Commentary | Budget, Taxes, and Public Investment

How High Should Top Income Tax Rates Be? (Hint, Much Higher)

This piece originally appeared in The Fiscal Times.

The U.S. economy is mired in a depression. Output is running $975 billion, or 5.8 percent, below its noninflationary potential as the result of a huge demand shortfall in the aftermath of the housing bubble’s implosion. Insufficient spending by households, businesses and government has resulted in a severe jobs crisis, with demand for workers having fallen sharply across all major industries and educational attainment levels. The downward trend in the unemployment rate has been driven by discouraged workers dropping out of the labor force, not robust rehiring; the unemployment rate would have registered 9.8 percent instead of 7.6 percent in March if some 4 million “missing” workers are added back to the labor force.

Worse, the pace of recovery has decelerated below rates needed to eventually recover, largely driven by expiring fiscal stimulus being replaced with austerity. The top policy priority must be ensuring a full economic recovery, and any near-term deficit reduction will necessarily delay recovery, albeit with varying degrees of impact per dollar.

Policymakers have nevertheless pivoted from prioritizing job creation to implementing near-term austerity, as underscored by recently implemented sequestration spending cuts, expiration of the payroll tax cut and obstruction of President Obama’s American Jobs Act. The U.S. is embarking down the austerity path despite virtual consensus among economists as well as ample evidence from Europe and elsewhere that spending cuts forced on depressed economies will elevate unemployment and counterproductively increase public debt as a share of the economy.

To the extent the policymakers are now fixated with deficit-reduction targets, revenue is needed in the mix to reduce the economic damage of austerity. And even though the public has consistently supported a balanced mix of spending cuts and increased revenue, deficit reduction enacted in the 112th Congress was exceptionally unbalanced, with roughly five dollars in spending cuts for every dollar of increased revenue. Yet conservatives oppose more revenue from either raising rates or closing loopholes alone. Their premise has been concern about slowing the economy and hurting the so-called “job creators” we heard so much about in 2012. But these concerns are not backed by economic research.

Unlike government spending cuts, increases in the top tax rate won’t markedly slow economic growth.

In the near-term, tax increases on upper-income households are the least damaging option for deficit reduction. A dollar of government spending cuts will do four to seven times as much economic harm as an additional dollar of revenue collected from upper-income taxpayers. Merely replacing a dollar of sequestration cuts with a dollar of progressive revenue would boost the economy by more than a dollar – and produce roughly the same effective deficit reduction because of improved fiscal feedback effects.

Long-term “supply side” effects of raising top tax rates, such as reducing the incentive to work and thus the labor supply, are extremely modest and smaller than these near-term demand effects. Moreover, supply-side concerns are not imminently relevant while the economy remains depressed; increasing the supply of labor will not increase potential economic output if there is inadequate demand.

Most importantly, recent economic research has shown that productive economic activity is relatively unresponsive to increases in the top income tax rate, and the top income tax rate is well below the levels where it maximizes revenue. Economists Peter Diamond and Emmanuel Saez estimate that the revenue maximizing income tax rate is 73 percent (combing federal, state and local taxes).

As I explain in a new paper, this implies that policymakers could raise the top federal statutory income tax rate from 39.6 percent to roughly 66 percent before reaching revenue-maximization, meaning there is substantial scope for top rate increases without unduly burdening economic growth.

The top tax rate is still very low compared to historical trends, even after it was raised from 35 percent to 39.6 percent as part of the fiscal cliff deal. While income inequality has soared over the past four decades, the tax code has been compressed away from the increasingly skewed market distribution of income; the top federal statutory income tax rate has fallen from 91 percent in the 1950s, and the inflation-adjusted taxable income threshold for the top tax bracket has fallen from roughly $3 million to $450,000 in 2013.

Moreover, time series analyses of top income tax rates since World War II suggest that their decline has had a statistically insignificant impact on economic growth and its driving factors — labor supply, savings, investment, and productivity. On the other hand, the falling top tax rate has had a statistically significant impact both in increasing the share of income concentrated at the very top of the income distribution and the share of income accruing to capital at the expense of labor income. All of which means that raising top rates is one of the more concrete policy levers for pushing back against growing income inequality.

Economic recovery should be the top priority for those genuinely concerned with long-term fiscal sustainability, and increases in the top income tax rate could replace sequestration and be used to finance job-creation measures to markedly accelerate the pace of recovery. Over the long-term, there is also substantial scope for increasing top income tax rates and raising revenue without unduly slowing growth.

Unfortunately, political realities stand in the way of optimal policy.

Raising top income tax rates from their relatively low current levels would be the least harmful policy option for deficit reduction and would potentially yield large reductions in income inequality growth.

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See more work by Andrew Fieldhouse