Should We Increase Marginal Tax Rates?

There’s an op-ed from Stanford economics professor Michael Boskin in the Wall Street Journal today bemoaning the prospect of an increase in the marginal tax rates:

It would be a huge mistake to imagine that the cumulative, cascading burden of many tax rates on the same income will leave the middle class untouched. Take a teacher in California earning $60,000. A current federal rate of 25%, a 9.5% California rate, and 15.3% payroll tax yield a combined income tax rate of 45%. The income tax increases to cover the CBO’s projected federal deficit in 2016 raises that to 52%. Covering future Social Security and Medicare deficits brings the combined marginal tax rate on that middle-income taxpayer to an astounding 71%. That teacher working a summer job would keep just 29% of her wages. At the margin, virtually everyone would be working primarily for the government, reduced to a minority partner in their own labor.

Nobody—rich, middle-income or poor—can afford to have the economy so burdened. Higher tax rates are the major reason why European per-capita income, according to the Organization for Economic Cooperation and Development, is about 30% lower than in the United States—a permanent difference many times the temporary decline in the recent recession and anemic recovery.

Earlier today I promised a post on marginal tax rates and this is it. There has been a persistent claim from one side of the bench that the effective tax rate is near historic lows and an equally persistent claim from the other side that raising taxes during an economic downturrn would be disastrous. That there is marked and strident difference of opinion is nothing new; I remarked on it in the context of the war in Iraq in one of my earliest posts here now nearly seven years ago.

Both claims remind me of nothing so much as a remark attributed to Herb Stein about supply side economics that there was nothing wrong with the claims that couldn’t be cured by dividing by ten. The claims are probably both true as far as they go. That federal tax revenues as a proportion of GDP have fallen to historic lows is neatly illustrated by this graph from calculated risk. I think that most of those who favor increasing marginal rates interpret that graph as proof positive that we need to raise the rates. I see it more as an indication that we need more economic growth and that excessive dependence on high income earners, able to avoid W-2 wages, is not realizing the revenues that it did during the Clinton Administration.

That reducing private consumption in favor of public consumption dollar for dollar results in less overall economic activity is fairly self-evident due to deadweight loss. Just how severe you think that decline in economic activity is depends on how great you think the deadweight loss actually is.

What would the actual outcome of an increase in marginal nominal federal tax rates on singles earning $200,000 or more and couples earning $250,000 or more be? The truest answer to the question is that nobody knows.

To understand why you’ve got to consider how federal income taxes are calculated. What’s being discussed is an increase in taxes on net W-2 wages. The simple description of how that’s calculated is by taking the amount on an individual’s W-2 or summing the amounts on a couple’s W-2s, subtracting deductions, and applying the new tax rate to amounts over $200,000 or $250,000, respectively.

I’ll need to define some of my terms next. I think that “the rich” are the top 1% of income earners and that “the ultra-rich” are the top .1% of income earners. Based on today’s incomes that’s roughly families earning more than $350,000 and families earning more than $1 million, respectively.

There are two sticking points in calculating how much revenue would be derived by an increase in tax rates on those income earners. The first is how much will be deducted? Only historic norms can be used to estimate that and the IRS is a mite cagey on releasing that information. The second is that it applies to W-2 income. Taken together I take that to mean that to the extent that this change would raise more revenue most of that revenue would be derived from those who derive most or all of their income from W-2 earnings. I strongly suspect that will largely consist of families with more than two or more income earners, particularly in a handful of urban areas. E.g. a doctor and a lawyer, a dentist and a schoolteacher, a firefighter and a high school teacher in New York, Boston, Chicago, Los Angeles, and so on. I also strongly suspect that those are precisely the people who are likely to consume a sizeable portion of their incomes rather than saving them.

The ultra-rich will shift their income away from W-2 earnings to something taxed at a lower rate, transfer their income offshore, or otherwise shield their incomes. Rather than taxing Daddy Warbucks, lighting his cigar with 20 dollar bills, we’ll be raising the taxes on people who are struggling to maintain an upper middle class lifestyle in a difficult economy, effectively a transfer from private consumption to public consumption.

The key problem with the strategy of returning the marginal tax rates to what they were under Bill Clinton is that the distribution of income isn’t the same as it was under Bill Clinton and, as a consequence, won’t realize the revenues that it did under Bill Clinton.

Don’t get me wrong. I opposed the reductions in the highest personal income tax rates in the early Aughts and I opposed their extension last year. I see that as a one-time political move rather than as an incremental strategy for raising taxes until the budget is balanced. In my view one increase and you’ve shot your wad. Trying to raise taxes in continuing approximation will become increasingly politically difficult and decreasingly credible. I favor the 3:1 cuts to revenues formula of the Bowles-Simpson commission and I’ve already given my preferences for cuts in previous posts.

However, I’m beginning to re-evaluate my views of increasing the marginal tax rates. Let’s apply the analytical approach of the post of mine I linked to above to the problem that we’re trying to solve. I understand the problem we’re trying to solve as one of increasing federal revenues without decreasing private consumption (and without appeals to rosy scenarios of unrealistically high economic growth to ease the pain). What strategy would effect that objective?

Please don’t propose that we can solve our fiscal dilemma on the basis of cutting expenditures alone. I find that strategy relies on a definition of “can” as mathematical or accounting equivalence. Not all spending reductions are equal and some have pretty severe economic consequences of their own, e.g. as far as I can see the Ryan plan for Medicare just drives present Medicare recipients into Medicaid and makes the state and local governments go bankrupt all the faster.

Update

Related: Does Washington Have a Spending Problem or a Tax Problem?. My answer: both. And raising the marginal tax rates on “the rich” won’t have nearly as much positive effect as its advocates suppose.