Good policy at a bad time is still good policy

by pdxblake

The Democrats are going to try again to get through good policy against Republican obstructionism, replicating a failed effort from 2010 to hold strong behind letting the Bush tax cuts expire for people earning more than $250,000 per year.  The politics are generally in favor of the Democrats’ argument, but that was also the case in 2010.  From a policy perspective, it is much more preferable to raise marginal tax rates on those with high incomes than those with lower incomes.  It is easier to do it when the economy is booming and the argument that adding any drag to the economy does not hold water, but it is never possible to pick the timing of things like the second coming of the expiration of the Bush Tax cuts (which was conveniently timed to originally expire a couple years after Bush’s second term).

The main argument against raising tax cuts on high income people is the old Laffer Curve argument that raising marginal tax rates will discourage by high income people enough so that its revenue-raising impact will be negative.  This has been re-branded into the simplistic (and cringe-inducing) reference to rich people as “job creators”.  However, economists Peter Diamond and Emmanuel Saez find that the optimal level for the highest marginal tax rate is close to 70%, much higher than both the current 35% and the 39.6% rate that will be the end result of the high-end Bush tax cuts expiring.

Paul Krugman described the logic behind the paper’s conclusion:

In the first part of the paper, D&S [Diamond & Saez] analyze the optimal tax rate on top earners. And they argue that this should be the rate that maximizes the revenue collected from these top earners — full stop. Why? Because if you’re trying to maximize any sort of aggregate welfare measure, it’s clear that a marginal dollar of income makes very little difference to the welfare of the wealthy, as compared with the difference it makes to the welfare of the poor and middle class. So to a first approximation policy should soak the rich for the maximum amount — not out of envy or a desire to punish, but simply to raise as much money as possible for other purposes.

Now, this doesn’t imply a 100% tax rate, because there are going to be behavioral responses – high earners will generate at least somewhat less taxable income in the face of a high tax rate, either by actually working less or by pushing their earnings underground. Using parameters based on the literature, D&S suggest that the optimal tax rate on the highest earners is in the vicinity of 70%.

Everyone and their mother likes to bitch and moan about the inefficiency of the tax system, and there are numerous solutions proposed, like flat taxes and removing all tax expenditure (the government encourages certain behavior by giving people money through the tax code rather than by spending directly), which all have their own problems.  The main goal that everyone pretends to support is that taxation should pay for the things we want the government to spend money on few distortions on the economy.  This is the same thing as what Krugman describes, and a part of creating the most efficient tax system is finding the point where the marginal tax rate on income maximizes revenue.  If the data show that the top maximum rate should be 70%, then by not having it at 70%, the government has to either borrow or levy taxes elsewhere, which will have a more significant impact on the economy in the long run.

The economy is not at the best point for fiscal tightening (i.e. spending cuts or higher taxes), but it is likely to be the best chance for a while to make a change that will help both lower income inequality and will be the first step towards lowering long-run fiscal deficits.  It is also a much less harmful idea than the Republicans alternative:

  • Save the tax cuts for the rich or let all of the Bush tax cuts expire
  • Offset Defense Department spending cuts by taking the knife to discretionary spending including assistance to the unemployed and lower-income people.

The Republican policy ideas are far more harmful to the economy than anything the Democrats have proposed.  But if they lose this fight, the Republicans will have no other choice but to go and ask the EPA and the Sierra Club to save the “job creators” from extinction.

For more information on empirical studies of the economic effects of raising the wealthy’s taxes, I recommend a report from the Center on Budget & Policy Priorities released in April 2012.