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Thanks in large part to new House member Alexandria Ocasio-Cortez, a New York Democrat, there’s been lots of discussion this week about hiking tax rates on the superwealthy. Her support in a 60 Minutes interview of top marginal rates of 70 or even 80 percent to pay for a “Green New Deal” has drawn bipartisan plaudits from Paul Krugman to Ann Coulter.
How should one think about the various economic dimensions of such policy? A good place to find some useful information and analysis is “Should the Top Marginal Income Tax Rate Be 73 Percent?,” a 2012 Tax Notes article by AEI economists Aparna Mathur, Sita Slavov, and Michael Strain.
That 70–80 percent range mentioned by Ocasio-Cortez didn’t come from nowhere. Mathur, Slavov, and Strain were responding to a paper in which economists Peter Diamond and Emmanuel Saez argue the optimal top marginal income tax rate (that is, the rate at which the government collects the most revenue) is 72.7 percent. Why not higher? Because at that point the “behavioral effect” on high earners outweighs the “mechanical effect” of higher rates collecting proportionally higher income: If you raise taxes too high, the highest earners will simply stop working as much and you’ll collect less revenue as a result.
Mathur, Slavov, and Strain disagree. They argue that Diamond and Saez underestimate a higher tax rate’s likely impact on behavior because it only looks at short-term changes. It doesn’t (and can’t) consider the longer-term effects of a tax hike, which might prove more detrimental. From the Tax Notes article:
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 preferences and market prices alone. If enough people made that choice, there wouldn’t be enough surgeons.
Or imagine a small business owner. His business is growing and he has the opportunity to expand it over the next decade. But because expanding it will require a lot of work — not to mention that the payoff is risky — he chooses not to. He decides that it’s just not worth it given that the potential rewards from his hard work will largely go to the government
This uncertainty should caution against adopting a vastly higher rate. And it’s not merely speculative. Again, from the article:
We agree with Diamond and Saez that the economics literature does not have good estimates of the long-run effects of high top marginal tax rates on human capital accumulation, career, entrepreneurship, and business development choices. But most economists would agree that those effects exist and may be important. We do not have estimates of their magnitude only because we lack appropriate data. Indeed, the most important questions in economics are often the hardest to answer because of data limitations. This is certainly one of those cases. In the absence of good empirical estimates, Diamond and Saez have picked an estimate that is clearly bad: They have effectively assumed that the long-run effects are zero.
Economic research also suggests the short-term behavior changes (the elasticity of taxable income, in econ jargon) for high-earners is higher than the elasticity of the average worker, and higher than Diamond and Saez’s estimates. The elasticity also varies by other characteristics: “While men don’t change their work decisions much in response to the tax rate, women — and more generally, secondary earners — exhibit more responsiveness to income tax rates.” So if you want more women in the workforce making high incomes, ostensibly a progressive goal, raising their marginal taxes seems counterproductive.
And as discussed in the Tax Notes piece, there are other ways people can change their behavior to avoid taxes than simply working less, such as by shifting income into nontaxable forms like employer-sponsored health insurance and other untaxed fringe benefits, or engaging in tax evasion by underreporting income. Martin Feldstein has argued the labor supply elasticity greatly underestimates the total deadweight loss of income taxation because it ignores those types of behavioral effects.
All of which warns against accepting 73 percent as the socially optimal, revenue-maximizing rate.
Matt Winesett is the Managing Editor of AEIdeas.
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