Undercover Economist

How high should the top rate of tax be, and who should pay it?

What should the top rate of income tax be? Should it be 70 per cent, as has been informally suggested by the young star of the US Democratic party, Congresswoman Alexandria Ocasio-Cortez? That instinctively feels too high to me. But, as an economist with sporadic hopes of making logical arguments based on evidence, I admit that “instinctively feels too high” is a weak response.

What about 50 per cent, the official policy of the UK’s opposition Labour party at the last general election? Or zero, the optimal top rate that emerged from a thought experiment posed by the late James Mirrlees, a Nobel laureate in economics?

An alternative is to tax wealth instead of income, as US Democratic Senator Elizabeth Warren has proposed. But — at least in principle — there is not much difference between a small annual tax on total wealth and a large tax on the nominal return generated by that wealth.

To make the case for a top rate of tax above 70 per cent, it helps to believe four things.

The first is that taxable income itself won’t evaporate in the face of a high rate, as it did in the UK when the top tax rate was briefly raised from 40 to 50 per cent in 2010, then cut to 45 per cent. Most high earners found it easy to realise income early, or late, and avoid the 50 per cent rate. A permanent increase is harder to avoid; so is an increase that is enforced with determined (or draconian) measures; as is an increase levied by a large economy with global legislative reach such as the US. In smaller economies such as the UK’s, the very rich are more likely to take themselves elsewhere for any given tax rate.

One academic paper produced by Emmanuel Saez (a star in the study of inequality) and Peter Diamond (a Nobel laureate and colleague of Mirrlees) estimated that the combined rate of tax on the income of high earners could be 73 per cent in the US without proving counter-productive. Another paper, published in the same journal, by Gregory Mankiw and co-authors, put the optimal top rate at just under 50 per cent instead. The difference lies in the assumptions.

The second thing one needs to believe is that the rich will barely miss any extra income if tax rates rise. The truth of this is unknowable, although another famous study from yet more Nobel laureates, Daniel Kahneman and Angus Deaton, suggests that money will not improve your everyday mood and wellbeing after an income of $75,000 a year or so. To reach their conclusions about the 73 per cent rate, Professors Diamond and Saez assume that a dollar is 25 times more valuable to a person on about $50,000 a year than to a person on $500,000. That is not an insane assumption, but it’s an assumption nonetheless.

If you accept these first two beliefs, the economic case for a high top rate of tax follows. A high rate maximises revenue if the tax base doesn’t shrink too much, and revenue maximisation is a reasonable goal if it’s true that the rich would barely notice the lost income.

But this argument ranges far beyond economics. If you like high tax rates, the third thing it helps to believe is that inequality is intrinsically corrosive. Perhaps it undermines democracy. Perhaps it causes stress, envy or resentment. The empirical evidence is not much help here; it is sketchy and often seems tendentious. Causal channels are unclear: does inequality lead to a hollowed-out state? Or does a hollowed-out state enable inequality? Perhaps a thought-experiment is more helpful here: how would you feel about a policy that simply confiscated resources from the super-rich and destroyed them? Would such a policy be a criminal waste and a grotesque infringement of liberty, or a helpful rebalancing of the scales?

Then there’s a fourth, often unstated, belief: that the rich have so much money that a high rate of tax will raise serious revenue. That depends on who you regard as “rich”. Ms Ocasio-Cortez mentioned a threshold of $10m. Profs Diamond and Saez focused on the highest earning 1 per cent of taxpayers, implying that the band would apply above around $500,000 a year. The Labour party wanted its highest rates to apply on incomes over £100,000.

These are very different definitions of “rich” and they have very different implications for revenue. For example, Ms Ocasio-Cortez’s income threshold of $10m is higher than that required to get into the top 0.01 per cent of the US income distribution: about 16,000 families. This tiny slice of the US population receives a less-than-tiny 5 per cent of total US income — which nevertheless implies that 95 per cent of income is earned by those making less.

The super-rich are a tempting target, but a serious attempt to raise revenue cannot stop with them. Whether we are talking about income or wealth, the lion’s share lies not with the billionaires but with the comfortably off. It is nice to talk about taxing somebody else’s money, but in a world of chronic budget deficits and worsening demographics, the ethics and economics of higher tax rates are unlikely to remain someone else’s problem.

Written for and first published in the Financial Times on 1 Feb 2019.

My book “Fifty Things That Made the Modern Economy” (UK) / “Fifty Inventions That Shaped The Modern Economy” (US) is out now in paperback – feel free to order online or through your local bookshop.

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