Defining Ideas

The Case Against Higher Tax Rates

Wednesday, January 23, 2019

A number of Democratic politicians—and some economists including Paul Krugman—have recently advocated substantially higher income tax rates on high-income Americans. The current top federal tax rate on income is 37 percent for married people filing jointly, and it applies to all taxable income over $612,350. The highest state income tax rate in the United States is in California, where it is 13.3 percent on taxable income over $1 million. Thus, the highest-income people in California lose over half of their incremental income to the government. That the politicians favor higher tax rates is not surprising; that some economists do and that one particular economist is making such a bad case for higher tax rates is somewhat surprising.

Economists, whatever their ideology, tend to oppose high marginal tax rates for one very good economic reason: what they call deadweight loss. Moreover, a substantial minority of economists, including myself, opposes high marginal tax rates on philosophical grounds. Also interesting is that the majority of Americans, if they understood how high are the tax rates that high-income Americans pay, would favor substantially cutting tax rates on the top earners.

Economists often come up with cumbersome terms to describe important concepts. But “deadweight loss” is not one of them. Rather, it beautifully describes one of the big harms from taxation. The deadweight loss from taxes is the loss imposed on some that is not a gain to anyone. So, for example, a typical estimate of deadweight loss from taxes is 30 percent of revenue raised. That means that if the government takes $1 million in additional taxes, there is an additional $300,000 cost imposed on players in the economy.

Where does this deadweight loss come from? It exists because people try to avoid taxes. So, for example, an increase in the marginal tax rate might cause people to work less. Or it might cause them to buy a more expensive house so that they can deduct the additional interest on the mortgage. Those are just two of the ways people can adjust. They might also evade taxes by understating income or overstating expenses and deductions. Why do we call the result deadweight loss? Because in each case, the tax system gives people an incentive to do something that they would not have chosen to do at a lower tax rate. The increased tax rate causes them to engage in behavior that otherwise would be inefficient for them.

This can best be illustrated with an extreme hypothetical example. Imagine that the federal government imposes a $2,000 additional tax on everyone, but gives them a way out: they can avoid the tax if they fly to Alaska and back. For those who would have flown to Alaska anyway, there is no deadweight loss. But for those who would not have, there is a deadweight loss. As long as the cost of flying to Alaska—including the cost of your time minus any “disvalue” you put on going to Alaska—is less than $2,000, you will do it. Imagine that the cost is $1,900. Then you will fly there, and the deadweight loss from your adjustment will be a whopping $1,900.

The fact that taxes cause people to adjust to avoid some or all of them is one of the reasons that many economists oppose high tax rates.

And here’s the kicker. A theorem in economics says that the deadweight loss from a tax is proportional not to the tax rate, but to the square of the tax rate. Consider the 37 percent top federal tax rate. Some economists, such as MIT’s Peter Diamond and UC Berkeley’s Emmanuel Saez, have advocated that it be raised to 70 percent or higher. To make the math simple, imagine that the Congress and President were to double it to 74 percent. The deadweight loss wouldn’t double. It would quadruple.

In the 1970s, when the top marginal tax rate in the United States was 70 percent, economist Art Laffer drew his famous Laffer Curve. He showed that tax rates could be so high that cutting them would actually increase revenue and raising them could decrease revenue. And even if raising tax rates doesn’t decrease revenue, what’s clear from both basic economics and empirical studies is that raising tax rates by x percent will raise tax revenues by less than x percent. Why? It’s because of the adjustments people make to avoid taxes.

So, for example, consider a high-income Californian who is currently paying 50.3 cents in federal and state taxes on every additional dollar earned, which means that he’s keeping 49.7 cents. Then imagine that the advocates of higher tax rates get their way and raise his federal tax rate to 70 percent. Now he’s paying 83.3 cents on every additional dollar earned and keeping only 16.7 cents. Put aside all the other ways he might adjust, and consider just his decision about how much to earn. His incentive to earn an additional dollar has fallen from 49.7 cents to 16.7 cents, a drop of 66 percent. Is it hard to imagine that that Californian will work less?

