Economics, Taxes and Spending

The 83% Solution: Why liberals think tax rates should double—and why they are wrong

President Obama has never proposed a long term debt-reduction plan. And the reason why is no mystery. If he did, the jig would be up. The plan would reveal the need for massive, record-setting tax increases over the coming decades to pay for the historically unheard-of levels of spending he favors. Some $3 billion a year from the Buffett rule ain’t going to cut it. Make no mistake, the White House understands this fiscal reality. As former White House budget director Peter Orszag wrote in a recent op-ed, “Although hardly anyone wants to admit it, we’re not going to solve our budget problem over the next decade unless revenue is part of the equation.” This means higher taxes on everyone.

And liberal economists are already laying the intellectual groundwork for an Obama Revolution of tax hikes that would completely reverse the Reagan Revolution of tax cuts.

Thomas Piketty and Emmanuel Saez, two superstar liberal economists who focus on income inequality issues, contend their research suggests “the top tax rate could be as high as 83 percent without harming economic growth.”

Peter Diamond, a failed Obama nominee to the Federal Reserve, recently put out a paper — highly recommended by New York Times columnist Paul Krugman — with Saez that concludes the optimal top rate is “73 percent, substantially higher than the current 42.5 percent top U.S. marginal tax rate (combining all taxes).”

– Former White House economic adviser Christina Romer says her new research finds that “the incentive effects of marginal rates are small” and that raising “marginal rates on the wealthy is a straightforward, effective way to counter [rising income inequality], while helping to solve our looming deficit problem.”

Let’s take a look at a natural experiment. When Ronald Reagan took office in 1981, the top marginal tax rate was 70%. And since the tax code was not indexed for inflation, cost-of-living pay raises pushed workers into higher tax brackets even though their take-home pay had not increased in real terms. Talk about bad incentives. As economic historian Bruce Bartlett points out, “The average federal income tax rate on a four-person family with the median income had risen from 7 percent in 1965 to 11 percent in 1978, and the marginal tax rate — the tax on each additional dollar earned — rose from 17 percent to 25 percent.”

And here was the macroeconomic landscape created by high taxes, high inflation, and high unemployment. From 1948 through 1972, real U.S. GDP grew at an average annual rate of 3.9%, while real GOP per person grew at 2.4%. But from 1973-1982, real growth was only half as fast. Real GDP grew 2% a year, per capita GDP 1%. And reflecting that malaise, the Dow Jones industrials fell by 75% in real terms.

Then, finally, a tax cut.

On Aug. 13, 1981, Reagan signed the Economic Recovery and Tax Act. Tax rates were slashed and tax brackets were indexed for inflation. And economic growth returned to its normal, post-war trajectory, even though the U.S. faced much stiffer international competition than it did in the 1950s and 1960s. From 1983 through 2000, real GDP rose at a 3.6% annual pace, per person GDP 2.5%. America was back.

And how did those tax cuts affect tax revenues? The post-World War Two average of income tax revenue as a share of GDP is 8%. And what was average income tax revenue as a share of GDP from 1983 through 1989 as the top marginal rate fell to 28% from 70%? It was 8%.

But some economists don’t care about the sort of evidence I just presented.

Romer, for instance, focuses on microeconomic studies that try to determine how individuals react to changes in marginal tax rates and how that influences taxable income. Romer endorses research that shows little impact from tax cuts. But other studies show quite a large impact, results that seem to better match reality.

Back in 1995, economist Martin Feldstein looked at Treasury Department tax data of more than 4,000 individual taxpayers to estimate the sensitivity of taxable income to the 1986 Tax Reform Act, which reduced the marginal tax rate of the highest-income individuals from 50 percent to 28 percent. Feldstein found “a very substantial response of taxable income to changes in marginal tax rates. … This sensitivity of taxable income also implies that high marginal tax rates create significant deadweight losses by inducing taxpayers to act differently than they otherwise would.”

