Up Against the Wall Street Journal

The Optimal Tax

Mainstream economics supports a 70% top income tax rate.

BY JOHN MILLER | May/June 2019

This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org

issue 342 cover

This article is from the
May/June 2019 issue.

Subscribe Now

at a 30% discount.

This week Paul Krugman leapt to the defense of Democratic freshman Rep. Alexandria Ocasio-Cortez’s idea of paying for a “Green New Deal” with a 70% marginal tax rate on the incomes of top earners.

Mr. Krugman cites a 2011 paper by Peter Diamond and Emmanuel Saez, based on a variety of extrapolations, [which] calculates that the “optimal” top tax rate is 73%. Case closed? Not even slightly. Messrs. Saez and Diamond are describing a world in which the wealthy have no opportunity to shield or hide their incomes.

Politicians may find it politically handy to be seen dinging the rich. The net result isn’t more revenue. It’s more efficiency-inhibiting economic distortions.

—Holman Jenkins, “High Tax Rates Aren’t Optimal: Nobody Really Thinks a Top Rate of 70% or 80% is a Good Idea in the Real World,” Wall Street Journal, Jan. 8, 2019.

We have been down this road before. In the 2016 presidential election Bernie Sanders proposed a top income tax rate of 70% to reduce our ever-worsening levels of inequality and help to finance social programs that would support those left behind by today’s economy. In response, a cavalcade of economic commentators lined up to denounce Sanders’ proposal as socialist lunacy sure to bring on an economic disaster.

But that’s not at all what the historical evidence shows. Sanders suggested as much when he quipped that he hadn’t proposed a 90% top income tax because “I’m not that much of a socialist compared to Eisenhower.” Economist Paul Krugman made the same point in his New York Times column that Wall Street Journal columnist Holman Jenkins found so objectionable: The top income tax bracket in the United States was higher than 70% “for 35 years after World War II—including the most successful period of economic growth in our history.” But Krugman’s defense of Rep. Alexandria Ocasio-Cortez’s (AOC’s) proposed 70% top income tax rate to help finance a Green New Deal did not stop there. He invoked the “optimum” income tax rate—a concept firmly entrenched in the canon of economic tax literature. As I explain below, calculations of this optimum tax show that the U.S. income tax could be highly progressive with a top income tax rate of 73% or higher without reducing government tax revenues.

That’s what really got Jenkins’ goat. To see why the optimal top income tax rate is as high as 70%, and probably higher, despite Jenkins’ objections, we’ll need to unpack some of the economics tax literature.

The Optimal Tax Rate Literature

To begin with, the debate about the optimal tax rate is about the top income tax, or “marginal” income tax as economists call it, and not the average tax levied on all taxable income. A marginal tax rate is the tax rate levied against the next dollar of taxable income. Currently, the graduated U.S. income tax has six tax brackets, or marginal tax rates, ranging from a low of 10% to a high of 37%. Individual taxpayers would pay 10% of their first $9,325 of taxable income (in 2018) in federal income taxes, whether that’s all of their taxable income or just a small portion of it. As taxable income rises above that threshold, taxpayers pay a higher rate only on that additional income. For instance, a millionaire would pay 10% on their first $9,325, and 37% only on their taxable income above $500,000.

AOC’s proposal would add an additional tax bracket, or a marginal tax rate of 70%, on taxable income above $10 million. So, like Sanders, she is not as much of a socialist as Eisenhower was. Actually, far from it. In the Eisenhower years, the top income tax rate of 91% was levied on individuals with taxable income of above $200,000—the equivalent of $1.14 million in 2019 when adjusted for inflation.

The economics literature on the “optimal” tax rate explores how high the top the income tax rate could be raised without reducing government tax revenues. That tax rate is “optimal” in that it would reduce inequality and make society better off, because the value of an additional dollar of income is far greater to a poor person than to a rich person. But there are limits to how high an optimal marginal tax should be. While a higher marginal tax rate would take a bigger bite out of the next dollar of taxable income, that higher marginal tax rate could discourage the rich from making more income, which would reduce the amount of income subject to that higher marginal tax rate.

In this way, the optimal tax rate relies on the cornerstone of liberal economics thinking that economist Arthur Okun popularized in his 1975 book Equality and Efficiency: The Big Tradeoff. Okun, who had been an economic advisor in the Johnson Administration, envisioned the government transferring income from the rich to the poor in a leaky bucket: the more income that went into the bucket to reduce inequality, the more leaked out in reduced economic efficiency by dulling the incentives of the well-to-do to work that would in turn slow economic growth in the private sector.

Just How High Is Optimal?

