The Economic Impact of Raising Taxes on High-Income Households

April 24th, 2012 at 6:03 pm

I’ve been waiting for this.

It’s the long-awaited, reader-friendly review by Chye-Ching Huang of the economic theory, evidence, and literature on the relationships—or lack thereof—between taxes on high–income households and their impact on growth, jobs, investment, and entrepreneurship.

CCH takes you—pretty gently, I’d say—through the facts of the case in some detail, but I’ve pasted in the key bullets below (see text for endnotes).   A lot of this reminded me of this post on small vs. large responder theories of how people respond to tax changes (hint: “small” usually wins).

A lot if it also reminded me of this: you know all those arguments we’re always having about supply-side, trickle-down economics?  Like every day in the Congress, on the campaign trail, and on cable TV?  Well, scholars have actually looked at this stuff and come up with consistent and compelling answers.  So, if we can just find our way back to The-Land-Where-Facts-Matter, we might be able to make some smart choices around tax policies.

  • Taxable income and revenue. Opponents of raising the taxes that high-income households face often point to findings that high-income taxpayers respond to tax-rate increases by reporting less income to the Internal Revenue Service (IRS) as evidence that high marginal tax rates impose significant costs on the economy.  However, an important study by tax economists Joel Slemrod and Alan Auerbach found that such reductions in reported income largely reflect timing and other tax avoidance strategies that taxpayers adopt to minimize their taxable income, not changes in real work, savings, and investment behavior.  While such strategies entail some economic costs, these costs are relatively modest.  Moreover, policymakers can limit high-income taxpayers’ ability to respond to increases in tax rates by engaging in tax avoidance activity — and also enhance the efficiency of the tax code — by broadening the tax base, as discussed below.
  • Work and labor supply. The evidence shows that changes in tax rates that fall within the ranges that policymakers are debating have little impact on high-income individuals’ decisions regarding how much to work.  As Leonard Burman, former head of the Urban-Brookings Tax Policy Center (TPC), recently testified, “Overall, evidence suggests [high-income Americans’] labor supply is insensitive to tax rates.”[2] A marginal rate increase may encourage some taxpayers to work less because the after-tax return to work declines, but some will choose to work more, to maintain a level of after-tax income similar to what they had before the tax increase.  The evidence suggests that these two opposing responses largely cancel each other out.
  • Saving and investment. Some claim that tax increases on high-income people — in particular, increases in capital gains and dividend tax rates — depress private saving rates and investment.  But as Professor Joel Slemrod has written, “there is no evidence that links aggregate economic performance to capital gains tax rates.”[3] Similarly, the Congressional Research Service (CRS) has reported that most economists find that reducing capital gains tax rates would have only a small — and possibly negative — impact on saving and investment.[4] Although tax increases on high-income individuals might reduce their saving, if the revenue generated is devoted to deficit reduction, the resulting increase in public saving is likely to more than offset any reduction in private saving.  CRS concludes, “Capital gains tax rate increases appear to increase public saving and may have little or no effect on private saving.  Consequently, capital gains tax increases likely have a positive overall impact on national saving and investment.”[5]
  • Small business. The evidence does not support the claim that raising top marginal income tax rates has a heavy impact on small business owners: a recent Treasury analysis finds that only 2.5 percent of small business owners fall into the top two income tax brackets and that these owners receive less than one-third of small business income.  Moreover, even those small business owners who would be affected by tax increases on high-income households are unlikely to respond by reducing hiring or new investment.  As Tax Policy Center co-director William Gale has noted:[6]

“[T]he effective tax rate on small business income is likely to be zero or negative, regardless of small changes in the marginal tax rates.  This is for three reasons.  First, small businesses can expense (immediately deduct in full) the cost of investment.  This alone brings the effective tax rate on new investment to zero, regardless of the statutory rate.  Second, if they can finance the investment with debt, the interest payments would be tax deductible, making the effective tax rate negative.  Third, they can deduct wage payments in full, so the marginal tax rate should have minimal impact on hiring.”

In addition, a review of the research finds little evidence for the common assertion that small businesses are responsible for the majority of job creation in the United States or that tax breaks for small businesses generally — as distinguished from start-up ventures — are effective at stimulating jobs or growth in Gross Domestic Product (GDP).

  • Entrepreneurship. CRS finds that “An extensive empirical literature on [the relationship between income tax rate increases and business formation] is mixed, but largely suggests that higher tax rates are more likely to encourage, rather than discourage, self-employment.”[7] One reason is that taxes may reduce earnings volatility, with the government bearing some of the risk of a new venture — by allowing tax deductions for losses — and receiving some of the returns.  Further, there is little evidence that the current preferential tax rates for capital gains and dividends substantially stimulate investment in new ventures.
  • Growth and jobs. History shows that higher taxes are compatible with economic growth and job creation: job creation and GDP growth were significantly stronger following the Clinton tax increases than following the Bush tax cuts.  Further, the Congressional Budget office (CBO) concludes that letting the Bush-era tax cuts expire on schedule would strengthen long-term economic growth, on balance, if policymakers used the revenue saved to reduce deficits.  In other words, any negative impact on economic growth from increasing taxes on high-income people would be more than offset by the positive effects of using the resulting revenue gain to reduce the budget deficit.  Tax increases can also be used to fund, or to forestall cuts in, productive public investments in areas that support growth such as public education, basic research, and infrastructure.
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16 comments in reply to "The Economic Impact of Raising Taxes on High-Income Households"

  1. Tyler says:

    “History shows that higher taxes are compatible with economic growth and job creation: job creation and GDP growth were significantly stronger following the Clinton tax increases than following the Bush tax cuts.”

