Why Ultrahigh Tax Rates Would Be Terrible For U.S. Economic Growth

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? (Not to mention Paul Krugman who would like to return to ultrahigh, 1950s tax rates.)

One big reason is research from two highly respected — and left-of-center — economists, Peter Diamond and Emmanuel Saez. (Diamond is a failed Obama nominee to the Federal Reserve Board in addition to being a Nobel Laureate, 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 Percent?,” 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 behavior 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 behavior 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 maximize 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 behavioral 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 behavioral response predicated in part on less evasion and more enforcement to compute an answer of 73 percent. 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.

  1. Goldgeller

    Thanks for posting this. It will be good to have this knowledge should it come up in a discussion.

     People read “avoid high tax rates” and interpret that as “quitting their job” well, few people will quit their jobs to avoid high tax rates. But the issue is this– will they work as hard and as late as they do for the extra money  if the government will take say… 50% of it? Probably not. 

    It creates a “good enough” type of fatalism. The intensity of the work (and the creativity) will disappear, even if we don’t see people “quitting.” 

  2. Misthiocracy

    Going back to 1950s tax rates only makes any sense if one also brings back certain other economic truths about the 1950s.

    Firstly, you’d have to make the United States the only functioning industrial economy on the planet, free from virtually any international competition:

    • Reduce Europe and Japan to rubble.

    • Reduce Russia and China to lands of peasants living in poverty.
    • Roll back all economic progress in the developing world by about 60 years or so.

    Secondly, completely eliminate the electronic movement of money, so people cannot move their wealth to lower-tax jurisdictions.

    Finally, drop the planet back into a global cold war with large parts of the globe completely inaccessible to travellers due to war and/or totalitarianism, so that people cannot vote with their feet and move to lower-tax jurisdictions.

    What a great plan.

  3. Adam Koslin

    I find it amazing that Ricochet loves Douglas Murray’s great “Coming Apart” and harps on its depiction of a fractured America splitting into upper and lower castes, yet screams whenever someone makes note of our steady trek upwards in the Gini coefficient rankings (a measure of national income inequality).  I’m hardly in favor of confiscatory taxation, but the stratification of the U.S. into the wealthy and the “rest” is just as worrying as the cultural and social fractures dividing the country. 

  4. Misthiocracy
    Adam Koslin: I find it amazing that Ricochet loves Douglas Murray’s great “Coming Apart” and harps on its depiction of a fractured America splitting into upper and lower castes, yet screams whenever someone makes note of our steady trek upwards in the Gini coefficient rankings (a measure of national income inequality).  I’m hardly in favor of confiscatory taxation, but the stratification of the U.S. into the wealthy and the “rest” is just as worrying as the cultural and social fractures dividing the country.

    Not necessarily, because a huge proportion of the “rest” today live far wealthier lives than aristocrats did in the past, thanks to technological innovations and lower prices.

    The problem with this isn’t the income inequality. The problem is that aristocrats in the past weren’t known for living lives of high moral virtue. When one’s every whim is taken care of, virtue becomes less important. Adultery, pornography, drugs, depravity, promiscuity, divorce, etc, were largely phenomena of the rich. The middle classes couldn’t afford such luxuries.

    Today, that relationship has flipped upside-down. Traditional values are seen more at the top end than at the bottom and the middle.

  5. Layla

    I dunno. I’m starting to come around the idea of raising rates on the evil, greedy, rapacious millionaires and billionaires. Hear me out.

    Yes, raising taxes, bad for growth, blahblahblah. So? If we put any faith in polls (and, ahem, perhaps we ought to…), we know that most Americans blame Congress for…well, pretty much everything. In particular, the administration and Democrats in the House and Senate have very effectively painted the GOP members of the House as terminally obstructionist. Why are we in the economic straits we’re in? Because GOP congressfolk have prevented Democratic initiatives from passing.

