Do Marginal Tax Rates Matter?

I have made it one of my little missions in life to convince proponents of what I call "Ultra-strong supply side-ism" that no, at the tax rates that currently prevail in the United States, you cannot raise tax revenue by cutting taxes.  So I was pleased to see that others like Karl Smith have taken up the cause, trying to explain why this isn't so.  This was my offering last year:

Consider the supply-siders.  The thing is intuitively appealling; when we get more money from working, we ought to be willing to work more hours.  And it is a mathematical truism that revenue must maximize at some point.  Why couldn't we be on the right-hand side of the Laffer Curve?

It was entirely possible that we were; unfortunately, it wasn't true.  And one of the reasons that supply-siders failed was that they were captivated by that one appealing intuition.  In economics, it's known as the "substitution effect"--as your wages go up, leisure becomes relatively more expensive relative to work, so you tend to do less of the former, more of the latter.

Unfortunately, the supply-siders missed another important effect, known as the "income effect".  Which is to say that as you get richer, you demand more of some goods, and less of others.  And one of the goods you demand more of as you get richer--a class of goods known as "superior goods"--is leisure.

Of course, some people are so driven that they will simply work until they drop in the traces.  But most people like leisure.  So say you raise the average wage by 10%.  Suddenly people are bringing home 10% more income every hour.  Now, maybe this makes them all excited so they decide to work more.  On the other hand, maybe they decide they were happy at their old income, and now they can enjoy their old income while working 9% fewer hours.  Cutting taxes could actually reduce total output.

(We will not go into the question of how much most people can control their hours--on the one hand, most people can't, very well, but on the other hand, those who can tend to be the high-earning types who pay most of your taxes.)

Which happens depends on which effect is stronger.  In practice, apparently neither was strong enough to thoroughly dominate, at least not when combined with employers who still demanded 40 hour weeks.  You do probably get a modest boost to GDP from tax cuts.  But you also get falling tax revenue.

It can't be said too often--and there you are, I've said it again.

Kevin Drum, however, takes this quite a bit further, arguing that this means that marginal tax rates don't matter at all:

So here's what I know. Last year I read a review of ETI research written by Emmanuel Saez, Joel Slemrod, and Seth Giertz. I'm not familiar with Gertz, but both Saez and Slemrod are pretty honest guys, so I figured their paper would provide an evenhanded look at what the ETI research indicates. Their conclusions were far from rosy. First, they suggested that the ETI literature of the past two decades varies so widely that it can't really be considered very reliable yet. Second, they make clear that incomes can decline for several reasons, and most of the reported income drops in the wake of tax increases are related to tax fiddling, not actual economic deterioration. From the paper:

While there are no truly convincing estimates of the long-run elasticity, the best available estimates range from 0.12 to 0.40. At the approximate midpoint of this rate -- an ETI of 0.25 -- the marginal excess burden per dollar of federal income tax revenue raised of 0.195 for an across-the-board proportional tax increase, and 0.339 for a tax increase focused on the top one percent of income earners.

....While there is compelling U.S. evidence of strong behavioral responses to taxation at the upper end of the distribution around the main tax reform episodes since 1980, in all cases those responses [are related to] timing and avoidance. In contrast, there is no compelling evidence to date of real economic responses to tax rates....If behavioral responses to taxation are large in the current tax system, the best policy response would not be to lower tax rates, but instead broaden the tax base and eliminate avoidance opportunities to lower the size of behavioral responses.

In other words, when taxes go up on the rich, they do report lower incomes. But that's mostly because they're fiddling with the tax code to report lower incomes, not because they're actually earning any less. If that's the case, we can draw a few conclusions:

  • We should reduce high-end tax loopholes so that the rich have fewer options for moving income around solely to optimize their taxes.
  • If we do that, modest increases in marginal rates on the rich will have very little impact on their taxable income.
  • And even if we don't, this sort of tax avoidance presents us with nothing worse than a mechanical issue of properly estimating tax receipts. Aside from the small inefficiency of paying tax accountants for lots of useless work, raising tax rates doesn't have a negative effect on the economy and has little or no effect on the actual incomes of the rich.
This all makes sense to me. After all, we've already run a sort of destruction test on this. During the 50s, top marginal rates were around 90%, and if high tax rates on the rich harm the economy then the tax rates of the 50s should have literally brought the United States to its knees. But even with heroic efforts, you can't make the case that those tax rates were anything more than a tiny drag on the economy. And if 90% rates produced only a tiny drag, then the effect of moving from, say, 35% to 40% would be literally too small to measure.

This is not at all what the cited literature says.  It doesn't tell us that marginal tax rates don't matter, but that we haven't been very successful at raising marginal tax rates.  It would in fact be much more difficult than Kevin makes out to really ramp up marginal tax breaks on top brackets--it would involve things like ending the tax-deductibility of muni bonds, getting rid of most charitable deductions, and really taxing the hell out of capital income.  If we did that, marginal rates would be higher.  But growth would probably be lower.

I don't mean to imply that Warren Buffett would suddenly stop working--at the very, very tippy top, marginal income tax rates probably have something very close to zero impact on work output.  Down the income scale, however, they might: not all wealthy people do things that are as rewarding as being the world's most famous investment manager.  Many of them do things like hump plumbing supplies, manage their franchise networks, and fill cavities.  They  are not necessarily working extra days for the soul-filling joy of providing donuts or water heaters to the Greater St. Louis Area; they are doing it to make money to buy fancy stuff they can have fun with.  Even at the CEO level, people might retire sooner.

Capital taxation, in particular, is very difficult, which is why even the Nordics don't hit capital income as hard as you'd expect: capital is mobile, and it is much easier to decrease your savings than to decide to work 30% less. It is no accident that the global era of high marginal tax rate coincides with the global era of fixed exchange rates and stiff capital controls.

Now, if you want to make an argument for raising the marginal tax rate to 90%, while leaving ample loopholes in the code to allow virtually everyone to pay more like 30%, simply because having a marginal rate of 90% gives you aesthetic pleasure . . . well, I think that would be very stupid, actually, but I freely allow it might not have much impact on growth.  However, if you actually succeeded in taxing income at that level, I think you'd see some very strong and unpleasant effects on economic growth.  Income shifting is not evidence that marginal tax rates don't matter.  It's evidence that marginal tax rates matter so much that people are willing to put a great deal of effort and money into lowering them.