Summary: Three of the most significant changes in America’s social and economic structure since the Reagan Revolution in 1980 are slowing GDP growth, the rising federal deficits and the great increase of inequality in wealth and income. Increasing taxes on the wealth might help reverse two or even all three of these trends. Today’s post examines the costs of rising taxes on the rich.
- Guest article by Jared Bernstein
- About the author
- Some articles providing a wider context about this topic
- For more information
(1) Today’s guest article
“The Economic Impact of Raising Taxes on High-Income Households“, Jared Bernstein, 24 April 2012 (Reposted here with his generous permission):
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.” 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.” 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.  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.” 
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: 
“[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).
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.”  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.
(2) About the author
Jared Bernstein joined the Center on Budget and Policy Priorities in May 2011 as a Senior Fellow. From 2009 to 2011, Bernstein was the Chief Economist and Economic Adviser to Vice President Joe Biden, executive director of the White House Task Force on the Middle Class, and a member of President Obama’s economic team.
Bernstein’s areas of expertise include federal and state economic and fiscal policies, income inequality and mobility, trends in employment and earnings, international comparisons, and the analysis of financial and housing markets.
Prior to joining the Obama administration, Bernstein was a senior economist and the director of the Living Standards Program at the Economic Policy Institute in Washington, D.C.
Between 1995 and 1996, he held the post of deputy chief economist at the U.S. Department of Labor.
He is the author and coauthor of numerous books for both popular and academic audiences, including “Crunch: Why Do I Feel So Squeezed?” and nine editions of “The State of Working America.” Bernstein has published extensively in various venues, including The New York Times, Washington Post, Financial Times, and Research in Economics and Statistics. He is an on-air commentator for the cable stations CNBC and MSNBC and writes at his website.
Bernstein holds a PhD in Social Welfare from Columbia University.
(3) Some articles providing a wider context about this topic
- “Reagan! Reagan! Reagan!“, Paul Krugman, New York Times, 7 November 2009 — About the slowdown in growth after 1980.
- “A standard Republican narrative of history“, Noah Smith (soon to be Asst Prof Economics at Stony Brook), 16 January 2012
- “How billionaires destroy democracy“, Linda McQuaig and Neil Brooks, Salon, 1 April 2012 — “Wealthy Wall Streeters have rigged the economy and the government against the people. Here’s how they did it.”
(4) For more information
(a) See the FM Reference Page America – how can we stop the quiet coup now in progress?
(b) Posts about taxes
- Are Americans over-taxed?, 9 April 2010
- Why Republicans Need Remedial Math: Their Budget Plans Explode the Deficit, 16 March 2012
(c) Posts about inequality and social mobility: once strengths of America, now weaknesses:
- A sad picture of America, but important for us to understand, 3 November 2008 — Our low social mobility.
- America’s elites reluctantly impose a client-patron system, 5 November 2008
- Inequality in the USA, 7 January 2009 — Also, we have a flat-tax system.
- A great, brief analysis of problem with America’s society – a model to follow when looking at other problems, 4 June 2009
- The latest figures on income inequality in the USA, 9 October 2009
- An opportunity to look in the mirror, to more clearly see America, 10 November 2009
- Graph of the decade, a hidden fracture in the American political regime, 7 March 2010
- America, the land of limited opportunity. We must open our eyes to the truth., 31 March 2010
- Modern America seen in pictures. Graphs, not photos. Facts, not impressions., 13 June 2010
- Why Republicans Need Remedial Math: Their Budget Plans Explode the Deficit, 16 March 2012