How far to soak the rich… Optimal top tax rates

You said it.  Source: Google images.

You said it. Source: Google images.

A quick read from this morning’s press turned up an interesting article – Determining the optimal U.S. tax rate for high earners.  In brief, the author summarises existing economic literature which empirically estimates the top tax band (NB: the top tax rate in the US is currently 39.6%, compared with 45% in the UK).  He finds the top rate can and should be substantially higher, using 3 elasticity approaches.

Some thoughts:

  • Background: tax policy is especially important in the US, relative to other countries, in order to achieve income redistribution.  Americans seem happier to use progressive taxation, rather than cash transfers, to help level the playing field.  Here’s some OECD data, summarised by Greg Mankiw, on the topic of US versus other countries in measuring tax progressiveness.
  • The issue: policy makers need to set top tax bands to achieve both needed revenue and a feeling from society that the rich are paying their fair share.  The big concern is the substitution effect, which means the rich will work less as their effective (after-tax) pay is cut.  The measure of this effect is called elasticity, which is measured in 3 ways by the research quoted in the article.
  • The result: in all 3 cases, the optimal higher tax rate is far above the existing rate – between 57% and 83%.  For history buffs, the latter is roughly where the top rate was in the 1930s-1950s.
  • How can that be true?  From the article, it seems high earners don’t care about their marginal tax rate – again spitting in the face of rational economic theory.  Perhaps they’re working for other reasons than earning a lot, and/or still feel rich with high marginal rates.
  • So what?  Part of me reads the article and feels the usual cynicism, e.g. “like that’ll ever happen”.  So worth asking why the US would raise the rates…maybe to squeeze just a bit more out of an already progressive tax system, in order to fund more progressive cash transfer system?  Also worth wondering what the elasticity would be for leaving town – testing the common argument that high earners will quickly leave town if rates are increased (e.g. London hedge fundies moving to Geneva when the top rate was increased to 50%, only to regret it later).  Finally, would hiking top tax rates actually raise additional revenue?  The elasticities in the article would hint at ‘yes’, but other authors suggest otherwise.

In sum: let’s put these findings in the basket of “hollow arguments the rich make to frighten working/middle class voters into voting against their best interests”.  Higher top tax rates may help raise revenue and social equality, with little effect on tax avoidance or decreased effort on behalf of high earners.

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2 thoughts on “How far to soak the rich… Optimal top tax rates

  1. Does 39.6% include state taxes or is it just Federal? Similarly the 45% rate in the UK doesn’t include 1.5% employee national insurance, although this is just a detail.

    I’d probably be in favour of a wealth tax, rather than a much higher income tax (the UK green party wants both of course). I think about 50% people start to avoid tax, just because its annoying. It might also make sense to roll up other taxes which are less progressive, into income or wealth tax (for example UK council tax, and whatever the US equivalent is).

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    • Just Federal – depending on state/city, those taxes can be much higher.

      Marginals are a bit of sleight of hand anyway, as average tax rate paid by Americans (even the rich) tend to be far less than top marginal.

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