Peter Diamond and Emmanuel Saez have a new paper, “The Case for a Progressive Tax: From Basic Research to Policy Recommendations.” I strongly recommend reading it, as Diamond and Saez are very well-regarded. To get the gist of their recommendations, the relevant part of the abstract reads as follows:

We obtain three policy recommendations from basic research that satisfy these criteria reasonably well. First, very high earners should be subject to high and rising marginal tax rates on earnings. Second, low income families should be encouraged to work with earnings subsidies, which should then be phased-out with high implicit marginal tax rates. Third, capital income should be taxed. We explain why the famous zero marginal tax rate result for the top earner in the Mirrlees model and the zero capital income tax rate results of Chamley-Judd and Atkinson-Stiglitz are not policy relevant in our view.

I was not convinced by all of the recommendations. Their discussion of the optimal top marginal tax rate was of particular interest to me:

When a tax system offers tax avoidance or evasion opportunities, the tax base in a given year is quite sensitive to tax rates, so that the elasticity e is large, and the optimal top tax rate is correspondingly low. Two important qualifications must be made. First, as mentioned above, many of the tax avoidance channels such as re-timing or income shifting produce changes in tax revenue in other periods or other tax bases—called “tax externalities”—and hence do not decrease the optimal tax rate. Saez, Slemrod, Giertz (2011) provide formulas showing how the optimal top tax rate should be modified in such cases. Second, and most important, the tax avoidance or evasion component of the elasticity e is not an immutable parameter and can be reduced through base broadening and tax enforcement (Slemrod and Kopczuk, 2002; Kopczuk, 2005). Thus, the distinction between real responses and tax avoidance responses is critical for tax policy. As an illustration using the different elasticity estimates of Gruber and Saez (2002) for high income earners mentioned above, the optimal top tax rate using the current taxable income base (and ignoring tax externalities) would be *=1/(1+1.5 x 0.57)=54 percent while the optimal top tax rate using a broader income base with no deductions would be *=1/(1+1.5 x 0.17)=80 percent. Taking as fixed state and payroll tax rates, such rates correspond to top federal income tax rates equal to 48 and 76 percent, respectively. Although considerable uncertainty remains in the estimation of the long-run behavioral responses to top tax rates (Saez, Slemrod, Giertz, 2011), the elasticity e=0.57 is a conservative upper bound estimate of the distortion of top U.S. tax rates. Therefore, the case for higher rates at the top appears robust in the context of this model. [Emphasis added]

As the authors helpfully acknowledge, (1) eliminating tax avoidance opportunities is very important and (2) their analysis omits discussion of two important elements, one of which, the presence of capital income, is discussed later in the paper and the other of which, a longer-run dynamic perspective, is not.

I found the latter omission more than a little odd, but the authors had a ready explanation:

Perhaps most critically, does an estimate based on a single period model still apply when recognizing that people earn and pay income taxes year after year? First, earlier decisions such as education and career choices affect later earnings opportunities. It is conceivable that a more progressive tax system could reduce incentives to accumulate human capital in the first place. The logic of the equity-efficiency trade-off would still carry through, but the elasticity e should reflect not only short-run labor supply responses but also long-run responses through education and career choices. While there is a sizable multi-period optimal tax literature using life-cycle models and generating insights, we unfortunately have little compelling empirical evidence to assess whether taxes affect earnings though those long-run channels. [Emphasis added]

Emmanuel Saez has co-authored a number of papers with Raj Chetty, the Harvard wunderkind who has done a great deal of interesting work on the effect of taxes on labor supply, which we’ve discussed in this space. It is safe to assume that Saez is familiar with Chetty’s recent findings drawn from Danish tax records, which he discussed in a paper co-authored with John N. Friedman, Tore Olsen, and Luigi Pistaferri:

Our results could help explain why macro studies and much larger elasticities than microeconometric studies (Blundell and MaCurdy 1999; Saez, Slemrod, and Giertz 2009; Chetty 2009a). Micro estimates are attenuated by frictions because they are identified from individuals’ responses to changes in tax rates or kinks after obtaining a job near their optimum. In contrast, macro variation in tax rates across countries changes the jobs individuals search for and the jobs offered by firms to begin with, producing larger elasticities. Our explanation for the gap between micro and macro elasticities complements recent work arguing that macro elasticities are larger because they incorporate both extensive and intensive margin responses (e.g. Rogerson and Wallenius 2009). Much of the difference in labor supply across countries with different tax regimes is driven by hours worked conditional on employment (Davis and Henrekson 2005, Chetty et al. 2011). That is, macro estimates of intensive margin elasticities are much larger than their microeconometric counterparts. Our analysis explains this divergence between intensive margin elasticities. We caution, however, that our findings do not provide justification for the very large elasticities (e.g. ” > 1) used in some macro models. [Emphasis added]

Another way of looking at this is that once we find a job in a place we want to live, it takes more than slight changes in the tax rate to really shape how much we work. We’re embedded. But when we’re figuring out want we want to do and where we want to live, or when we reach some life milestone and are open to making a change, the tax rate might matter much more. Chetty discussed these “frictions” in a working paper from April of last year. Arpit Gupta wrote a great piece that explains these issues far better than I can.

I can definitely see why Diamond and Saez didn’t incorporate these findings into their analysis. But it does make intuitive sense to me that we’d want to have a good sense of the long-run behavioral responses before we embraced much higher top marginal tax rates.

Next, Diamond and Saez endorse the shift in anti-poverty policy towards conditional work supports:

In recent decades in most high-income countries, a concern arose that traditional welfare programs overly discouraged work and there has been a marked shift toward lowering the marginal tax rate at the bottom through a combination of: a) introduction and then expansion of in-work benefits such as the Earned Income Tax Credit in the United States; b) reduction of the statutory phase-out rates in transfer programs for earned income as under the U.S. welfare reform; and c) reduction of payroll taxes for low income earners as in the recent U.S. Making Work Pay credit. Those reforms are consistent with the logic of optimal taxation we have outlined, as they both encourage labor force participation and provide transfers to low income workers seen as a deserving group.

And finally, Diamond and Saez argue that capital income should be taxed, which puts them at odds with Alan Viard, Glenn Hubbard, and a large number of other economists with an interest in tax reform:

The bottom line is that uncertain future earnings opportunities argue against zero taxation of capital income, as do savings preference heterogeneity, limited distinctions between capital and labor incomes, and borrowing constraints. It is true that these arguments are based on life-cycle analyses, and that the empirical literature finds that the life-cycle approach, while helpful, is limited in its success in explaining savings behavior. The belief that many people do not save enough for their own retirements often leads to policies to encourage savings, particularly retirement savings. The most widely employed method is some form of forced saving through mandatory contributions to a retirement systems. This is often complemented with a combination of taxing capital income and having tax-favored retirement savings (including some subsidies) targeted to those liable to save too little.

This is a conclusion that will be controversial, I’m sure, and I’m eager to read the inevitable responses. The Bush tax reform panel’s Growth and Investment Tax Plan proposes taxing capital income at 15%, the lowest non-zero rate at which it taxes regular income. I’ve seen this as a reasonable compromise in the past, and I imagine that it would meet with the approval of Diamond and Saez, though perhaps they’d want to see an even higher rate.

All of this is food for thought as we contemplate big changes to our tax code.