    History shows only that higher taxes correlate with economic growth and job creation. It does not show that higher taxes cause economic growth and job creation. The real credit for prosperity during the 1990s should be given to Bill Gates and the Internet boom, not Bill Clinton’s tax increases.


    • Mike says:

      I don’t think anyone is saying the Clinton tax increases caused the 1990′s boom. They’re merely saying all the doom and gloom predicted by the GOP was false and that the doom and gloom being predicted today about letting the Bush tax cuts expires is likely to be false also.


      • Ryan says:

        I used to think that correlation implied causation.
        Then I took a statistics class.
        Now I’m not sure…


        • vshawnt says:

          I suspect a strong causal relationship between taking a statistics class and understanding the differences between correlation and causation.


    • mgoodfel says:

      The whole tone of these tax-the-rich plans tick me off. It’s “how hard can we whip the mules without killing them?” No admission of the plain fact that it’s not your money. And there are other problems:

      - The income of the rich is volatile, so you are making government revenues more unstable by relying on the rich. This has gotten California in trouble.

      - The ideal amount of tax should maximize growth, not revenue. If the economy grows faster, your tax revenue would increase in the long term.

      - You are converting some amount of private spending into government spending. That’s the point of higher taxes. And much of government spending is a waste. It nearly always come with high overhead as the spending is “administered”.

      - You are sending a signal to the public that they can have more government services, because it’s “free”. This will not end well.

      - People with low income think they are making it and don’t have to update their skills and education, when in fact, they are getting thousands of dollars per year of government subsidy.

      - I’m not convinced that any of these tax increases will help the deficit, since there’s no political will to reduce spending. Cut spending first, then we’ll see about a tax increase.


      • Dollared says:

        Your post is a collection of half truths and misconceptions. First, rates are historically lower than they have ever been (at least since the Great Depression – there’s another correlate fact about low tax rates for you). So returning to them to where they were before Bush looted the Treasury and sent us the bill is a matter of simple integrity.

        Second, we can and will reduce spending, as soon as the Republicans agree to do so. Since more than half of all spending is highly inefficient military spending, your buddies are the problem.

        Third, people are plenty motivated to increase their income. Or don’t you believe in the power of economic incentives. The problem is that since corporate America has gutted the unions and outsourced work, more than 25% of all the jobs in the US are at or near minimum wage. It’s great that you want to play musical chairs with people’s livelihoods and lives, but we have to have more chairs or we will continue to have 1/3 of all our children in poverty.

        Fourth, government spending is very efficient. Ask Boeing how many billions they wasted on delays in 787 production because they wanted to screw the unions, or how much Lockheed wastes on the F-35 every year. Government spending creates more middle class jobs, and more infrastructure that produces return across society, than private spending.
        The part about rich people’s incomes being inconsistent is simply moronic. $10M in one year and $30M in another is not a hardship. Period. And you only pay taxes on what you make in a year, so who cares? Nobody.

        Finally, this you must understand or the mob will make you understand: Rich people make a profit off all the lives they touch. Their capital concentrates economic activity and extracts wealth. It must be taxed commensurate with the concentration effect of that wealth. You want control, outsized benefits and you don’t want to pay for it. Parasite.


        • Nash says:

          Military Spending should be cut but it’s not “more than half the spending”. It accounts for around 15-25% depending on whether you count foreign military aid.

          Social Security, Medicare and other safety net programs account for “more than half the spending”


  2. Chris G says:

    A little off-topic but here’s an excerpt from Casey Mulligan’s NYT Economix blog post today:

    “… both raising taxes on high earners and cutting subsidies for low earners would reduce the government deficit, but the former would reduce employment and the latter increase it. For the same reasons, raising subsidies and cutting taxes for low earners, as the 2009 American Recovery and Reinvestment Act did, would both add to deficit and reduce employment.”

    Please discuss;-)

    Link to full post: http://economix.blogs.nytimes.com/2012/04/25/the-varying-impact-of-austerity-and-stimulus/?hp


    • Tyler says:

      Chris,

      I touched up the quote from Milligan to remove the falsehoods:

      “… cutting subsidies for low earners would [undoubtedly reduce employment because 50 million Americans are living in poverty and are thus guaranteed to spend their subsidies]. For the same reasons, raising subsidies and cutting taxes for low earners, as the 2009 American Recovery and Reinvestment Act did, [did not add to the long-term deficit because they increased employment].”

      Casey Mulligan should work for the Wall Steet Journal.


  3. Mike says:

    “letting the Bush-era tax cuts expire on schedule would strengthen long-term economic growth, on balance, if policymakers used the revenue saved to reduce deficits”

    That, to me, is by far the most important part.


  4. Art Patten says:

    Jared: “letting the Bush-era tax cuts expire on schedule would strengthen long-term economic growth, on balance, if policymakers used the revenue saved to reduce deficits”

    Mike: “That, to me, is by far the most important part.”

    That’s actually the part where Jared ends our little trip into Where-Facts-Matter-Land. Intertemporal govt budget constraints and crowding out are highly theoretical, empirically wanting, poor descriptions of reality.

    http://jaredbernsteinblog.com/the-economic-impact-of-raising-taxes-on-high-income-households/#comment-158138


  5. Jack says:

    One only need to look at the history of the beginning of the 20th Century to see where the author’s facts hold true.

    Regan cut taxes and we had a very bad recession. Reagan raises rates and some form of prosperity blooms. Bush cuts rates and starts a war and again people lose jobs and fall into poverty. Clinton raises rates and the economy blooms again and a surplus appears.

    Bush II gives away the surplus and more….then here we are.


    • Daniel Francis says:

      Sorry, but it was Bush 1 who raised taxes first before Bill Clinton. Clinton just built off of George’s work. Other then that good job.


  6. theod says:

    Republicans don’t care about empirical facts. Their feelings rule their every waking moment of every waking day. And money, too.


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