A Taxing Dilemma: What’s the Optimal Rate for the Rich?

Commentary, Frontier Centre, Taxation, Worth A Look

In 1980, the top 1 per cent of income earners in the United States paid income taxes equal to 1.5 per cent of the country’s GDP. The top marginal tax rate was 70 per cent. Now the top 1 per cent pays income taxes equal to 3.3 per cent of GDP. The top marginal tax rate is 35 per cent.

From a halving of the top tax rate, in other words, came a doubling of revenue.

Question: If former president Ronald Reagan had doubled the top tax rate to 140 per cent, instead of cutting it in half, would tax revenue (as measured against GDP) also have doubled?

The question is, superficially, ridiculous. You can’t impose an income tax rate of 140 per cent – because no one can pay an income tax in excess of 100 per cent and survive. But the question is relevant to the search for the optimal top tax rate.

The top rate is one thing. The effective rate (after tax deductions) is one thing. But the consequences of the top tax rate on revenue is another thing altogether. Would anyone impose a higher tax rate on the rich if they knew that the higher rate would reduce revenue?

Arguably, the halving of the top U.S. marginal tax rate benefitted the bottom 99 per cent more than it benefitted the top 1 per cent. This was certainly true for the bottom 95 per cent, as IRS records show.

In 1916, the bottom 95 per cent paid zero per cent of U.S. income tax revenue (as measured against GDP). Only the rich paid income taxes.

In the following decades, the bottom 95 per cent paid progressively larger shares – which peaked, not coincidentally, in 1980. By this time, the bottom 95 per cent paid income taxes equal to 5.4 per cent of GDP. Yet in the 32 years since, the bottom 95 per cent have paid a declining share: falling to 3.2 per cent. The bottom 95 per cent thus collected a windfall tax cut equal to 2.2 per cent of GDP: $300-billion a year. (Top 5 per cent income earners make $154,000 a year or more.)

Two weeks ago, PBS Newshour invited two noted economists to discuss the search for the optimal marginal tax rate: supply side economist Arthur Laffer, who first doodled his famous Laffer Curve on a napkin over lunch with Republican administrators Dick Cheney and Donald Rumsfeld in 1974 (during the Gerald Ford presidency); and Massachusetts Institute of Technology economist Peter Diamond, a prominent Democratic economist.

Mr. Laffer argued for a lower top marginal tax rate, observing that you always get less of things when you tax them – a fact, he says, that no one doubts. “Do you really think that taxing tobacco makes people smoke more?” he asked. “Do you really think that fines for speeding make people speed more?” Tax income more, he said, and you get less of it. He advised setting the top marginal tax “well below the point of maximum short-term revenue.”

On the Laffer Curve, there are two rates that will produce any particular amount of revenue: one low and one high. This is, of course, unequivocally so for a zero per cent tax rate (which produces zero revenue) and for a 100 per cent tax rate (which produces zero revenue). But logically the rule holds for tax rates between the two extremes. Mr. Laffer insisted: “The presumption that higher tax rates on the top 1 per cent will raise tax revenues is false.”

Prof. Diamond didn’t altogether disagree. “You never want to go into that part of the Laffer Curve [where high tax rates discourage work],” he said. But he would raise the marginal tax on the top 1 per cent (perhaps as high as 60 or 70 per cent) – and cut taxes for middle-income wage earners who, he says, are more apt to start businesses and create jobs.

Simple and obvious though it may be, the Laffer Curve set in motion a global lowering of tax rates, a process far from finished. Why? Regardless of ideology, it is in everyone’s interest – especially now – to identify the lowest marginal rate that remarkably bestows the most revenue. An equally difficult task remains: the chore of distinguishing between wise spending and foolish spending. You can identify an increase in government revenue but you can’t guarantee that it will be prudently spent.