Advancing a Free Society

Diamond and Saez Ignore the Effects of Higher Marginal Tax Rates

Wednesday, April 25, 2012

Yesterday’s Wall Street Journal op-ed by Peter Diamond and Emmanuel Saez received quite a reaction. Diamond and Saez advocate raising the top marginal tax rates on the rich to between 50-70%. Their recommendation is based on a 2011 paper they published in the Journal of Economic Perspectives (PDF) where they advocated 1) Raising marginal tax rates on the very rich, 2) Subsidizing earnings (phasing out at a high rate) for low earners, and 3) Taxing capital. Their paper was widely discussed when it was published, and it is serving as a justification for many on the left to raise taxes on high-income earners. It’s their first recommendation that I would like to address.

There are several key limitations with the authors’ methodology used to conclude that raising marginal tax rates is optimal social policy. Two I'll mention here are the dynamic effects of raising marginal tax rates in the medium and long term, and the volatility that comes with higher rates on a small portion of the population.

First, and this is the most important issue with the paper, Profs. Diamond and Saez are unable to produce estimates of the effect higher marginal tax rates have on economic growth or tax revenues in the medium or long term. (I’d note that Scott Sumner highlighted the following excerpt months ago. Still, it should be front and center of the criticism of their recommendation.) From their paper:

It is conceivable that a more progressive tax system could reduce incentives to accumulate human capital in the first place. The logic of the equity-efficiency trade-off would still carry through, but the elasticity e should reflect not only short-run labor supply responses but also long-run responses through education and career choices. While there is a sizable multiperiod optimal tax literature using life-cycle models and generating insights, we unfortunately have little compelling empirical evidence to assess whether taxes affect earnings through those long-run channels.

Translated: We don’t know what will happen in a few years as a result of this change.

The effects of their optimal tax recommendation after more than a few time periods cannot be predicted with any accuracy. It seems unreasonable to have confidence in such a recommendation. Their suggestion isn’t a small change either; it would completely alter the tax code. When playing with hundreds of billions - or even trillions - of dollars, we should be confident about what the results will be.

Yet the justification the authors cite in the WSJ for ignoring the effects higher rates have on economic growth is historical adjusted US growth in the past half-century, first from 1950-1980 and then from 1980-2010. They note that the top marginal tax rates were 70% in the earlier period, and much lower in the recent period. First one thing to make clear is the enormous difference between marginal tax rate and effective tax rate (a point John Cochrane brilliantly made a few days ago). Second, correlation isn’t causation. I think if I had used their example as justification for such a policy in an introductory econometrics class, I would be given a failing grade.

To be fair, some of the reaction to the authors’ recommendation is that raising marginal tax rates would lower economic revenue in the long-run, since we’d see lower growth. But Diamond and Saez aren’t saying that – what they’re saying is that in the short-run, we could haul in a sizable chunk of tax revenue from the rich before they have a chance to respond. Pity we aren’t playing a single-period game.

The solution is instead to shift focus from identifying the revenue-maximizing tax system to the growth-maximizing tax system, while still raising enough revenue to operate the necessary functions of the federal government.

The second critical flaw in the authors’ optimal tax policy is that it completely ignores the volatility in tax revenues such a system would induce. (This, of course, stems from failing to predict behavior a few time periods out.) Assuming tax avoidance wouldn’t run rampant (ever wonder why we created the AMT?), tax revenues would vary widely from peak to trough. Has anyone ever sought to create a tax system that’s volatile? I’d be willing to wager that a majority of economists prefer a stable system of tax collection through a broader base and lower rates is preferable to a volatile tax system with a narrow base and high rates, even if the stable system collected slightly less revenue.

Meanwhile, I’ll wait for an “optimal tax policy” that includes predictions of its effects on both economic growth and tax revenue.

Tom Church is a research fellow at the Hoover Institution. Click here to subscribe to his RSS feed.