Politicians who want to raise taxes on the rich will be disappointed to learn they wouldn’t get much additional money to spend by doing so, though it would slow economic growth.
Economists have debated for decades the best rate to tax people to collect the most money. Everyone knows there is a trade-off between the top rate and revenue, familiarly known as the Laffer curve. But experts don’t agree on how it’s shaped, or whether the current top federal income tax rate of 37 percent is near its apex. Estimates range from the 40s to the 70s.
The economists at the scrupulously nonpartisan Joint Committee on Taxation have developed the most realistic model of the mindbogglingly complex U.S. tax code, and three of them just published a paper with the title: “Laffer Curves Are Flat.”
“Large changes in top tax rates around the revenue-maximizing rate yield small changes to revenue,” conclude Rachel Moore, Brandon Pecoraro and David Splinter.
That’s true for the federal income tax on its own, and it’s even more true when factoring in state and local taxes. Holding the rest of the tax system constant, they found the top federal rate to maximize total government revenue would be 39 percent, and that would only raise long-run revenue by 0.21 percent. Any top rate in the range of 30 percent to 45 percent raises roughly the same amount of total revenue over the long run. Go higher, and revenue falls.
How can this be? The authors found that changes in behavior matter a lot for determining the shape of the Laffer curve. If the top marginal rate increases, individuals and pass-through businesses in the top bracket will find different ways to reduce their tax burden. Not only are these methods legal, but they are encouraged by the tax code.
Failing to consider the interactions with state and local taxes is another weakness in most previous research. If raising more federal revenue corresponds with reductions in state or local revenue, then there’s not much point in raising it, since those other jurisdictions are likely to beg Washington for funds.
Moore, Pecoraro and Splinter say that searching for the exact revenue-maximizing top rate is not that important. “The relevant policy choice is between tax progressivity and growth: the equity-efficiency trade-off,” they write.
Though their paper found small changes in revenue from raising the top rate, it also finds significant reductions in economic growth from doing so. Squeezing those last 0.21 percentage points of revenue out of the rich by raising the top rate to 39 percent reduces long-run GDP by 0.12 percent. Going up to 45 percent shaves off 0.5 percent. A top tax rate of 54 percent takes 1 percent off long-run GDP, and 67 percent takes off 2 percent. In practice, these modest-sounding changes in growth mean millions fewer jobs and an economy that’s worth trillions less, all with less revenue to show for it.
Without necessarily intending it, the U.S. government has been making the trade-off in favor of progressivity for decades. While the top rate on the rich is lower today than it was 50 years ago, the tax base is larger, meaning more income is subject to taxation. Additionally, the U.S. has greatly expanded refundable tax credits for poorer people, such that the federal income tax burden for roughly the bottom half of earners is negligible.
A recent report from the Congressional Budget Office found that the federal tax and transfer system significantly reduces income inequality. While it’s true that the top 1 percent of income earners have gradually gained a larger share of pretax income over time, their share of the federal income tax burden has increased faster.
The CBO report finds that social insurance, taxes and transfers lower the most common measure of income inequality, something called the Gini coefficient, by 28 percent. Other rich countries have much less progressive tax systems, not because they tax the rich less, but because they tax the middle class more.
Making an already progressive income tax a little more progressive isn’t worth the trouble.
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