Why A 70% Marginal Tax Rate Won't Fix Inequality

The usually lifeless topic of taxes has been propelled into the spotlight by Congresswomen Alexandria Ocasio-Cortez’s proposal earlier this year to introduce a 70% marginal tax rate on income generated above $10 million. 

The proposal quickly gained traction, offering at least part of a solution to very big economic problems like income inequality and outrageously expensive healthcare and education. The tax also fits into a narrative that vilifies the rich and puts a face to the name of income inequality. 

But if a solution seems so simple, it’s because it probably is. Before we can assess whether a 70% top tax would be effective, we have to understand the objective of introducing such a tax rate. Arguments floating around in favor of the tax could be classified into three objectives:

  1. To increase government revenue
  2. To reduce income inequality
  3. To maximize social welfare

The first of these objectives is technically an enabler of the next two, but for the purposes of this discussion, we’ll analyze each independently, on its own merit.

The Tax Won’t Meaningfully Increase Government Revenue

The 70% top tax rate sounds like a lot of money. But the problem is there really aren’t that many people in the United States who earn more than $10 million in income. Economist and Bloomberg Opinion writer Noah Smith has, in my opinion, written with the most clarity about the effects of introducing a 70% top rate, and wrote a piece stating that it simply won’t generate that much revenue.

If you simply calculate the amount of money the tax would raise if the wealthy paid all of the tax, it would yield roughly $72 billion a year. That would increase federal tax revenue by about 3.6%.

And that isn’t including the reduction you would have to take into account for the disincentives introduced by the tax if it were to go into effect. 

Only 3.6%.

There is historical precedence to support this point. “While it’s true that top rates in the U.S. used to run even higher than 70%, it’s also true that these taxes raised relatively little additional revenue for the government,” Smith writes.

The Tax Won’t Meaningfully Decrease Income Inequality

Let’s turn to the second objective, income inequality. Income inequality, it should be stated, is a massive problem in the United States. A recent opinion piece in the New York Times by David Leonhardt shows a fascinating graph of the top 1% as the only demographic tranche to benefit from income growth over the last 40 years.    

Introducing a very high top tax would not redistribute wealth in a way that would offer more equal opportunity across the spectrum. It would only serve to slightly squish the disparity between the 1%, as Noah Smith put it. 

[It] would only serve to compress the distribution a bit at the top—to bring the rich and the super-rich slightly closer together. It would do nothing to reduce the yawning disparities between the well-off and the middle class, much less the poor. 

A more effective marginal tax rate, according to economists, Peter Diamond and Emmanuel Saez, would be to tax income above $300,000 at a 70% rate. Their idea has been widely cited as one that could address not just income inequality, but would also maximize social welfare.

The Tax Won’t Dramatically Increase Social Welfare

Diamond’s and Saez’s paper proposes three recommendations as part of this social-welfare-optimizing tax reform.

  • Recommendation 1: “Very high earnings should be subject to rising marginal rates and higher rates than current U.S. policy for top earners.”
  • Recommendation 2: “Tax (and transfer) policy toward low earners should include subsidization of earnings and should phase out the subsidization at a relatively high rate.”
  • Recommendation 3: “Capital income should be taxed.”

Note that their proposal is much broader than just introducing a top tax rate. Including a tax on capital income is critical to any tax reform since this is where much of the wealth concentration is stored at the top. The highest earners often have wealth tied to company stock, which isn’t taxed as ‘ordinary income,’ as Bill Gates pointed out.

The Tax Black Box

The biggest problem with taxes is the lack of clarity between the tax burden people carry and the benefits they receive. The most immediate problem with taxes is fixing the correlation between what we as taxpayers pay and what we get in return. 

The hypothesis I believe to be true is that many Americans in the 90th percentile and above would be willing to carry a higher tax burden if they believed it would help social welfare. 

Let’s assume higher taxes were introduced tomorrow and that in this hypothetical scenario the tax generated sizeable incremental revenue for the government. How many people could confidently say that incremental revenue would be deployed effectively?

A quick, informal poll asking a group who qualify as the 90th percentile to clarify what happens with their taxes, offers one answer to this question: 

  • “Infrastructure?”
  • “Funding President Trump’s travel.”
  • “Medicare.”
  • “It’s supposed to be social security but I know the government will have to generate much more revenue to fund what its projected to need.”

Before we introduce new tax reform, we have to introduce the effectiveness of the current revenue generated. Looking at 2017 OECD data of government expenditure and revenue as a percentage of GDP, the U.S. spends more than it makes, benchmarking poorly against its Nordic peers.

Greater Tax Effectiveness Is Possible 

The most glaring problem with our taxes in the U.S. is we can’t clearly point to what they’re funding. In Nordic countries, with great healthcare, and social benefits, individuals are incentivized to allocate a large portion of their income to taxes. “Economists say high taxes work in the Nordic region because the notion of state welfare is so deeply rooted in its culture,” Jonas O Bergman and Kati Pohjanpalo wrote for Bloomberg.

It might be impossible to replicate that model in the U.S. which is nearly 60x the population size of Denmark, for example. On this point Bergman and Pohjanpalo cite economist Olli Karkkainen, “[T]aking the Nordic model and attempting to implement it in the U.S., which has a much larger population and very different history, it wouldn’t work there in the same way as it works here.’’

While it might be impossible to replicate the Nordic model in America, it does point to an important part of the puzzle that too often gets overlooked. Tax reform won’t work until we untangle the path a tax dollar takes after it leaves the taxpayer’s pockets, guiding it to smoothly land in a good place.   


Follow Stephanie Denning on Twitter: @stephdenning

And Also Read:

Why Amazon Pays No Corporate Taxes

The Benefits Of The Sprint and T-Mobile Marriage

 

source: forbes.com