Taxing the Rich Won’t Work

The new budget reportedly hopes to raise $364 billion over ten years by raising the top two tax rates, plus $105 billion by raising the tax on dividends and capital gains to 20% from 15%, and $500 billion through discriminatory caps and limits on personal exemptions and deductions allowed to other taxpayers.

The $364 billion from raising the top two tax rates pales in comparison to the $2.56 trillion from keeping the rest of the Bush tax cuts in place, including $600 per couple (the 10% bracket) for everyone still rich enough to pay taxes (the Obama plan would exempt half of  U.S. workers from paying income tax).  That contrast between $364 billion and $2.56 trillion is definitive proof that Democrats’ endless complaint about the Bush tax cuts going “mainly to the rich” was one of the biggest big lies of the past decade.

The President's urge to penalize mature, two-earner educated couples earning more than $250,000 is symbolic populism, having essentially nothing to do with reducing the deficit. Table S-2 of the Budget (p. 147) lists “Upper-income tax provisions dedicated to deficit reduction” as just $34 billion in 2011 — less than 1% of estimated spending of $3.8 trillion. Errors in estimating next year’s deficit have often been much larger than $34 billion, particularly during the early stages of economic recoveries.

Still, the false belief that higher tax rates on the rich could eventually raise significant sums over the next decade is a dangerous delusion, because it means long-term deficits are seriously understated.

Here are just a few reasons why punitive marginal tax rates on high-income families cannot possibly raise even the relatively trivial sums the Budget is counting on:

1.    Professionals and companies who currently file under the individual income tax (including most trial lawyers and hedge fund managers) would form C-corporation to shelter income, because the corporate tax rate would then be lower with fewer arbitrary limits on deductions for costs of earning income.

2.    Investors who jumped into dividend-paying stocks in 2003 when the tax rate fell to 15% would dump some of those shares in favor of tax-free municipal bonds if the dividend tax went up, and keep the rest in tax-free IRA or 401k accounts.   Prices of dividend-paying stocks and funds could be depressed, reducing the yield of the capital gains tax.

3.    If faced with a higher capital gains tax next year, investors would rush to realize taxable capital gains (those not in IRAs and 401ks) later this year.  After 2010, investors would make greater efforts to avoid realizing gains in taxable accounts unless they had offsetting losses, and they would also make fewer investments in assets subject to the capital gains tax.

4.    Many two-earner couples would become one-earner couples, early retirement would become more popular, physicians would play more golf, etc.

That is a small sampling of known behavioral responses which economists call “the elasticity of taxable income” or ETI for short.  What that means is this: When the marginal tax rate goes up, the amount of reported incomes goes down.  As a forthcoming study by Joel Slemrod, Seth Giertz and Emmanuel Saez concludes, “There is much evidence to suggest that the ETI is higher for high-income individuals who have more access to avoidance opportunities.”

I presented a 60-page paper in 2008 full of graphs and tables, many derived from the tax data of Thomas Piketty and Emmanuel Saez, offering undeniable evidence that static revenue estimates (which ignore or minimize the ways in which people react to higher tax rates) greatly exaggerate potential revenue from higher tax rates on individual salaries, dividends and capital gains.

I concluded, “There is a serious fiscal risk in the future that overly-optimistic revenue estimates based on the assumption of zero or 0.25 elasticity of taxable income could lead the federal government to make long-term spending plans on the basis of phantom revenues from higher tax rates, embarking on major new entitlement programs (in the guise of refundable tax credits) in the false hope that these static or nearly-static revenue estimates are realistic.”