OPTIMAL TOP TAX RATES: A REVIEW AND CRITIQUE.

• Author: Reynolds, Alan

Several prominent economists who advocate more egalitarian use of taxes and transfers to redistribute income have used selective (and arguably low) estimates of the "elasticity of taxable income" (ETI) to suggest that U.S. individual income tax rates of 73-83 percent at high incomes would be "socially optimal" in the sense of maximizing revenue available for political redistribution.

Proponents of major increases or reductions in U.S. marginal tax rates have long cited historical evidence to support their policy recommendations. Elasticity of taxable income estimates are simply a relatively new summary statistic used to illustrate observed behavioral responses to past variations in marginal tax rates. They do so by examining what happened to the amount of income reported on individual tax returns, in total and at different levels of income, before and after major tax changes.

The ETI compares the percentage change in reported taxable income (i.e., income after deductions) to the percentage change in the net-of-tax rate (i.e., the portion of marginal income a taxpayer is allowed to keep, which equals 1 minus the marginal tax rate). Thus, if the marginal tax rate decreases from 60 to 40 percent, the net-of-tax share will increase from 40 to 60 percent and taxpayers will have an incentive to earn and/or report more taxable income, other things being constant. ETI measures the strength of that response.

For example, if a reduced marginal tax rate produces a substantial increase in the amount of taxable income reported to the IRS, the elasticity of taxable income is high. If not, the elasticity is low. ETI incorporates effects of tax avoidance as well as effects on incentives for productive activity such as work effort, research, new business start-ups, and investment in physical and human capital.

ETI estimates, in turn, have been used by economists to estimate various concepts of an ideal or "optimal" tax rate within a linear flat rate tax system or a nonlinear progressive tax system. What is optimal from the point of economic efficiency or incentives, however, is not necessarily optimal if the government's priority (or the economist's priority) is to maximize tax revenue collected from high incomes, ostensibly for the purpose of redistributing that extra revenue to the poor.

To estimate a redistributive-optimal or revenue-maximizing top tax rate, Diamond and Saez (2011: 171) claim that, if the relevant ETI is 0.25, then the revenue-maximizing top tax rate is 73 percent. Such estimates, however, do not refer to the top federal income tax rate, as is frequently implied (Krugman 2011), but to the combined marginal rate on income, payrolls, and sales at the federal, state, and local level. I find that, with empirically credible changes in parameters, the Diamond-Saez formula can more easily be used to show that top U.S. federal, state, and local tax rates are already too high rather than too low. By also incorporating dynamic effects--such as incentives to invest in human capital and new ideas--more recent models estimate that the long-term revenue-maximizing top tax rate is between 22 and 49 percent, and one study (Judd et al. 2018: 1) finds that, in certain cases, the optimal marginal tax rate on the top income is negative, which was also the conclusion of Stiglitz (1987).

Piketty, Saez, and Stantcheva (2014: 233) likewise claim the relevant ETI is only 0.2, which lifts their redistributive-optimal top tax rate to 83 percent (effectively on all income--including corporate income, dividends, and capital gains--to minimize opportunities for tax avoidance). But they add that "the optimal top tax rate ... actually goes to 100 percent if the real supply-side elasticity is very small" (ibid.: 232).

They support the claim that 83 percent top tax rates on all income would be harmless by comparing percentage point changes in top individual tax rates from about 1960 to 2009 among 18 OECD countries with their per capita GDP growth rates. Yet percentage point changes from 1960 to 2009 cannot tell us whether tax rates were high or low during most of the many years between those distant end points. Piketty, Saez, and Stantcheva's comparison of long-term GDP growth rates with percentage point changes in top tax rates simply shows that countries like Germany and Japan reduced top tax rates to 50-53 percent in the 1950s, decades before the United States and United Kingdom did the same. If Germany, Switzerland, France, or Spain had cut their top tax rates by as many percentage points as the United States has since 1960, their top tax rates would now be well below zero.

Piketty, Saez, and Stantcheva (2014) imply that top corporate executives are the main target of their 83 percent marginal tax, and that high CEO pay is mainly just wasteful rent. Their alleged evidence for a "nonconventional bargaining model" and "CEO rent-extraction" rests mainly on an undocumented claim that the "use of stock-options has exploded in the post-1986 period, i.e., after top tax rates went down" (ibid.: 261). Evidence shows the opposite--namely, that stock-based executive compensation exploded after 1993 when top tax rates went up (Gorry, Hubbard, and Mathur 2018: 16).