    OK, then. Many (most?) of the uber-wealthy–and certainly the most vocal among them–were and are over the moon for Obama. So why on *earth* should the GOP go to the mat for such ingrates? Let their rates go up. Give the President what he wants. Yes, this will hurt the uber-wealthy. Yes, this will hurt *all* of us. But if as a result the economic ideas undergirding Obamanomics are undermined…wouldn’t short-term pain be worth the long-term gain?

    I can still be persuaded otherwise, but for now I say, eat the rich.

  6. ConservativeWanderer

    James, you misunderstand the leftists.

    To them, slowing American economic growth to a crawl, or even reversing it, is not a bug, it’s a feature.

    America is “too rich,” we have “made too much,” and are “too powerful.” We need to be brought back to the level of other nations, preferably North Korea and Cuba, so that we don’t serve as an example of how freedom works better than totalitarianism.

  7. Misthiocracy
    Layla: I dunno. I’m starting to come around the idea of raising rates on theevil, greedy, rapacious millionaires and billionaires. Hear me out.

    How about higher tax rates for those convicted of fraud, theft, and other white collar and/or property crimes?

    Increased taxes for bad people.

    After two seconds, I answered my own question.  Governments would simply lower the bar for the definition of “bad” to include everybody but their friends.

  8. Adam Koslin
    Misthiocracy

    Not necessarily, because a huge proportion of the “rest” today live far wealthier lives than aristocrats did in the past, thanks to technological innovations and lower prices.

    The problem with this isn’t the income inequality. The problem is that aristocrats in the past weren’t known for living lives of high moral virtue. When one’s every whim is taken care of, virtue becomes less important. Adultery, pornography, drugs, depravity, promiscuity, divorce, etc, werelargelyphenomena of the rich. The middle classes couldn’t afford such luxuries.

    Today, that relationship has flipped upside-down. Traditional values are seen more at the top end than at the bottom and the middle. · 14 minutes ago

    Hooey.  Okay, so Joe Farmer never participated in debauchery like Caligula.  But to think that the poor in eras past were somehow more virtuous than they are now?  Either you’re wearing rose-tinted glasses or have bad information.  Alcoholism was a disease of the poor.  Flophouses didn’t cater to the rich.   Opium dens were notorious in lower-class London.  “Tijuana bibles” were hardly expensive.  There may be virtues to be found in poverty, but moral rectitude isn’t usually one of them.

  9. ConservativeWanderer
    Misthiocracy

    Layla: I dunno. I’m starting to come around the idea of raising rates on theevil, greedy, rapacious millionaires and billionaires. Hear me out.

    How about higher tax rates for those convicted of fraud, theft, and other white collar and/or property crimes?

    Increased taxes for bad people.

    After two seconds, I answered my own question.  Governments would simply lower the bar for the definition of “bad” to include everybody but their friends. · 2 minutes ago

    Edited 0 minutes ago

    I fully support raising taxes on Hollyweird media tycoons, singers, actors, and other “stars.”

    I know some conservatives, like Jon Voight or our own Rob Long and Pat Sajak, will also get hit with the higher taxes, but just the proposal would cause such outrage among the left that it would be highly instructive… not to mention downright entertaining!

    And the chances of the Obamacrats actually implementing such a tax are about the same as the chances of tigers turning vegetarian.

  10. Adam Koslin

    CONT’D. 

    Also, I’d argue that income inequality – especially severe and visible income inequality – is a bad problem to have.  We are social beings, and we constantly compare ourselves to ourselves.  When you are unable to take part in activities, goods, and services that are viewed as “essential,” you get resentful.  When you don’t have access to the same quality medical care as someone else, you get resentful.  Sure, it may be base, but it’s understandable.  If the system is not benefitting you, why be part of it?  If the current social infrastructure isn’t benefitting you, why should you buy into its dictates?

  11. Goldgeller
    Adam Koslin: CONT’D. 

    Also, I’d argue that income inequality – especially severe and visible income inequality – is a bad problem to have….  If the system is not benefitting you, why be part of it?   · 21 minutes ago

    I don’t think inequality is bad on it’s own terms. It depends on why there is inequality. 

