How Much Could We Raise Income Taxes on the Rich? Actually, A Lot.

Rep. Alexandria Ocasio-Cortez really set the cat among the pigeons with her recent remarks about taxation. Asked how she would pay for everything in the proposed marks about taxation. Asked how she would pay for everything in the proposed Green New Deal, she said:

You look at our tax rates back in the ’60s, and when you had a progressive tax rate system your tax rate, let’s say, from zero to $75,000 may be 10 percent or 15 percent, et cetera. But once you get to the tippy tops — on your 10 millionth dollar — sometimes you see tax rates as high as 60 or 70 percent. That doesn’t mean all $10 million are taxed at an extremely high rate, but it means that as you climb up this ladder you should be contributing more.

Feathers flew. Rep. Steve Scalise tweeted that Democrats want to  "[t]ake away 70% of your income and give it to leftist fantasy programs," to which Ocasio-Cortez tartly replied, "You’re the GOP Minority Whip. How do you not know how marginal tax rates work?" For those of you who find yourselves in the same boat as Scalise, the marginal tax is the amount of tax you pay on the next dollar of income; it's relevant when we're looking at your incentives. The average rate is the tax you pay divided by your income, or in other words, the share of your income that goes to taxes. Ocasio-Cortez is quite explicitly talking about marginal rates; Scalise's tweet mixes up marginal rates and average rates.

But in defense of Scalise, it's quite possible under Ocasio-Cortez's proposal for someone to end up paying very close to 70% of their income. Consider, for example, the 25 highest-earning hedge-fund managers and traders profiled by Forbes. They earned an average of more than $670 million each in 2017; if they were paying 70% on income above $10 million, virtually all of their income would have been taxed at 70%. If this strikes you as the job for you, by the way, don't be shy. Fully half of them, including some getting compensation over $1 billion, performed worse at picking investments than you could expect if you were choosing at random.

Rate Amnesia

In any case, Ocasio-Cortez is if anything understating the history of high marginal rates. From 1951 through 1963 the top marginal tax rate never went below 91%. From 1964 through 1980 it never went below 70%, and not until 1987 did it get below 50%.

Today, though, this (relatively recent) history seems to have been all but forgotten, as  attested by this clip from the World Economic Forum in Davos, Switzerland. An economist finally speaks up about the actual history of tax rates in the U.S., to incredulity from the interviewer. And even he understates the case: as we have seen, a 70% rate persisted through 1980. (Don't miss Michael Dell's smug performance as Davos Man.) 

High top rates were the rule during some of the strongest periods of economic growth in U.S. history, which suggests they weren't a huge burden on the economy. Yet the idea that high marginal tax rates have big negative effects on incentives is one of the most cherished beliefs of American conservatism. How much should we be worried about the economic consequences of raising rates?

As it happens, some extremely distinguished economists have just weighed in on that question. Two recent papers attempted to estimate the incentive effects of high marginal rates and to find the economically optimal top rate. Both find that the effect is small, and their estimates of the optimal top rate are correspondingly high: one estimate is 72%, the other 84%. 

It seems pretty reasonable, then, to tax the income of the rich at high rates. Yet Democrats have so far been quite bashful about proposing any changes to income taxes, even members of the progressive wing of the party, like Bernie Sanders, Elizabeth Warren, and Kamala Harris. To fund various ideas they have proposed an increase in the estate tax (Sanders,Warren, Harris), a tax on financial transactions (Sanders), and a tax on wealth (Warren).

There's nothing wrong with any of those taxes (with the possible exception of the wealth tax, whose constitutionality will surely be challenged, bringing it before a Supreme Court that has been fiercely protective of the rights of the rich). But it's long past time to reestablish the norm of taxing the rich and the ultra-rich at high rates. There doesn't appear to be any political downside: a poll in January showed 59-41 support for a top tax rate of 70 percent.

