Sunday, January 30, 2011

The Power and Potential of Progressive Tax Rates

The United States is running large federal deficits. Something has to be done. The first solution is always to figure out ways to cut expenses by eliminating services. The second solution never seems to make it on the agenda: raise taxes. The issue is not really to raise taxes so much as to return them to their traditional values. Raising the marginal tax rate on the highest earners is viewed as an economic mortal sin by some.

Eliot Spitzer has an article in “Slate” titled: Debunking the Claim that Higher Tax Rates Reduce GDP. He includes the following chart and commentary.

“A caveat—obvious but critical—is in order. Simultaneity does not equal causation. Annual growth rates are a consequence of many factors, macro and micro, and the isolated impact of marginal tax rates on growth is hard, if not impossible, to discern from these numbers alone.”

“That said, it's obvious that there is no correlation between higher marginal tax rates and slowing economic activity. During the period 1951-63, when marginal rates were at their peak—91 percent or 92 percent—the American economy boomed, growing at an average annual rate of 3.71 percent. The fact that the marginal rates were what would today be viewed as essentially confiscatory did not cause economic cataclysm—just the opposite. And during the past seven years, during which we reduced the top marginal rate to 35 percent, average growth was a more meager 1.71 percent.”

“More sophisticated efforts to analyze this relationship also produce decidedly murky results. An excellent review of this in the Yale Law Journal, "Why Tax the Rich? Efficiency, Equity, and Progressive Taxation," concludes that there is scant, if any, legitimate academic support for the proposition that moderate, as opposed to dramatic, increases in marginal rates have any impact on the willingness of the wealthy to participate in the economy.”
If one accepts the notion that moderate increases in the highest tax rates will not destroy the economy, the next question is “How much gold is there waiting to be harvested?”

The “Tax Foundation” provides us with the necessary data. The results are quite interesting. The taxable income, the amount of tax paid and the effective tax rate of the top 0.1%, 1.0% and 5% are provided. The latest data available is for 2008. We will examine 2007 data as being more representative of a healthy (or at least robust) economy. To make it into these income groups required threshold incomes of:

>0.1%   $2,155,365

>1.0%   $410,096

>5.0%   $160,041
The average tax rates paid by these groups were:

>0.1%   .215

>1.0%   .224

>5.0%   .205

To give the devil his due, these upper income groups pay a large fraction on the total income tax revenue, which was $1,116B in 2007. The taxes paid by these groups were

>0.1%   $225B

>1.0%   $451B

>5.0%   $676B
Considering the marginal tax rates that had been part of our economically healthy past, yet still trying to be moderate, what would be the result of imposing the following effective rates on the three groups?

>5.0% and <1.0%   .25

>1.0% and <0.1%   .35

>0.1%   .50
The net increase in tax revenue from the top group alone would be $300B and a net of $505B from all three groups. That is equivalent to a 45% increase in income tax revenue. A half trillion dollars is a lot of money, even in Washington. It could ease some pain for much more than 1% of the population.

The selected tax rates are not unreasonable. They indicate that society has the option to make different choices if it wishes different social outcomes. The path we seem to be following is to protect the income of the wealthy by eliminating services for the non-wealthy. That does not seem like very smart or very sustainable social policy.


  1. Given the tax shelters and capitol gains rates, what marginal rate would you think would be needed to achieve an average tax rate that you suggest? Please don't mix up average rates with marginal ones.
    As I understand today's argument, it is that it would be unwise to tax the population more during the 'great recession' and its recovery. You are arguing for the long term and I bet we have that argument before the next national election.
    Before trying to impose larger marginal rates, I think it would be wise to simplify the tax code to make it somewhat harder to hide under the tax shelters that exist today. The issue I have is how to make sure that capitol doesn't take flight away from the US, which I think it will do if rates get too onerous.
    I think the real problem that needs addressing is the income disparity that has grown so large. I call this one of the classic failure modes of capitalism and usually a government has to step in to moderate it. Tax is one of the ways to do that, but I hope there are others.
    Steve C.

  2. I was not trying to rewrite the tax code, although that would not be a bad idea. It would need to be more complicated than just changing the top marginal rates. I was just trying to point out that there are reasonable approaches to deficit reduction coming from the revenue side. The top 0.1% does not pay much tax. Taxing them now would have little effect on the economy. In fact the money might actually get spent in a more beneficial mode.

  3. Rich,
    Even if one grants that $500B could be raised in this way, one still needs to address the other $1T in the annual deficit. And this is before the entitlements grow even more enormous and the Social Security trust fund has to be repaid out of the 'operating' federal budget. Spending cuts must be a major part of the solution to the long term deficit problem. Getting out of two wars will hopefully help. Is it true that we spend more on defense than the rest of the world combined?
    Steve C

  4. I think we are in agreement in that expenditures have to be reduced. I think cutting 500B in expenditures is going to be a lot more painful than raising an equivalent amount of new revenue. As for defense spending I would view that is a growing target for reductions. I have seen that comment about our level of defense spending but I have never tried to verify it.


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