Paul L. Caron

Saturday, November 24, 2012

Should the Top Marginal Income Tax Rate Be 73 Percent?

Tax AnalystsAparna Mathur, Sita Slavov & Michael R. Strain (all of the American Enterprise Institute), Should the Top Marginal Income Tax Rate Be 73 Percent?, 137 Tax Notes 676 (Nov. 5, 2012):

In this article, Mathur, Slavov, and Strain respond to the argument by Peter Diamond and Emmanuel Saez that the socially optimal top marginal income tax rate is around 73%, with a range from 54% to 80% [The Case for a Progressive Tax: From Basic Research to Policy Recommendations, 25 J. Econ. Persp. 165 (2011)]. The authors argue that Diamond and Saez’s analysis underestimates the distortive effect of a higher tax rate on real economic choices and embodies judgments about fairness that many Americans may find unacceptable. They also assert that Diamond and Saez’s underlying economic model cannot prudently be used as the basis for specific, real-world policy recommendations.

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This is a great way to ensure a failed second term.

Posted by: michael livingston | Nov 25, 2012 2:37:29 AM

Try reading the paper, Anon. It's short. The only assumptions are yours (about the Tax Notes authors) and those of Diamond and Saez.

The paper explains that Diamond and Saez made several assumptions which are of questionable validity. The Tax Notes authors did not attempt to make alternate assumptions. Instead they show that prior results point to a wide range of possibilities for elasticity of taxable income at high incomes, the most crucial assumption made by Diamond and Saez and in my opinion the most inaccurate one.

The range of possible optimum tax rates is so wide as to render any specific prediction meaningless. Not to mention that Diamond and Saez make a capital gains tax rate recommendation with no theoretical support at all. The 73% paper looks shabby by comparison to earlier work of these two authors. It appears Krugmanesque, as if the conclusion determined the reasoning rather than vice versa.

Posted by: AMTbuff | Nov 24, 2012 8:53:08 PM

This excellent and accessible article omits one consistently overlooked influence on elasticity of taxable income: financial aid for college expenses. Need-based aid operates like a large add-on to the marginal tax rate from about $50,000 to $150,000 income, covering most of the middle class. Because tuition far outpaces inflation, this range moves higher in real terms every year.

College financial aid increases medium-term elasticity of taxable income by further reducing or even eliminating the financial benefit of having a spouse take a paying job vs. remaining at home as children approach college age.

One of the earliest papers explaining the marginal tax rates implicit in college financial aid is Martin Feldstein's
Felstein shows that the marginal rates can exceed 90%, and that's based on only a 28% federal income tax rate without phase-outs such as the education credit (AOC) and without AMT.

I don't think Congress has a clue what today's marginal rates really are. If the public knew the truth, the upper middle class would probably go on strike. It wouldn't cost them much on net, so why not?

One good counterpoint is that financial aid is heavy on loans and low on grants. Student loans are far from free money: They are the worst kind of debt you can take on. Therefore the calculations of Feldstein and others should be adjusted to count only grant money. That correction will make a sizable dent in the true marginal rate.

Posted by: AMTbuff | Nov 24, 2012 5:45:16 PM

I think we knew the conclusions without even needing to read the study.

For corporate donors to AEI:

"The growth in the size and scope of the federal government represents a direct threat to the values AEI shares with the private sector—the engine of America's freedom and prosperity. Corporate support of the Institute helps keep AEI scholars at the forefront of public policy debates, evaluating the impact of policy proposals and regulations while advancing sound reforms."

Translation-- give us money, and we'll argue for lower taxes.

The only interesting question is how AEI tortured the data and which absurd assumptions they decided to use this time.

Posted by: Anon | Nov 24, 2012 3:40:07 PM