Friday, May 18, 2012

Revenue Maximizing vs. Inequality reducing tax rates

A number of events have occurred recently that relate to the Laffer Curve. First, France elected a new president who has advocated a top tax rate of 75%, a rate that even many liberals recognize as revenue reducing. However, Emmanuel Saez, along with Gruber, Picketty, and Diamond, argues that tax rates in that range are justifiable. One reason offered is that there is very little correlation between economic growth and tax rates. However, growth rates were not the point of the Laffer Curve. Economic growth will be the same as long as the people who are working are becoming more productive.
An additional problem with the Saez argument involves his elasticity measure. The peak of the Laffer Curve depends on how people respond to different tax rates. If people keep working the same amount no matter what the tax rate is, then we say that taxable income is inelastic (or the elasticity is zero). An elasticity of 1 means that a 5% increase in tax rates will result in a 5% decrease in taxable income. An elasticity greater than 1 means that a 5% increase in tax rates leads to a greater than 5% decrease in taxable income. In order to justify a tax rate of 75%, the elasticity measure would have to be approximately .2. His own research estimates an elasticity closer to .4 for the overall population. However, even he recognizes that the elasticity measure rises with income and his elasticity estimate for people making over $100,000 (1992 dollars) is .57. Wealthy people may work less, retire earlier, use tax loopholes, renounce their citizenship, or take some other action which reduces the amount of taxes they owe. Other researchers find considerably higher elasticities, especially for high income individuals. If the elasticity is 1 or greater, then the revenue maximizing tax rate falls to 40% or lower. When you include top federal rates of 35% (and possibly going up to 39.6%), medicare taxes, sales taxes, state taxes (perhaps as high as 13.3% in California), estate taxes, and corporate taxes (now the highest in the developed world), then we may already be beyond the revenue maximizing rate.
However, the goal of tax policy in this case is not to raise revenue, it is to reduce inequality. I have argued before that the best evidence that tax rates effect effort is rising inequality. At low tax rates, the wealthiest people keep working and get richer and richer which drives up inequality. At high tax rates, these people work less which reduces inequality. If reducing inequality is a goal in and of itself, as many people believe it should be, then confiscatory tax rates are beneficial. Under this viewpoint, it is OK to punish the poor as long as you punish the rich even more.

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