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Optimal Top Tax Rates: A Review and Critique

The Cato journal, 2019-09, Vol.39 (3), p.635-665 [Peer Reviewed Journal]

COPYRIGHT 2019 Cato Institute ;2019. This work is published under NOCC (the “License”). Notwithstanding the ProQuest Terms and Conditions, you may use this content in accordance with the terms of the License. ;ISSN: 0273-3072 ;EISSN: 1943-3468 ;DOI: 10.36009/CJ.39.3.8

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  • Title:
    Optimal Top Tax Rates: A Review and Critique
  • Author: Reynolds, Alan
  • Subjects: Avoidance ; Behavioural responses ; Capital ; Capital gains ; Changes ; Chief executives ; Claims ; Compensation ; Dividends ; Economic activity ; Economic development ; Economic models ; Economists ; Efficiency ; Egalitarianism ; Elasticity ; Elasticity of demand ; Employee benefits ; Executive compensation ; Extraction ; GDP ; Gross Domestic Product ; Human capital ; Incentives ; Income distribution ; Income redistribution ; Income tax ; Income taxes ; Marginal ; Municipal bonds ; Parameters ; Payrolls ; Personal finance ; Progressive taxes ; Redistribution ; Sales ; Statistical data ; Statistics ; Tax administration and procedure ; Tax avoidance ; Tax law ; Tax rates ; Tax reform ; Tax revenues ; Taxable income ; Taxation
  • Is Part Of: The Cato journal, 2019-09, Vol.39 (3), p.635-665
  • Description: Several prominent economists who advocate more egalitarian use of taxes and transfers to redistribute income have used selective (and arguably low) estimates of the "elasticity of taxable income" (ETI) to suggest that U.S. individual income tax rates of 73-83 percent at high incomes would be "socially optimal" in the sense of maximizing revenue available for political redistribution. Proponents of major increases or reductions in U.S. marginal tax rates have long cited historical evidence to support their policy recommendations. Elasticity of taxable income estimates are simply a relatively new summary statistic used to illustrate observed behavioral responses to past variations in marginal tax rates. They do so by examining what happened to the amount of income reported on individual tax returns, in total and at different levels of income, before and after major tax changes. The ETI compares the percentage change in reported taxable income (i.e., income after deductions) to the percentage change in the net-of-tax rate (i.e., the portion of marginal income a taxpayer is allowed to keep, which equals 1 minus the marginal tax rate). Thus, if the marginal tax rate decreases from 60 to 40 percent, the net-oftax share will increase from 40 to 60 percent and taxpayers will have an incentive to earn and/or report more taxable income, other things being constant. ETI measures the strength of that response. For example, if a reduced marginal tax rate produces a substantial increase in the amount of taxable income reported to the IRS, the elasticity of taxable income is high. If not, the elasticity is low. ETI incorporates effects of tax avoidance as well as effects on incentives for productive activity such as work effort, research, new business start-ups, and investment in physical and human capital. ETI estimates, in turn, have been used by economists to estimate various concepts of an ideal or "optimal" tax rate within a linear flat rate tax system or a nonlinear progressive tax system. What is optimal from the point of economic efficiency or incentives, however, is not necessarily optimal if the government's priority (or the economist's priority) is to maximize tax revenue collected from high incomes, ostensibly for the purpose of redistributing that extra revenue to the poor. To estimate a redistributive-optimal or revenue-maximizing top tax rate, Diamond and Saez (2011: 171) claim that, if the relevant ETI is 0.25, then the revenue-maximizing top tax rate is 73 percent. Such estimates, however, do not refer to the top federal income tax rate, as is frequently implied (Krugman 2011), but to the combined marginal rate on income, payrolls, and sales at the federal, state, and local level. I find that, with empirically credible changes in parameters, the Diamond-Saez formula can more easily be used to show that top U.S. federal, state, and local tax rates are already too high rather than too low. By also incorporating dynamic effects-such as incentives to invest in human capital and new ideas-more recent models estimate that the long-term revenue-maximizing top tax rate is between 22 and 49 percent, and one study (Judd et al. 2018: 1) finds that, in certain cases, the optimal marginal tax rate on the top income is negative, which was also the conclusion of Stiglitz (1987). Piketty, Saez, and Stantcheva (2014: 233) likewise claim the relevant ETI is only 0.2, which lifts their redistributive-optimal top tax rate to 83 percent (effectively on all income-including corporate income, dividends, and capital gains-to minimize opportunities for tax avoidance). But they add that "the optimal top tax rate . . . actually goes to 100 percent if the real supply-side elasticity is very small" (ibid.: 232). They support the claim that 83 percent top tax rates on all income would be harmless by comparing percentage point changes in top individual tax rates from about 1960 to 2009 among 18 OECD countries with their per capita GDP growth rates. Yet percentage point changes from 1960 to 2009 cannot tell us whether tax rates were high or low during most of the many years between those distant end points. Piketty, Saez, and Stantcheva's comparison of long-term GDP growth rates with percentage point changes in top tax rates simply shows that countries like Germany and Japan reduced top tax rates to 50-53 percent in the 1950s, decades before the United States and United Kingdom did the same. If Germany, Switzerland, France, or Spain had cut their top tax rates by as many percentage points as the United States has since 1960, their top tax rates would now be well below zero. Piketty, Saez, and Stantcheva (2014) imply that top corporate executives are the main target of their 83 percent marginal tax, and that high CEO pay is mainly just wasteful rent. Their alleged evidence for a "nonconventional bargaining model" and "CEO rentextraction" rests mainly on an undocumented claim that the "use of stock-options has exploded in the post-1986 period, i.e., after top tax rates went down" (ibid.: 261). Evidence shows the opposite-namely, that stock-based executive compensation exploded after 1993 when top tax rates went up (Gorry, Hubbard, and Mathur 2018: 16). These authors argue that an 83 percent marginal rate on top incomes could greatly reduce pretax pay of allegedly overpaid CEOs. But that appears incongruous with their claim that the 83 percent tax rate could also maximize revenue. I also find the combined compensation of the top five executives in S&P 1000 firms accounted for less than 6 percent of top 1 percent income in 2005, which narrows the relevance of an unsubstantiated "CEO rent-extraction" hypothesis.
  • Publisher: Washington: Cato Institute
  • Language: English
  • Identifier: ISSN: 0273-3072
    EISSN: 1943-3468
    DOI: 10.36009/CJ.39.3.8
  • Source: Digital Library of the Commons
    ProQuest Central
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