But just how full could liberal economists fill their bucket before all of the additional income leaks out in the form of lost efficiency? In their 2011 paper, Nobel prize winning economist Peter Diamond and his co-author economist Emmanuel Saez found that after taking into account the responsiveness of how much less the rich would work in response to a higher tax rate, the optimum tax rate was well above the average 42% tax rate that the rich paid in federal state and local taxes in 2005. Because their estimate of how many fewer hours the rich would work (what economists call “the elasticity of the labor supply of the rich”) in response to higher taxes on adjusted gross income (income less income tax deductions) above $300,000 was “quite low,” they recommended an optimal tax rate of 73%. After adjusting for inflation, this means that in today’s dollars, an optimal tax rate of 73% would be levied on income above $383,000 of adjustable gross income.

As you can imagine, the Diamond and Saez estimates of the optimal tax rate did not go down very well with the “shrink the government down to the size it can be drowned in a bathtub” conservative crowd. Those conservatives objected that it was never their goal to make the income tax as progressive as possible without losing tax revenues to facilitate equity- enhancing redistribution. True enough. But that never stopped conservative economist Arthur Laffer from selling his proposal to cut what he called “prohibitively high” tax rates by promising that lower tax rates would increase government tax revenues, not lower them. Laffer’s claim was predicated on lower tax rates boosting economic growth by so much that government tax revenues would rise despite lower tax rates—a claim which never held up in practice. Moreover, it flies in the face of the lack of responsiveness of the rich to higher taxes that Diamond and Saez report. Jenkins, the Wall Street Journal op-ed writer, has yet other objections to the optimal tax literature. He is especially concerned that enacting a higher top income tax rate would push the rich to seek out yet more ways to avoid paying taxes. The net result would be, as he says, “more efficiency-inhibiting economic distortions”—not more revenues. Economists Diamond and Saez are concerned about this possible result as well. But they are convinced that “the natural policy response should be to close tax avoidance opportunities.” Fewer tax loopholes would increase tax revenues, and make Diamond and Saez’ estimate of a small reduction in the number of hours the rich would work in response to higher taxes (an estimate that holds even as incomes rise) “a reasonable benchmark.”

Other conservative commentators, such as Matt Winesett from the American Enterprise Institute, a Washington, D.C.-based think tank dedicated to promoting free enterprise, worries that a high optimal tax would inhibit small business owners from expanding their business or push a medical student to decide to become a pediatrician instead of a heart surgeon “because a large share of the extra money she would earn being a surgeon would be taken away by the government.” Diamond and Saez readily admit they have not taken these kinds of long-term effects into account because the economics literature does not have good estimates of them. Then again, neither does Winesett.

Plenty of Room to Do Good

Judged by Diamond and Saez’s optimal tax calculations, AOC’s tax proposal, which kicks in only on income above $10 million—a much higher threshold than was in effect during the Eisenhower administration—has left a considerable amount of money on the table. That money is much needed, whether it would go toward fighting climate change or making sure that everyone who wants a job can find one.

If Jenkins and his ilk need something to worry about, they should give up pondering immeasurable outcomes such as the likely effect an optimal tax might have on tax loopholes, capital formation, and the education of doctors, and try worrying about a warming planet. That threat is measurable and existential. Shouldn’t that be enough for Jenkins, like Krugman, to leap to the defense of a Green New Deal that could measure up to counteracting global warming?

is a professor of economics at Wheaton College and a member of the Dollars & Sense collective.

Paul Krugman, “The Economics of Soaking the Rich: What does Alexandria Ocasio-Cortez know about tax policy? A lot,” New York Times, Jan. 5, 2019; Peter Diamond and Emmanuel Saez, “The Case for a Progressive Tax: From Basic Research to Policy Recommendations,” Journal of Economic Perspectives, vol. 25, no. 4, Fall 2011; Arthur Okun, Equality and Efficiency: the Big Tradeoff (Brookings Institution, Washington D.C.: 1975); Ryan Bourne, “No, Economists Don’t Agree a 70 Percent Top Marginal Tax Rate Is a Good Idea,” Reason, Jan. 9, 2019; Kimberly Amadeo, “Laffer Curve Explanation: Why Tax Cuts No Longer Work,” The Balance, Jan. 6, 2019; Matt Winesett, “What is the optimal top marginal income tax rate? Probably far lower than 70 or 80 percent,” AEIdeas, Jan. 9, 2019; Robert McClelland and Shannon Mok, “A Review of Recent Research on Labor Supply Elasticities,” Congressional Budget Office Working Paper 2012-12, October 2012.

end of article

Please consider supporting our work by donating or subscribing.