Why Heavily Taxing The Rich Doesn't Work

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Photo: White House via Flickr

It’s strange when you think about it.Not only is President Obama pushing the largest round of tax hikes in almost a generation, but those increases would come during the most anemic economic expansion since World War Two — or maybe ever in American history.

Still, the White House appears not at all concerned that raising the tax burden and hiking marginal tax rates would make a sickly economy even weaker.

Nor is Team Obama concerned, apparently, about the risk of raising the long-term tax burden at a time when demographic changes will begin making it harder for the US economy to grow as fast in the future as it has in the past.

How can Team Obama be so preternaturally carefree and nonchalant about its taxapalooza?

One big reason is research from two highly respected — and left-of-centre — economists, Peter Diamond and Emmanuel Saez. (Diamond is a failed Obama nominee to the Federal Reserve Board, while Saez is perhaps best known for his work on income inequality with Thomas Piketty.)

In their paper, “The Case for a Progressive Tax,” they contend that the top federal income-tax rate in the US could more than double to 73% from 35% today without hurting economic growth.

To put it another way, the US is nowhere close to the top of the Laffer Curve, where higher tax rates start lowering tax revenues. If Diamond and Saez are correct, raising the top marginal rate to roughly 40% (actually closer to 43% when you account for other tax code changes), as Obama wants to, is no problemo.

Diamond and Saez summarize their findings in an April op-ed for The Wall Street Journal:

Thus we conclude that raising the top tax rate is very likely to result in revenue increases at least until we reach the 50% rate that held during the first Reagan administration, and possibly until the 70% rate of the 1970s. To reduce tax avoidance opportunities, tax rates on capital gains and dividends should increase along with the basic rate. Closing loopholes and stepping up enforcement would further limit tax avoidance and evasion.

Diamond and Saez, shorter: Let’s use an “all of the above” tax hike strategy to create a tax-hike “straitjacket” of higher rates and fewer tax breaks for wealthier Americans (and small business). The approach is the clear model for Obama-style tax reform.

But a new American Enterprise Institute analysis, published in Tax Notes, of the Diamond and Saez research suggests Obama might want to rethink his tax-hike strategy — or at least his cavalier attitude toward the potential risks it poses to US economic growth and job creation. In their paper “Should the Top Marginal Income Tax Rate Be 73 per cent?,” Aparna Mathur, Sita Slavov, and Michael Strain say they “do not believe that the [Diamond-Saez] model can be used prudently as the basis for the real-world public policy problem of determining the socially optimal top marginal income tax rate.”

Conducting the sort of deep dive that economic policymakers and pundits rarely make, Mathur, Slavov, and Strain highlight a number of questionable assumptions and choices made by Diamond and Saez:

1. Diamond and Saez assume that high-income taxpayers react to tax hikes more or less like lower-income taxpayers, meaning not so much. While there is no consensus here, studies focusing on high-income individuals tend to find much higher estimates of short-term responsiveness than studies of lower-income households. It makes intuitive sense: Wealthier taxpayers have a greater ability to alter how much they work, in what form they get their income, and fashion tax- avoidance strategies. “We do not believe that in the real world the top tax rate should be set under the assumption that tax avoidance and evasion behaviour can be dramatically changed,” Mathur, Slavov, and Strain write.

2. Diamond and Saez assume sharply raising tax rates has zero, zilch, zippo long-term impact on taxpayer behaviour and the economy since, well, those effects are hard to measure. But economists agree those long-term effects are important. America benefits greatly from people who take risks and make career choices in hopes of striking it rich. “Significantly reducing that possibility by hitting those individuals with extremely high income taxes is of first-order importance in determining the optimal top tax rate,” Mathur, Slavov, and Strain argue.

3.  Diamond and Saez have created a model — admittedly a lovely and elegant one — with a built-in bias that says more equality is better than less equality. Or, in other words, government should maximise the revenue it collects from high earners since they value each additional dollar of income less than lower-income earners. “Because the social loss from taking money from the rich is assumed to be zero and the social gain from giving money to the non-rich is greater than zero, society’s goal is clear: The government should take as much money as possible from the rich and redistribute it to the non-rich,” Mathur, Slavov, and Strain write. But is this really the role Americans want their tax code to play? The AEI economists:

Gregory Mankiw, a Harvard economist and former senior economic adviser to President George W. Bush, has said: “My sense is that people are rarely outraged when high incomes go to those who obviously earned them. When we see Steven Spielberg make blockbuster movies, Steve Jobs introduce the iPod, David Letterman crack funny jokes, and J.K. Rowling excite countless young readers with her Harry Potter books, we don’t object to the many millions of dollars they earn in the process. The high incomes that generate anger are those that come from manipulating the system. The CEO who pads the corporate board with his cronies and the banker whose firm survives only by virtue of a government bailout do not seem to deserve their multimillion dollar bonuses. The public perceives them (correctly or incorrectly) as getting more than they contributed to society.

A better criterion, according to Mankiw, would be: ”People should get what they deserve.”

Diamond and Saez’s academic work is filed with caveats and explanations not found in their work for public consumption, which is far more black and white. And to some degree that’s understandable. But a deeper reading leads Mathur, Slavov, and Strain to this conclusion:

Diamond and Saez ignore long-term behavioural responses, assume more equality is a better social welfare function, assign no social value to the marginal dollar of consumption for the rich, and use a short-run behavioural response predicated in part on less evasion and more enforcement to compute an answer of 73 per cent. Consequently, we can be pretty sure that the answer is significantly less than that. Further, we find the suggestion that the government should take more than half of a citizen’s income in taxes to be unpalatable.

Cranking up taxes on the rich isn’t the free lunch or cure-all that liberals so desperately desire it to be. And anyway, the revenue-maximizing tax rate isn’t the same as the growth-maximizing tax rate. America needs a tax code that pays for the amount of government it wants in a way that is as efficient and least harmful to economic growth as possible while also broadly reflecting society’s sense of equity. Using a $15 trillion economy to run a precarious, ideologically-driven experiment to find the exact tax-rate tipping on the Laffer Curve of the current tax code — and thus temporarily avoiding politically risky entitlement and tax reform — is a terrible way to pursue public policy.

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