Some more academic studies that show taxes matter, and they matter a lot:

1. In a 2003 paper, Nobel Prize-winner Edward Prescott concluded that lower U.S. taxes explain why Americans now work 50% more than do the Germans, French, and Italians, which was not the case in the early 1970s, when the Western Europeans worked more than Americans.

2. In a 2004 study, Steven Davis of AEI and Magnus Henrekson found that “higher tax rates on labor income and consumption expenditures lead to less work time in the market sector, more work time in the household sector, a bigger underground economy, and smaller value added and employment shares in industries that rely heavily on low wage, low skill labor inputs”

3. A 2004 study by Young Lee of Korea’s Hanyang University and Roger Gordon of the University of California, San Diego, found that “increases in corporate tax rates lead to lower future growth rates within countries. The coefficient estimates suggest that a cut in the corporate tax rate by ten percentage points will raise the annual growth rate by one to two percentage points.”

4. A 2011 study from Dean Scrimgeour of Colgate University found “lower financial income taxes stimulate innovation and enhance labor productivity in the long run.”

5. A 2007 study by AEI’s Kevin Hasset and Alex Brill found “robust statistical evidence of a corporate tax Laffer curve. We find that the revenue maximizing point has dropped over time, and is about 26 percent by the end of our sample.”

6. A 2010 study found “tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent. … The behavior of output following these more exogenous changes indicates that tax increases are highly contractionary.” Who co-authored that study? Romer.

A high-tax future for America is a future of stagnation and declining global influence. America can do better. It’s time to lower rates, broaden the base, and quit penalizing savings and investment. Paul Ryan’s Path to Prosperity moves in the right direction. So does Mitt Romney’s tax plan.

Time to get America moving again.

 

6 thoughts on “The 83% Solution: Why liberals think tax rates should double—and why they are wrong

  1. You realize, but fail to mention, Reagan raised taxes THREE times, after which the economy grew. Wonder why you left that out???

    • Partly because you just referred to “taxes” in a vague sense with no numbers, which could mean he raised national excise taxes by plus 1% three times — which is meaningless. This piece, on the other hand, makes specific reference to the impact of marginal tax rates on people’s behavior.

      I don’t have to wonder why you left out specifics in your criticism. It’s probably because of the inherent weakness in your arguments and the tendency of people with weak arguments to ask pointless rhetorical questions as if you were in fact clever and coming from a position of argumentative strength.

  2. Behavior is influenced by MARGINAL tax rates. From an economic standpoint it is counterproductive to construct a tax scheme with, say, a 20% average income tax rate and an 80% marginal rate. You are much better off with one that has a 20% average rate with, say, a 25% marginal rate. But you can’t do that if you persist in the fantasy that half of your taxpayer should have zero average rates.

    On a parallel subject, conservatives should resist the temptation to argue within a framework where the objective is assumed to be maximization of government’s revenue. Why wouldn’t the objective be to maximize the income of its citizens?

  3. I think it’s pretty hard to see much of an economic boom following the Reagan tax cuts. The much superior performance in the very high tax rate 50′s and 60′s is clear. The boom of the 90′s following the Clinton tax hikes is clear. The collapse following the Bush tax cuts is clear. Reagan is more mixed, and it looks much better after 1986 following the tax hikes he implemented for Social Security and some other tax broadening measures, while also lowering some rates. Kind of a mixed bag there that was followed by some decent performance.

    I think Pethoukokis is just kind of winging it here, whereas Saez and others are being more rigorous. This is why they come to much different conclusions that he does.

    • You are exactly right, Jon.

      James’ misleading piece comes from anecdotal evidence and is not supported by concise reasoning. In particular, Edward Prescott’s piece that was cited doesn’t account for wage stagnation and income stagnation, which explains why people worked more hours to shore up their eroding standards of living.
      Colgate’s Dean Scrimgeour ignored the role of technological advances, particularly shipping, telecommunication, and manufacturing automation, in enhancing productivity.
      Before the 1970s, the US was the highest-wage nation among developed post-WWII economies. This explains why they didn’t work as many hours.

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