Raising Income Tax Rates on the Rich

Let's see what the revenues might be from an increase in tax rates at the top. The boundaries of the top 1%, 0.1%., and .01% make convenient tax bracket cutoffs: roughly $500,000, $2,000,000 and $10,000,000 in a year  (Table I, p. 575). Using information about those three income classes, I've done some rough estimates of the added revenue from relatively "moderate" increase in tax rates to 50%, 58%, and 65%. (I've posted an explanation of my methodology here.)  I get an estimate of $222 billion.  (Interestingly, of the three new steps, two-thirds of the revenue comes from the first one, the increase to 50%, and nine-tenths comes from the first two.)

To be sure, $222 billion is not enough to put much of a dent in the cost of Medicare for All, which would run to between two and three trillion dollars a year. But $222 billion is enough to fund some things that could have a really dramatic impact on people's lives. Leaving aside items that have already been proposed by one or another Presidential candidate, here's one cut:

• Spend $150 billion per year eliminating America's infrastructure spending shortfall;
• Treat with buprenorphine the 2.1 million people with prescription-opioid use disorder at $5980/year each, for a total cost of $13 billion.
• Increase the salary of each of the 3.6 million public school teachers by $10,000, for a total cost of $36 billion;
• Increase by 50% the budgets of the National Science Foundation ($3.9 billion) and the IRS ($5.8 billion) 

That still leaves us more than $13 billion in the black. And we haven't raised taxes on anyone in the lower 99% by one cent.

And don't worry that we'll be leaving the 1% destitute.  They're currently paying 27% of their income in Federal taxes (Table 1, last row); this increase would raise that to 38%.

It's All About the Base

It's easy, though, to be hypnotized by the controversy about tax rates and miss an equally important question: What is the income base to which those rates are being applied? If we say the top rate is 70%, we need to remember to ask: 70% of what?

When it comes to taxing the rich, there are two big items in the definition of the tax base.  The bigger of the two is tax treatment of capital gains. Capital gains are what you net when you sell an asset for more than you paid for it; the difference, the capital gain, is taxable income. But if you held the asset for more than a year, you are taxed at rates much lower than those on ordinary income. The usual justification is that it encourages long-term, and discourage short-term, investment. This claim, though, is controversial. 

The other and more recent tax break is the special treatment of "qualified" dividends. The idea is to extend the reduced rate on capital gains to dividend income as well. Both these tax breaks are, to some extent, used by the non-rich as well as the rich. 

But they are used a lot more by the rich: this table shows that these two tax preferences were used for more than three-quarters of the taxes paid by those with incomes over $1 million. In no other income class did those tax breaks account for even ten percent of taxes paid, and in no class making less than $100,000 did they account for even  two percent. A repeal of those provisions would be nearly as well targeted as a rate increase.

The Treasury Department has estimated (items 69 and 70) revenue loss from the qualified dividend provision and the capital gains provision to be $29 billion and $110 billion, respectively.  Adding that revenue to our estimate of the revenue from raising marginal rates gives a total of just over $360 billion-- or, as they would say in the Washington style of talking in ten-year chunks, $3.6 trillion. (That's without taking account of interaction effects, i.e., the fact that higher rates would now be  applied to a bigger base.)

That is a lot of money. It's enough to fund what you could either call a leftist wish list or a transformation in the lives of ordinary people. Take a moment to contemplate, for instance, the Brown-Khanna bill to dramatically increase the Earned Income Tax Credit. At a cost of $140 billion, it would raise the incomes of more than a third of working households in the US, in most cases by thousands of dollars, and reduce the poverty rate by a third. 

Bear in mind, too, that the revenues we've been discussing here are only those from the personal income tax, and not the corporate "income" tax (which no longer is based on corporate income). That's way too complicated to get into now, so for the time being I will simply assert that a selective undoing and alteration of some of the changes of the 2017 tax legislation could produce revenue of at least $170 billion a year, with very likely a net gain in economic efficiency.

In his inaugural address in 1989, President George H.W. Bush said, "We have more will than wallet." That wasn't true then, and it's even less true today. There's plenty of wallet. What's been lacking is the will.