May 8, 2012
Reynolds: Of Course 70% Tax Rates Would Reduce Federal Revenues
Some scholars argue that top rates can be raised drastically with no loss of revenue. Their arguments are flawed.
President Obama and others are demanding that we raise taxes on the "rich," and two recent academic papers that have gotten a lot of attention claim to show that there will be no ill effects if we do.
The first paper [The Case for a Progressive Tax: From Basic Research to Policy Recommendations], by Peter Diamond of MIT and Emmanuel Saez of the University of California, Berkeley, appeared in the Journal of Economic Perspectives last August. The second [Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities], by Mr. Saez, along with Thomas Piketty of the Paris School of Economics and Stefanie Stantcheva of MIT, was published by the National Bureau of Economic Research three months later. Both suggested that federal tax revenues would not decline even if the rate on the top 1% of earners were raised to 73%-83%.
Can the apex of the Laffer Curve—which shows that the revenue-maximizing tax rate is not the highest possible tax rate—really be that high?
The authors arrive at their conclusion through an unusual calculation of the "elasticity" (responsiveness) of taxable income to changes in marginal tax rates. According to a formula devised by Mr. Saez, if the elasticity is 1.0, the revenue-maximizing top tax rate would be 40% including state and Medicare taxes. That means the elasticity of taxable income (ETI) would have to be an unbelievably low 0.2 to 0.25 if the revenue-maximizing top tax rates were 73%-83% for the top 1%. The authors of both papers reach this conclusion with creative, if wholly unpersuasive, statistical arguments. ...
But the ETI for all taxpayers is going to be lower than for higher-income earners, simply because people with modest incomes and modest taxes are not willing or able to vary their income much in response to small tax changes. So the real question is the ETI of the top 1%. ... A midpoint between the estimates would be an elasticity for gross income of 1.3 for the top 1%, and presumably an even higher elasticity for taxable income (since taxpayers can claim larger deductions if tax rates go up.)
But let's stick with an ETI of 1.3 for the top 1%. This implies that the revenue-maximizing top marginal rate would be 33.9% for all taxes, and below 27% for the federal income tax.
To avoid reaching that conclusion, Messrs. Diamond and Saez's 2011 paper ignores all studies of elasticity among the top 1%, and instead chooses a midpoint of 0.25 between one uniquely low estimate of 0.12 for gross income among all taxpayers (from a 2004 study by Mr. Saez and Jonathan Gruber of MIT) and the 0.40 ETI norm from 30 other studies. That made-up estimate of 0.25 is the sole basis for the claim by Messrs. Diamond and Saez in their 2011 paper that tax rates could reach 73% without losing revenue.
The Saez-Piketty-Stantcheva paper does not confound a lowball estimate for all taxpayers with a midpoint estimate for the top 1%. ... Nevertheless, to cut this "large" elasticity down, the authors begin by combining the U.S. with 17 other affluent economies, telling us that elasticity estimates for top incomes are lower for Europe and Japan. The resulting mélange—an 18-country "overall elasticity of around 0.5"—has zero relevance to U.S. tax policy.
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The "Tale of Three Elasticities" paper, which I found at http://www.voxeu.org/sites/default/files/file/DP8675.pdf , is creative but I don't believe its assertions:
1. The paper presumes that proper enforcement could reduce tax avoidance (and presumably also evasion) to negligible levels: "...the deeper policy implication is that one needs to first close tax avoidance opportunities, in order to reduce the shifting elasticity and only then increase the top tax rate."
Translation of this obfuscation: Capital gains must be taxed at the same rate as ordinary income; otherwise people will find ways to transform ordinary income into capital gains.
Here in the real world, the writers of tax law have never been able to eliminate tax avoidance and evasion. Higher marginal rates increase the return to such activity. Tax lawyers are better paid and more creative than the tax law writers. Tax professionals, not the government, would be the primary beneficiaries of a 70% tax rate.
2. "we found that income including realized capital gains is exactly as elastic as income excluding them, using a full century long data series."
It defies common sense that highly discretionary income such as realized capital gains has only a 0.25 sensitivity to tax rate. Something must be wrong with the data, which in any case does not include any time period when the tax rate on realized capital gains came anywhere near 70%.
However due to item 1, the authors need the elasticities to come out the same for ordinary income and capital gains. If the elasticities are not the same (which in reality they are not) then the revenue-maximizing rates are not the same for the two types of income. In our current system there is a dual-rate compromise that accounts for both tax avoidance strategies and the different elasticities.
Posted by: AMTbuff | May 8, 2012 6:09:20 PM
continued from my first post...
3. I'm skeptical of the authors' conjecture that high-income people don't always bargain as hard as they can to maximize their income. The authors claim to believe that higher tax rates would cause people to demand less pretax income. Common sense tells me the opposite: that they would feel a need for more pre-tax income. This so-called income effect appears to be missing from the paper's model. Consider a dentist. Tax him at a higher rate and how will he respond? By raising his prices, of course. Why would a management executive do the opposite?
4. The Laffer peak (total revenue vs. tax rate) is quite flat, as shown in an excellent paper at http://www.ecb.int/pub/pdf/scpwps/ecbwp1174.pdf
It's a fundamental result of microeconomics that the deadweight loss of a tax grows as the square of the tax rate. Near the Laffer peak revenue is increasing much more slowly than the tax rate, let alone the square of the tax rate. Therefore the optimum rate for society is significantly below the Laffer peak. Maximizing revenue would be correct only if money left in the private economy had no value at all to society, an obviously false proposition.
Posted by: AMTbuff | May 8, 2012 6:11:25 PM
Pointed and persuasive critique by Reynolds. Readers eagerly await the rebuttal, if any, by Saez-Piketty-Stantcheva, especially what they have to say, if anything, about the "made-up estimate" charge.
Posted by: Jake | May 8, 2012 9:35:26 PM