Tuesday, November 22, 2011

What SHOULD the top marginal tax rate be?

I often hear folks debating whether or not to let the Bush-era tax cuts on the top marginal tax rate expire.  The Occupy movement, Obama's anti-jet-class public statement during the default crisis, and Warren Buffet's comments all symbolize a "take more from the rich" ethic.  On the other hand are views like those of my father, that find a tithing-like tax more fair (e.g. 15% on everyone, whether you make 10K a year or 10 million).  In both camps, the complaint is often made that the richest are not taxed enough, or that they are taxed too much.  However, I find that few who raise their voices know what the tax rate is, what that number means, and what income/assets are taxed and how much.  In any case, the complaints don't answer the important question of what the tax rate should be, and why

I'll admit I don't have the answer on this one- but over the past few years I've frequently reflected that it is an important question.  Below I paste some dialogue I'm starting with my parents and sister Dani on this question, and invite your input as well.  Let's learn together!

Per our dinner conversation, I thought I'd offer a little more on the question of what the tax rate should be for Americans toward the richest end of the spectrum. The Economist recommends a recent article called The Case for a Progressive Tax: from Basic Research to Policy Recommendations (attached and here).  I'll include some excerpts and analysis, and invite your comments on the article as well.

The Economist:
"In their paper, they look at what the top marginal tax rate ought to be, given more or less current levels of government spending, in order to maximise tax revenue from the wealthy and hence minimise the tax burden on the poorest, and to prevent either poor people dropping out of the work force or rich people ceasing to work or taking advantage of tax dodges. As they write, the most difficult variable here is how much you think rich people will alter their work and tax-avoidance behaviour in response to rate hikes, ie the "elasticity".
The key remaining empirical ingredient to implement the formula for the optimal tax rate is the elasticity e of top incomes with respect to the net-of-tax rate. With the Pareto parameter a = 1.5 if e = .25, a mid-range estimate from the empirical literature, then τ* = 1/(1 + 1.5 X .25) = 73 percent, substantially higher than the current 42.5 percent top U.S. marginal tax rate (combining all taxes)."
I think the focus on elasticity is appropriate, though it's not the end of the analysis.  The higher the tax burden on the poor, the more attractive it looks to avoid employment.  The higher the tax burden on the richest, the more they'll engage in tax-avoidance, and change how they work to avoid the disproportionate burden.  Within certain "sweet spot" parameters, revenue can be high, and tax evasion or low-efficiency work behaviors minimized.  One of the best ways to stay in the sweet spot is to have a fairly low rate and a large tax base (thank you public finance class), but I think there's a lot more nuance to the equation. 

The article:
"Social welfare is larger when resources are more equally distributed, but redistributive taxes and transfers can negatively
affect incentives to work, save, and earn income in the first place. This creates the classical
trade-off between equity and efficiency which is at the core of the optimal income tax problem."

I think the authors hit that nail on the head.  Generally, the primary incentive to work and produce is weakened the more "take from the rich and give to the poor" that happens.

The authors make three recommendations- which I appreciate, compared to much scholarly literature in the public administration domain, which merely analyzes.  The recommendations summarize the conclusions as well:
"Recommendation 1: Very high earnings should be subject to rising marginal rates and higher rates than current U.S. policy for top
Recommendation 2: Tax (and transfer) policy toward low earners
should include subsidization of earnings and should phase out the
subsidization at a relatively high rate.
Recommendation 3: Capital income should be taxed."

Okay, I think I understand their recommendations, with the exception of not understanding capital income quite yet.  We'll keep going.

The article:
"The share of total income going to the top 1 percent of income earners (those
with annual income above about $400,000 in 2007) has increased dramatically from
9 percent in 1970 to 23.5 percent in 2007, the highest level on record since 1928
and much higher than in European countries or Japan today... Although the average federal individual
income tax rate of top percentile tax filers was 22.4 percent, the top percentile paid
40.4 percent of total federal individual income taxes in 2007 (IRS, 2009a)."

Wow- I learned a lot in just a couple sentences.  The top 1 % pay about 1/4 of their income in taxes, which accounts for two-fifths of income tax revenue.  Once again, I think this underscores the importance of this question, given the consequences of federal revenue (or lack thereof).

The article:
"For the U.S. economy, the current top income marginal tax rate on earnings
is about 42.5 percent,3 combining the top federal marginal income tax bracket of
35 percent with the Medicare tax and average state taxes on income and sales"

Wow, I think I understood that!  I wouldn't have though the optimal top tax rate would be so easy to derive.  At least I know what would maximize revenue (42.5%) and where we are (23.5%), in a simplified way.  That leaves a lot of wiggle room for raising the top marginal tax rate from its current level. 

"the $1,364,000 average income of the top 1 percent in 2007"

Huh, the top 1% starts at annual income of 400K, but the average of the top 1% is 1.4 million.  That says something about the distribution of wealth even in the top 1%! 

"Although considerable uncertainty remains in the estimation
of the long-run behavioral responses to top tax rates (Saez, Slemrod, and
Giertz, forthcoming), the elasticity e = 0.57 is a conservative upper bound estimate
of the distortion of top U.S. tax rates"

Anyone know how that elasticity compares with, say, the middle income quintile?

"the optimal marginal tax rate
formula at any income level (applying to the combination of all taxes) takes a form
that can be expressed directly as a function of the income distribution as follows
(Diamond, 1998):
T ′(z) = [1 – G(z)]/[1 – G(z) + α(z) e(z)]

Okay, I'm impressed.  They gave a formula for calculating the optimal marginal tax rate at any income level! Now, granted, there are a couple assumptions about what "optimal" means in the sense they're using it, but hey, not bad for prescribing a progressive curve.

"In the current tax system with many tax avoidance opportunities at the higher
end, as discussed above, the elasticity e is likely to be higher for top earners than
for middle incomes, possibly leading to decreasing marginal tax rates at the top
(Gruber and Saez, 2002). However, the natural policy response should be to close
tax avoidance opportunities, in which case the assumption of constant elasticities
might be a reasonable benchmark."

Huh, I would have thought the elasticity would vary more across the income spectrum.

"In recent decades in most high-income countries, a concern arose that traditional
welfare programs overly discouraged work, and there has been a marked
shift toward lowering the marginal tax rate at the bottom through a combination
of: a) introduction and then expansion of in-work benefifi ts such as the Earned
Income Tax Credit in the United States; b) reduction of the statutory phase-out
rates in transfer programs for earned income, as under the U.S. welfare reform; and
c) reduction of payroll taxes for low-income earners, as in the recent U.S. Making
Work Pay credit. Those reforms are consistent with the logic of optimal taxation
we have outlined, as they both encourage labor force participation and provide
transfers to low-income workers, seen as a deserving group."

Did Congress do something right?  The authors must be exaggerating... ;-)

Okay, I'm going to guess capital income is returns on investments and savings.  On that presumption:

"A straightforward argument for taxing capital is that it is often difficult to
distinguish between capital and labor incomes."

I would imagine.  I would also predict increasing the increased ratio of labor/capital tax rate would drive more income coming from the latter category.

"The bottom line is that uncertain future earnings opportunities argue against
zero taxation of capital income, as do savings preference heterogeneity, limited
distinctions between capital and labor incomes, and borrowing constraints."

I'm going to trust the authors' analysis somewhat here. I should be better at this analysis, having an MPA and all.  I'll end here for now.

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