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Framing the Decision on Higher Tax Rates

e21 | 07/25/2012
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There are three basic positions one can take on the question of whether Congress should increase tax rates on high income taxpayers:

  1. No to higher tax rates – higher tax rates will result in less work, savings, and investment which will slow the economy.
  2. Yes to higher tax rates – there is no evidence that high income taxpayers respond to higher tax rates by working less. High income workers are more likely to save the incremental income rather than spend it so the tax increase will not depress output or demand.
  3. Yes to higher tax rates – the negative economic impact of higher tax rates on work and investment is small relative to the economic costs of higher deficits.

The policy debate is principally between those who embrace positions (1) and (2). Those who support tax increases tend to be dismissive of the impact of tax rates on behavior. Robert Rubin famously ridiculed the notion that tax rates dent incentives to work by pointing to his experience on compensation committees. No executive ever told him they planned to work less the next year because marginal tax rates went up. Academic support for this position comes from a 2000 Journal of Political Economy paper authored by former CEA Chair Austan Goolsbee. Goolsbee looks at the taxable income of top corporate executives and finds no evidence that long-run taxable income responds to tax rates. While corporate executives would change the timing of compensation to reduce tax liabilities, Goolsbee finds no evidence of sustained economic changes in response to higher tax rates.

The Goolsbee evidence is both compelling and beside the point. The corporate executive income data Goolsbee surveys is the place one would be least likely to find evidence of a behavioral response to higher tax rates. The CEOs of Fortune 500 companies do not suddenly reduce their hours worked in response to higher tax rates and it is odd to even think that they would. In many ways, the focus on the taxable income of the highest individual earners is knocking down a straw man: the expected variation in household taxable income would come from other sources like the income of second earners, while some of the response would come from changes in consumption that would not be visible from taxable income data at all.

The first place one sees evidence of the impact of higher tax rates is on second earners’ workforce participation. Households in the top two income-tax brackets are nearly three times more likely to have two earners and tend to work 27 hours more per week, on average, than households in the other tax brackets. Since the income of the second earner is taxed at the couple’s marginal tax rate, higher tax rates make child care relatively more expensive than staying home. The empirical results suggest this effect is rather strong, as higher tax rates depress spousal income and hours worked.

Secondly, higher tax impact consumption choices. As Martin Feldstein’s research uncovered, the 1993 Clinton tax increases reduced the amount of taxable income reported by high-income taxpayers by 7.8%. The reduction was tied to an increase in “deductible consumption,” such as spending more on housing by taking out a larger mortgage or accepting more nontaxable fringe benefits like a more generous health insurance policy at work. The tax increase also caused more investments to be shifted into low-or-no-tax forms, like municipal debt.

Finally and perhaps most consequentially, higher tax rates impact the decision to contract out for domestic services, which depresses the hours worked of housekeepers, mechanics, contractors, painters, child care professionals, and other service providers. Advanced European countries like France have grown at a slower rate than the U.S. economy because the number of hours of work supplied has been 50% less than in the U.S. According to Nobel Laureate Ed Prescott, higher marginal tax rates explain virtually all of the difference in the hours of labor supplied. The hours largely come from the market production of services that could be performed at home. Taxpayers in a number of professions often face rational choices between supplying additional hours or work or raking the leaves, fixing the car, or performing other domestic activities. The decision to stay home and paint the house, for example, not only reduces the homeowner’s hours of work but also depresses the income of the professional painter.

In short, the amount of hours of work supplied is hugely important because economic growth can be decomposed into hours of labor supplied and the productivity per hour worked. The focus on demand loses sight of the fact that expenditures equal output in each period. Additional hours of work create purchasing power, which translates to demand. Focusing on whether high income households save or spend the marginal dollar of income presupposes that the activity that generates the income is supplied regardless. That’s simply not the case.

To believe that higher tax rates are economically neutral, one would have to believe that (1) there is no impact on taxable income or hours worked; and (2) the government is better able to spend that incremental income than the household. If either (1) or (2) do not hold, it does not make sense to raise taxes while the economy is depressed. (While this analysis ignores the deficit impact of the reduced tax collections, the high income portion of the tax extension is very small – about one-tenth the overall cost.) In a depressed economy, it makes little sense to enact damaging tax increases that would, at best, reduce the annual deficit by 2%. If Congress and the President wish to raise tax rates for social policy reasons, that is certainly their prerogative. But no one should be under any illusions about the likely economic impact of such action.


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