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Taxation and Taxable Income

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Taxation and Taxable Income

April 20, 2011

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President Obama believes a huge portion of the nation’s required fiscal adjustment can be financed through tax increases on high earners. In his speech on the budget at George Washington University, President Obama reiterated his desire to ensure high income households face higher tax rates. Other commentators have gone further, encouraging the President and Congress to push rates back to pre-Reagan levels when the top marginal income tax rate was 70%.

It is doubtful that large increases in the tax rates applied to income earned at the top end of the distribution would generate revenue sufficient to meaningfully reduce current deficits. (See WSJ: Where the Tax Money Is.)  Even if it were possible arithmetically, relying on tax rates well above current levels would not only elicit real economic responses (reduced work and savings), but also increase the value of tax planning.

Efforts to tax the rich tend to run into two main problems. The first is that higher tax rates reduce the incentives to supply additional labor or capital. As a Tax Foundation analysis of Census data shows, 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. Relative to other tax brackets, rich households are much more likely to have two sources of income. Higher tax rates on two income families could make child care less economical and cause the second earner to leave the workforce. The empirical results suggest this effect is rather strong, as marginal tax increases reduce second earners’ workforce participation.

Higher tax rates change a variety of investment-consumption decisions. High-income households report 83% of all partnership and S-corporation income. This is not simply because small business owners tend to pay taxes at the individual level, but also because rich people tend to use their savings to provide the capital that allows small business to start or grow. The higher the tax rate applied to income (if any) derived from these business ventures, the less attractive it is to make these types of investments. Low tax rates encourage entrepreneurial entry and financing by permitting owners of new businesses to keep a larger share of the upside profits derived from investments with high failure rates.

Secondly, research has shown that tax increases on the rich can fail to generate revenue even if none of the aforementioned “supply side” effects manifest themselves. If rich people respond to tax increases by shifting income out of taxable form, then tax increases could fail to raise revenue even when there is no substantive economic response to the tax increase. This means that even if tax increases do nothing to change the supply of labor or investment capital they could still fail to generate additional revenue simply by changing portfolio holdings and increasing the gains from tax planning services offered by lawyers and accountants.

The rich derive a relatively small share of their income from wages and salaries. For the most recent tax year, the IRS reports that wages and salaries accounted for less than 20% of the income of taxpayers with more than $10 million of adjusted gross income. The bulk of their income comes from investments in securities and business enterprises over which they have almost total discretion. The higher the tax rate, the more attractive it becomes to substitute municipal bonds for dividend-paying stocks, establish trusts to defer or eliminate tax liabilities, and generate losses to reduce business income.

As Larry Lindsey found in a 1987 paper, the ability of high income households to shift income out of taxable channels means the revenue maximizing rate on income might be only 35%. Similarly, Martin Feldstein found that a 1% increase in after-tax income is associated with at least a 1% increase in taxable income. In both cases, the researchers presumed that some of the deadweight costs imposed by tax increases is real (reductions in labor supply and investment) but that the more important component comes from income shifting. The basic intuition behind this line of research is that higher marginal tax rates cause the investment and portfolio decisions of the rich to become much more tax-sensitive. Beyond portfolio changes, higher tax rates also increase the relative value of employer-provided health care, owner-occupied housing, and other tax exclusions and deductions.

For these reasons, it should be no surprise that the reduction in tax rates has resulted in substantial increases in the amount of taxable income reported by the rich. This has increased the top 1%’s share of pretax income, which has, ironically, led some to argue for higher taxes on the rich. The graph below plots the top marginal tax rate against the share of pretax income reported by the top 1% (from CBO). The correlation is –0.55: as the tax rate applied to the highest income falls, the amount of income (and share of total income) reported by this group increases on a predictable basis.

The only real exception to this rule came in the 1990s, as top marginal rates increased even as the top 1%’s share of income grew. Yet, this too was likely tax-related, as the reduction in capital gains tax rates to 18% led to larger and more frequent realizations. Since income includes only realized capital gains, lower tax rates on this form of income can increase taxable income simply by increasing the number and frequency of realizations. While this can improve the economy’s efficiency if positions that would have been held purely for tax purposes are liquidated, again, increases in taxable income can result even when the economic gains are not present.

It is ironic that increases in the level and share of income reported by the top 1% of the income distribution has led to calls to increase taxes on the rich because the tax literature suggests that the phenomenon itself is caused by the low rates. As the tax rate on ordinary and investment income has fallen, so too has the relative value of tax exemptions and exclusions. This has led rich households to move more of their income into taxable form – capital gains realizations, dividends, and non-corporate business income. Increasing the top marginal tax rate to 70% would substantially reduce the amount of income reported in the top income bracket without having any material impact on inequality.

Even worse, a reduction in taxable income among the top 1% of the income distribution would actually reduce the share of the tax burden financed by these households. According to CBO, the top 1% pays nearly 40% of all federal income taxes, more than double the share paid in 1979 when the top tax rate was 70%. While left-of-center analysts attribute the growing tax share to the right-skewed income distribution, it is actually a testament to the progressivity of the tax code. According to CBO, the top 1% of households report only 19% of total income. This means that the ratio of the share of income taxes paid by the top 1% to the share of income reported by the top 1% is greater than 2 (40% divided by 19% for 2006). The 2006 ratio of 2.08 was above the 1.97 recorded in 1979, suggesting that the tax code has become significantly more progressive since that time.

As tax rates have fallen over the past 30 years the taxable income reported by the rich has increased substantially. Part of the increase is likely the result of substitution effects, as households work and investment more in response to the greater after-tax returns to these activities. A larger share of the increase is attributable to the decline in the relative value of tax preferences and tax planning strategies more generally. Raising tax rates on these households is unlikely to be a successful strategy for reducing the deficit because four-fifths of their income comes from non-wage sources and is therefore likely to be moved to non-taxable channels in response to tax increases. Theory and empirical evidence suggests that best way to increase the share of government financed by the top 1% is to reduce the tax rates applied to their income.

e21 Partnership

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