I got to see Arthur Laffer speak in 1981 in Memphis and he predicted what would happen the next few years with tax revenue as a result of the Reagan Tax Cuts and he was right on every prediction.
May 8, 2012 by Dan Mitchell
I’ve explained that it is silly for Obama and others to think it is easy to squeeze more money from rich taxpayers, and I’ve also provided evidence from the 1980s to show that upper-income people have considerable ability to respond to changes in tax rates by shifting the timing, level, and composition of their income.
But I haven’t specifically responded to some recent studies which make rather outlandish claims that the revenue-maximizing tax rate is 70 percent or above.
Fortunately, my Cato colleague Alan Reynolds has stepped forward. His column in today’s Wall Street Journal decimates these assertions.
President Obama and others are demanding that we raise taxes on the “rich,” and two recent academic papers that have gotten a lot of attention claim to show that there will be no ill effects if we do. The first paper, by Peter Diamond of MIT and Emmanuel Saez of the University of California, Berkeley, appeared in the Journal of Economic Perspectives last August. The second, by Mr. Saez, along with Thomas Piketty of the Paris School of Economics and Stefanie Stantcheva of MIT, was published by the National Bureau of Economic Research three months later. Both suggested that federal tax revenues would not decline even if the rate on the top 1% of earners were raised to 73%-83%.
How do they arrive at such high numbers? Alan explains.
The authors arrive at their conclusion through an unusual calculation of the “elasticity” (responsiveness) of taxable income to changes in marginal tax rates. According to a formula devised by Mr. Saez, if the elasticity is 1.0, the revenue-maximizing top tax rate would be 40% including state and Medicare taxes. That means the elasticity of taxable income (ETI) would have to be an unbelievably low 0.2 to 0.25 if the revenue-maximizing top tax rates were 73%-83% for the top 1%. The authors of both papers reach this conclusion with creative, if wholly unpersuasive, statistical arguments.
Is this assumption warranted? Hardly. Alan elaborates, making the same points I’ve made about rich people being different than the rest of us.
But the ETI for all taxpayers is going to be lower than for higher-income earners, simply because people with modest incomes and modest taxes are not willing or able to vary their income much in response to small tax changes. So the real question is the ETI of the top 1%. Harvard’s Raj Chetty observed in 2009 that “The empirical literature on the taxable income elasticity has generally found that elasticities are large (0.5 to 1.5) for individuals in the top percentile of the income distribution.” In that same year, Treasury Department economist Bradley Heim estimated that the ETI is 1.2 for incomes above $500,000 (the top 1% today starts around $350,000).
Alan cites other studies as well, all of which show that Saez, Piketty, Diamond, and Stantcheva, are well outside the mainstream.
For all intents and purposes, they cherry-picked data and made unrealistic assumptions in order to justify class-warfare tax policies.
That’s why you’re much better off looking at this research from economists at the University of Chicago and the Federal Reserve. Heck, even the IMF is acknowledging that it’s self-defeating to raise tax rates in a nation like Greece – and top tax rates there are less than 50 percent.
P.S. Lest I forget, it’s also worth mentioning that it’s a very bad idea to be at the revenue-maximizing spot on the Laffer Curve. The economic damage, per dollar raised, is enormous. And that’s true whether the revenue-maximizing rate is 20 percent or 70 percent.