The Agenda

Megan McArdle on the Future of Tax Rates

Megan McArdle has a new post on the near-term trajectory of marginal effective tax rates:

[I]n terms of behavior, the percentage increase in the rate, or the percentage decrease in total income, is much less important than a third figure: the percentage decrease in your after-tax dollar.  Most people think less about their nominal annual salary than about how much they bring home in each paycheck.

Taking your tax rate from 5% to 10% decreases your after tax income by 5.26%.  But by the time your tax rate is 50%, you’re only keeping half of your income.  So increasing the tax rate by 5% decreases your after-tax income by 10%: you used to take home 50 cents out of every dollar, but now you only take home 45 cents.  

If you were surprised that Gerard Depardieu decided to leave France rather than pay the new 70% top rate, think of it this way: the rate increase was only 30%, but it was going to cut his income in half. Yes, that would still leave him with more money than you and I live on.  But people don’t think this way: if the government came and took half your after-tax income away, that would still leave you with more money than a middle-class family in Bangalore lives on, and you would still be hopping mad, not to mention panicking about how the mortgage was going to get paid.  Even if they only took half of your marginal after-tax income away–an extra 50% of every dollar you made over $40,000 say–you would be pretty upset, because you’ve probably already earmarked uses for those dollars. [Emphasis added]

In October, Arpit Gupta published an article on tax rates and economic growth in National Review that offers a sober, not terribly ideological summary of recent research:

Many liberal advocates of higher taxes point out that taxes tend not to change the behavior of people who are already working, at least not immediately. This should not be surprising — after all, very few people will want to quit working entirely in response to tax changes, and most workers are tied to a specific schedule in their current jobs.

The picture changes, however, in the long run. Raj Chetty, an economist at Harvard, has suggested that people slowly adjust their work hours downward when taxes rise — for example, by finding less demanding jobs. Chetty’s research suggests that a 10 percent increase in taxes could lead to a 5 percent decrease in hours worked.

Economists, including Princeton’s Richard Rogerson, have also found that tax rates can have large effects on individuals’ decisions to enter or leave the work force. And they have found that some workers are more tax-sensitive than others. Married women with children and people nearing retirement age tend to be particularly sensitive, since many such workers are on the fence about whether to participate in the labor force to begin with.

Some researchers have tried to measure the impact of tax rates on a variety of other life decisions, such as whether to start a business or go to college. Ideally, we could tally up all of the effects that tax rates have and arrive at a grand total. Unfortunately, that remains a challenge. There are many things that are still unclear about the overall effect of tax rates on GDP. 

One thing that can be said for going over the fiscal cliff is that it will create a tremendous opportunity for students of tax policy to gauge the short-run impact of higher taxes.


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