Economist Paul Krugman, in his January 5, New York Times column, admits that high tax rates reduce the incentive to work but says it doesn’t matter for anyone other than the people who are taxed. Perhaps you think that I’m exaggerating his point. But here’s what he wrote:

In a perfectly competitive economy, with no monopoly power or other distortions – which is the kind of economy conservatives want us to believe we have — everyone gets paid his or her marginal product. That is, if you get paid $1000 an hour, it’s because each extra hour you work adds $1000 worth to the economy’s output.

In that case, however, why do we care how hard the rich work? If a rich man works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, the combined income of everyone else doesn’t change, does it? Ah, but it does – because he pays taxes on that extra $1000. So the social benefit from getting high-income individuals to work a bit harder is the tax revenue generated by that extra effort – and conversely the cost of their working less is the reduction in the taxes they pay.

Or to put it a bit more succinctly, when taxing the rich, all we should care about is how much revenue we raise. The optimal tax rate on people with very high incomes is the rate that raises the maximum possible revenue.

Krugman’s denial of basic economics is stunning. The fact is that there are gains from trade, and the fewer people there are producing things, the less trade there is. So the losers from higher tax rates are not just those who are taxed but also those who don’t get to buy the goods and services that those higher-taxed people stop producing. There is no contradiction between the idea that people are paid their marginal product and the idea that when they produce, other people benefit. (For more on this, see the essay by Robert P. Murphy titled “Does a Worker Help the Rest of Society?”)

Notice something else that Krugman seems to believe: rich people literally don’t count. He writes, “[T]he social benefit from getting high-income individuals to work a bit harder is the tax revenue generated by that extra effort.” That’s true only if rich people aren’t part of society. And in case you thought Krugman was just being careless, look at another line above: “[W]hen taxing the rich, all we should care about is how much revenue we raise.” He seems to regard “the rich” as cattle to be raised and exploited. That’s a very negative view of humanity.

It’s also a strange view. Krugman, who is quite rich whether measured by income or wealth, is excluding himself from society. Some might say that I care more about Paul Krugman than Paul Krugman does.

Fortunately, I’m not alone. Guess who else cares about rich people, whether we measure “richness” by income or wealth? The vast majority of Americans do. If you poll people about whether the rich should pay more in taxes, the majority will typically say yes. But then ask them what percent of their income the rich should pay in taxes, and the vast majority will give a number that’s below the percent they currently pay. In a 2012 poll conducted by The Hill, 75 percent of respondents thought that the rich should pay a rate of 30 percent or lower. So they don’t forget about fairness when they consider taxes on the rich, and they don’t, like Krugman, seem to regard the rich as cattle.

Unfortunately, the poll specified neither whether the question was about marginal tax rates or average tax rates, nor whether it was about income taxes or taxes in general. Still, the data are striking. And they’re consistent with data from a Reader’s Digest poll in the 1990s. The poll asked what percent of their income a family of four making $200,000 should pay in all taxes to all levels of government, including income taxes, Social Security, sales taxes, and property taxes. The median response of almost all income and demographic groups was that the maximum should be 25 percent. That is well below the percent of income paid in taxes by actual families making $200,000 then (which is approximately $320,000 in today’s dollars.)

Even noted activist Al Sharpton thought the rich should be taxed less. In a 2004 interview with John Stossel, Sharpton said that the rich should pay their fair share of taxes. Stossel asked him what percent of total federal income taxes the rich should pay. Sharpton’s answer: at least 15 percent. At the time, noted Stossel, they paid 34 percent of all federal income taxes. All the rich people I know, except for Paul Krugman, would take Sharpton’s deal in a New York minute.

The simple fact is that people are ignorant of the tax structure and don’t understand how a progressive income tax works. In the 1990s, a petitioner asked a high-income friend of mine to sign a petition to put a progressive income tax on the ballot in Massachusetts. The state constitution required, and still requires, a proportional state income tax. My friend asked the petitioner why she thought higher-income people should pay higher tax rates. She answered, “Because people who make more money should pay more in tax." My friend agreed, saying, "If I make five times as much as you, then my taxes should be five times as high as yours." "We agree," said the woman. "Now will you sign my petition?" Of course he refused. She didn’t understand that with Massachusetts’ proportional tax on income, she had already achieved what she claimed to want.

In short, the economics, the polling data, and basic fairness say that it’s a bad idea to raise taxes further on high-income people. That probably won’t stop many advocates from pushing for higher taxes. But it should.