they can engage in tax evasion by underreporting income.” While economists (and empirical studies) have not reached a consensus as to the responsiveness (elasticity) of income relative to the marginal rates for high-income earners, there is some support for the idea that the behavioral effect may be larger than that used by Diamond and Saez. 

They also challenge Diamond and Saez’s implicit assumption that the only behavioral response that matters is the short-term effect of a small increase in the top marginal income-tax rate. The real world isn’t as black and white, they note. That means that even if higher taxes don’t discourage the efforts of those who are wealthy today, they decrease the incentive for individuals to become wealthy in the future. They write: 

Imagine a high school student who graduates in a world where the top marginal income tax rate is more than 70 percent. He may decide not to pursue his dream of becoming a college-educated engineer because the government will take a large share of the returns to his college investment — that is, much of the extra money he will earn because he is a college-educated engineer will be seized by the government, so he may conclude that going to college isn’t worth it. He is worse off because of the high top income tax rate. And so is society, because we now have one less engineer.

Or imagine a medical school student. She may decide to become a pediatrician instead of a heart surgeon because a large share of the extra money she would earn being a surgeon would be taken by the government. There is nothing wrong with pediatricians, but the problem is that the government is distorting this medical student’s decision — that is, she isn’t making the choice based on her preference sand market prices alone. If enough people made that choice, there wouldn’t be enough surgeons (an economist would say there is an inefficient allocation of human resources).

After giving another example, they continue to explain that “issue of investment in schooling, occupational choice and business creation and development” are more important when thinking about the real-world (as opposed to academic model produced) tax rates than Saez and Diamond given them credit for. Economists do not have good estimates of the long-run effects of high marginal rates on human capital accumulation, career, entrepreneurship and others choices, but most do agree that these effects exist and may be important. As a result, it is inappropriate for Diamond and Saez to assume that this long-term effect is zero. 

In fact, the work of economist Michael Keane illustrates how taxes have a very pronounced effect along some of the margins outlined by Mathur, Sita and Strain, especially for women. Summarizing the work of Keane in our chapter in the recent Occupy Handbook, Tyler Cowen and I noted recently that “The point is not that current tax rates are necessarily the correct ones, only that we should not overestimate the gain from trying to tax the rich more heavily. It’s a core economic lesson that trade-offs are everywhere.” 

There is much more to say on this topic, of course, but the bottom line is that things are not always what they seem, especially when it comes to taxes. Increasing taxes on the wealthiest earners may raise some revenue for the government in the short run, but the long-term costs may be quite significant. 

However, one thing is sure: The current obsession with raising taxes on the rich alone is allowing lawmakers to ignore the necessity of reforming programs such as Social Security and Medicare. To be sure, ignoring this problem is politically expedient. However, those who believe that taxing the rich alone, even at much higher rates than we are talking about today, without any spending reductions can address our upcoming debt problem are simply kidding themselves. Not cutting spending means much higher taxes sooner or later, on every single one of us

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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