Taxing The 1%

One of the stylised facts of the past quarter of a century is that there has been a general increase in the share of the income going to the top 1% of the population globally. Part of that has been blamed on a move towards lower top marginal income tax rates. The political rationale, exemplified by the Laffer curve, has been that lower tax rates stimulates economic activity and investment, thus raising economic growth and tax revenues.

That this didn’t quite happen should be quite evident.

Now this gem of a paper landed in my inbox  a couple of days ago (abstract; emphasis added):

Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities
Thomas Piketty, Emmanuel Saez, Stefanie Stantcheva

This paper analyzes the problem of optimal taxation of top labor incomes. We develop a model where top incomes respond to marginal tax rates through three channels: (1) the standard supply-side channel through reduced economic activity, (2) the tax avoidance channel, (3) the compensation bargaining channel through efforts in influencing own pay setting. We derive the optimal top tax rate formula as a function of the three elasticities corresponding to those three channels of responses. The first elasticity (supply side) is the sole real factor limiting optimal top tax rates. The optimal tax system should be designed to minimize the second elasticity (avoidance) through tax enforcement and tax neutrality across income forms, in which case the second elasticity becomes irrelevant. The optimal top tax rate increases with the third elasticity (bargaining) as bargaining efforts are zero-sum in aggregate. We then analyze top income and top tax rate data in 18 OECD countries. There is a strong correlation between cuts in top tax rates and increases in top 1% income shares since 1975, implying that the overall elasticity is large. But top income share increases have not translated into higher economic growth, consistent with the zero-sum bargaining model. This suggests that the first elasticity is modest in size and that the overall effect comes mostly from the third elasticity. Consequently, socially optimal top tax rates might possibly be much higher than what is commonly assumed.

It’s a fairly long paper, and very nearly a complete reference work on modelling taxation. More importantly, the authors have done a bang-up job in coming up with a new framework in analysing the factors that reduce the tax yield from high income earners.

The economic literature report that high income earners respond to higher taxation in three ways:

1. As the marginal tax rate increases, the incentive to work and earn more decreases – there are diminishing returns on increasing taxation (basically the Laffer curve hypothesis);
2. As the marginal tax rate increases, people find ways to avoid tax liability, such as changing the nature of income to lower tax categories (e.g. from wage income to capital gains income; non-monetary benefits), or at the extreme, tax fraud and offshore tax shelters;
3. As the marginal tax rate increases, high income earners are less likely to try to and bargain up their wages at the expense of lower income earners, as the gains from this strategy become less.

The corresponding negatives apply – as the marginal tax rate falls, high income earners supposedly work more, avoid tax less, and increase bargaining behaviour to extract rents.

Most previous studies have concentrated on one or the other of these factors, and the uniqueness of this study is that the authors think they’re the first to look at all three in combination. That’s an important innovation as looking at each factor in isolation risks omitted variable bias.

The results obtained are fascinating – overall elasticity for top income earners is around 0.5, implying that the actual tax yield only increases at half the rate of any increase. Breaking it down, it works out to about 0.2 from reduced economic activity, and 0.3 from reduced bargaining. Implementing the correct tax policies would make it possible to reduce the second factor – tax avoidance – to null, especially via a tax neutral approach to income (i.e. you tax capital gains at the same rate as wages), broad based tax policies (e.g. GST or VAT) and via enforcement.

In Econoenglish:

1. The empirical observation of higher income shares of the top 1% can be explained only partly through tax cuts promoting higher economic growth, but more mainly through income suppression of the bottom 99%.
2. Raising taxes from present levels will not only raise overall tax revenue (disproving Laffer’s hypothesis), but will also reduce income inequality.

The optimal top tax rate for each country will obviously vary, depending on institutional and cultural factors, but the authors calculate it to be between 57% and 83% to maximise the tax yield from high income earners.

That’s a far cry from our present 26%, which doesn’t even cover capital gains.

Technical Notes:

Thomas Piketty, Emmanuel Saez, Stefanie Stantcheva, "Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities", NBER Working Paper No. 17616, November 2011