These authors argue that an 83 percent marginal rate on top incomes could greatly reduce pretax pay of allegedly overpaid CEOs. But that appears incongruous with their claim that the 83 percent tax rate could also maximize revenue. I also find the combined compensation of the top five executives in S&P 1000 firms accounted for less than 6 percent of top 1 percent income in 2005, which narrows the relevance of an unsubstantiated "CEO rent-extraction" hypothesis.

Conflicting Views about Elasticity and Effects on Long-Term Prosperity

In 2019, a University of Chicago survey asked a panel of economic experts (Chicago Booth 2019) whether or not they agreed that "Raising the top federal marginal tax on earned personal income to 70 percent ... would raise substantially more revenue (federal and state combined) without lowering economic activity." Among those answering, 20 economists disagreed and 8 agreed. This result reflects considerable professional disagreement about the parameters used to estimate optimal top tax rates, notably ETI estimates, and what they imply for tax policy.

Elasticity of taxable, or perhaps gross income (Chetty 2009), can be "a sufficient statistic to approximate the deadweight loss" from tax disincentives and distortions (Saez 2001: 212). Although recent studies define revenue-maximization as "optimal," Goolsbee (1999: 39) rightly emphasizes, "The fact that efficiency costs rise with the square of the tax rate are likely to make the optimal rate well below the revenue-maximizing rate." (1)

If the estimated ETI for high-income taxpayers (not all taxpayers) is relatively high, that suggests that past increases in top marginal tax rates were associated with little or no increases in tax revenue because economic activity was discouraged and tax avoidance encouraged. With an ETI of 1.0 or more at top incomes, the reduction in reported income would offset the higher tax rate (on reduced taxable income) leaving no increase in revenue.

In 2009, Chetty observed 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 This finding has led some to suggest that reducing top marginal tax rates would generate substantial efficiency gains" (Chetty 2009: 1). For example, Gruber and Saez (2002: 28) wrote, "These findings [about the ETI being highest at the highest incomes] may have important implications for the optimal tax structure, suggesting a tax system which is progressive on average but not on the margin, with... marginal rates that are flat or falling with income."

Since about 2011, however, scholars who had previously argued that reducing top marginal tax rates would be economically optimal (to minimize distortions and disincentives) began theorizing that increasing top tax rates might be socially optimal (to maximize income redistribution). This metamorphosis required discounting evidence that elasticities are large (0.5 to 1.5) for individuals in the top percentile. And it required assuming or asserting that the highest, most distortive marginal tax rates on labor, capital, and entrepreneurship could be greatly increased without impairing incentives or lowering economic activity.

When the United States Tried 70-92 Percent Tax Rates in 1951-63, Revenues Were Below Average

From 1951 to 1963, the top U.S. federal tax on individual income was 91-92 percent and the lowest rate was 20 percent, yet revenues from individual income taxes were only 7.5 percent of GDP (OMB 2019: Table 2.3). From 1982 to 1990, the top rate was first reduced to 50 percent and then to 28 percent, yet revenues rose to 8 percent of GDP. The top tax rate was subsequently increased twice--in 1991 and 1993--climbing to 39.6 percent, yet revenues from 1991 to 1996 fell to 7.7 percent of GDP. Finding a revenue-maximizing top tax rate is evidently not as easy as it may appear.

Following the advice of Piketty, former French president Franyois Hollande briefly experimented with a super tax in 2012-14, with a top rate of 75 percent on incomes above 1 million euros (and also raising the next-highest rate from 41 percent to 45 percent). Real GDP growth fell below 0.5 percent in 2012-13 and unemployment rose to nearly 10.5 percent. The 75 percent tax rate was abandoned in favor of a 45 percent top rate after raising only trivial sums on paper (160 million euros in 2014, compared with a previously estimated 30 billion), while arguably losing more government revenue as a result of a nearly stagnant economy and accelerated exodus of affluent expatriates (Murphy and John 2014). In fact, relatively high personal income tax rates in France never raised much revenue. According...