New Academic Research Confirms the ‘High Price’ of High Tax Rates

I periodically cite new academic research about tax policy and economic activity. I sometimes even publicize research from international bureaucracies showing the link between taxes and growth.

I’m not naive enough to think that any particular study will change minds, but when the bulk of the research unambiguously tells us that lower tax rates are better for economic performance, I think (or at least hope) that it may have some impact on government officials.

That’s why I’m particularly interested in some new research by Cornell University’s Karel Mertens.

Here are some key findings from Mertens’ study, beginning with some observations on existing research.

To what extent do marginal tax rates matter for individual decisions to work and invest? The answer is essential for public policy and its role in shaping economic growth. The strand of the empirical literature that uses tax return data, surveyed in Saez, Slemrod and Giertz (2012), finds that incomes before taxes react only modestly to marginal tax rates and that the response is mostly situated at the very top of the income distribution.

So what does this mean? A lot depends on how one defines “modestly,” though it’s worth noting that even very small changes in growth—if sustained over time—can have big impacts on prosperity. That, in turn, has a significant effect on government finances.

And I have no objection to the assertion that upper-income taxpayers are most sensitive to changes in tax rates. After all, people like me who rely on wage and salary income don’t have much opportunity to alter our compensation in response to changes in tax rates.

But upper-income taxpayers get most of their compensation in the form of business profits and investment returns, and this gives them substantial control over the timing, level, and composition of their income. So it’s quite understandable that their taxable income is quite sensitive to changes in tax rates.

That being said, Mertens’ research suggests that conventional analysis has underestimated the impact of tax rates on the general population.

This paper adopts a macro-time series approach that addresses the endogeneity of average marginal tax rates in novel ways and permits insight into dynamics. Based on this approach, I find large income responses to marginal tax rates that extend across the income distribution. … The empirical results in this paper are relevant for several important debates. First, they reinforce the findings by a number of recent macro studies of large effects of aggregate tax changes on real GDP both in the U.S. and internationally. The results imply that raising marginal tax rates to resolve budget deficits comes at a high price and that a proportional across-the-board tax cut provides successful stimulus that does not necessarily lead to greater income concentration at the top.

Interestingly, the first part of the last sentence helps to explain the very poor results of tax-heavy “austerity” packages in places like Greece, Spain, Ireland, the United Kingdom, and Portugal. Politicians in those countries are squeezing the private sector in hopes of minimizing the restraint imposed on bloated public sectors. But that doesn’t generate good results. The Baltic nations took a much better approach, imposing genuine spending cuts the moment the crisis hit. Now their finances are in stronger shape and they’re enjoying renewed growth.

 

But I’m digressing. Let’s return to Mertens’ research. He also produced some interesting results about tax rates and high-income taxpayers.

Many of the postwar tax reforms have made particularly large changes in top marginal tax rates. This variation in top statutory rates may be used to estimate the effects of a hypothetical tax reform that only alters marginal tax rates for the top 1%. … The specification … displays the response to a 1 percent rise in the net-of-tax rate of the top 1% in the income distribution. … The tax cut leads to significant increases in average top 1% incomes, which rise on impact by 0.52 percent and by 0.97 and 1.02 percent in the following two years, after which there is a gradual decline. …[T]he cut in top 1% tax rates leads to a statistically significant increase in real GDP of up to 0.34 percent in the third year. … There are also spillover effects to incomes outside of the top 1%. Average incomes of the bottom 99% rise by 0.15 percent on impact and by up to 0.35 percent in the third year.

So we learn that lower tax rates for the “rich” are good for the economy and also benefit the general population’s living standard.

Why, then, would anybody want to impose higher tax rates? Here’s a hint from the study:

Despite the spillover effects, a top marginal rate cut unambiguously leads to greater inequality in pre-tax income.

In other words, the rich get richer faster than the non-rich get richer when the top tax rate is reduced. So if you’re driven by class-warfare animus, you may decide that you’re willing to hurt poor and middle-class people in order to prevent upper-income taxpayers from realizing a bigger share of the economy’s increased output.

That doesn’t make much sense. Iif you watch this video on class-warfare tax policy, there’s no logical reason to support higher tax rates on more successful taxpayers.

Unfortunately, politicians generally are motivated by a desire to maximize votes and power, not by what’s logical.

That’s why, when I’m doing educational outreach on Capitol Hill, I often make an extra effort to explain that a bigger economy—enabled by small government and free markets—is fiscally the same as a bigger tax base.

That’s far from a pure libertarian argument, to be sure, but it’s not easy when you’re trying to convince the foxes that it doesn’t make long-run sense to deplete the henhouse.

P.S.: Notwithstanding all the academic evidence, there’s a group of people in Washington who deliberately assume that tax policy has no impact on economic output.