    A lot of the arguments about income inequality are actually picking up on social artifacts like the changing composition of the family, and the fact that a person’s income is rarely tracked over time. What you see are snapshots of different incomes and different age cohorts (where the older cohort throws off the younger cohort’s earnings). Actually, most people lead relatively equal lives if you track them over time (in the US).  

    But the income discussion is a red herring. I’m more concerned with consumption. Low income people typically have cool gadgets and they aren’t starving to death. They can’t go to fancy resorts, but I’m not ready to condemn markets to make incomes equal. 

  12. Frozen Chosen

    The problem is that the “rich” includes small business owners making $200-$500k a year, which is more often than not their business income, not their household income.

    And if you think that making $200-$300k a year makes you rich you are seriously deluded.  That’s middle class, baby.

    If the lefties want to bring back the 70% tax rate that’s fine, assuming they also bring back all of the loopholes and deductions that existed when those rates were in effect which made the effective rate much lower.  But of course they will never restore the deductions, which will kill small business and lead to rampant tax evasion – legal and otherwise.

    Let’s all go over the cliff, I say.

  13. Southern Pessimist
    Layla: I can still be persuaded otherwise, but for now I say, eat the rich. · 1 hour ago

    I am not nearly as tasty as you think I am.

  14. bagehot99

    Fixing the deficit isn’t the objective. Fixing the ‘problem’ of a widening income gap is the objective.

    Which is also called redistribution; a central plank of socialism.

    Which is the objective.

  15. Dan Hanson

    Most of the arguments against high taxation focus on the incentive effects.  Just as important is the removal of capital from those people who have shown that they know how to use it effectively and shunting it to bureaucrats with no such track record.

    Imagine that Elon Musk had been subject to a 91% tax bracket.  Let’s further assume that Elon Musk is so driven that he continued to work just as hard under the new tax regime.  Would there be any negative effect?  Of course.  Musk’s fortune from Paypal would have landed in the government’s hands instead of his own, and as a result there would have been no SpaceX.  And that would be a tragedy.

    Silicon Valley is powered by venture capital.  Venture capital comes from people who made a fortune then leveraged their knowledge and capital to reinvest in new start-ups.  They’re the people who have already demonstrated a proven ability to build companies, and are the perfect people to decide which new companies are deserving of investment.  

    Tax away their wealth, and the investment that goes into Silicon Valley and other start-up ventures will vanish.

  16. Dan Hanson

    Another problem with high marginal rates is that they punish risky investment.  High risk requires high reward.  If you ask me to invest a million dollars in a venture that has a 10% chance of success but which will return 50 million if it’s successful, that’s a pretty good deal.  Tax that 50 million at 91%, and suddenly I’d be an idiot to make that investment. 

    High tax regimes lead to ‘safe’ investment behavior that ultimately contributes to economic stagnation.   You wind up like France, where private business makes boring safe investments and innovation is crushed.

  17. Misthiocracy

    Weren’t the high tax rates in the 50s actually a hold-over from the tax rates during the Second World War?

    In other words, weren’t the rates increased during war time, as a “temporary” measure, and then not reduced again?

    If yes, that helps explain why the rich didn’t revolt at the time. They understood that total warfare requires sacrifice, and they were told the increased rates would be temporary.

    It’s completely different today. Krugman is suggesting massive increases on the rich as a permanent, peacetime measure, and as punishment for being too rich to boot!  Of course the reaction of those being taxed would be different than the reaction in the 40s/50s!

  18. wilber forge
    Layla:I can still be persuaded otherwise, but for now I say, eat the rich. · 3 hours ago

    Have been waiting for someone to say this. I say, Eat the Poor. They are far more plentifull and it will save money ! Soylent time.

  19. wilber forge

    Double post.

  20. Steve MacDonald

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

    I believe it is all about power. Low economic performance leads to greater Govt. dependency which in turn leads to Democrat victory at the polls. Think Detroit & California.

    If we seek equality, we should do things like eliminate the Federal tax deduction for State and municipal taxes, or mortgage interest deductions, or eliminate federal grants for anything not covering the 50 states. But we won’t because they would negatively impact political power.