Asymmetrical Information - Megan McArdle

The Future of Tax Rates

How much higher can top marginal rates go?

12.26.12 4:54 PM ET

With the minutes ticking away until January 1st, it looks like we'll probably go over the fiscal cliff, at least temporarily.  Many of you may be asking yourself, "So exactly how much do my taxes go up?"  

That's a highly personal question, one that your accountant will probably have to answer.  But Tyler Cowen points us to a new paper which gives us some answers about the shape of the changes that are scheduled to take place unless something is done:  

This paper compares state-by-state estimates of the top marginal effective tax rates (METRs) on wages, interest, dividends, capital gains, and business income for tax year 2012 to the rates scheduled for 2013 under scheduled law. Scheduled tax law for 2013 assumes the expiration of the 2001 and 2003 tax cuts and the new PPACA taxes. Overall, the average top METR on wage income is scheduled to increase by approximately six percentage points (41.8 percent to 47.8 perent), while taxes on dividends would increase the greatest (19.0 percent to 47.9 percent). The top METRs on wages, dividends, interest, and partnership/sole proprietor income would exceed 50 percent in California, Hawaii, and New York City.  

A few thoughts on this.  

First, for all the talk about "going back to the Clinton-era tax rates", that is not exactly what we're doing.  Since Clinton, other tax hikes have been passed, most notably to pay for Obamacare, which raise the marginal tax rates on the wealthy well above their Clinton-era levels.  

Second, we're getting to a marginal income tax level on top incomes that I'm personally uncomfortable with.  As libertarians go, I'm not particularly fussed about taxes--I am, for example, on the record as in favor of letting the Bush tax cuts expire.  

But I am uncomfortable when the government makes more money off your labors than you do.  Yes, some people don't work very hard to earn their money, or earn it in ways that seem illegitimate.  But the solution is to change the law so that it's harder to earn money in illegitimate ways, not to take the majority of their money in taxes--and the majority of the money of other people who work quite hard indeed.  

And third, we're pushing surprisingly close to the limits of the "raise tax rates on the rich" strategy.  Oh, they can maybe go up another 10%, which would raise some real money--about $150 billion a year.   But it's not nearly as much money as we need. And my back-of-the envelope calculation assumes, fairly unrealistically, that raising the top marginal tax rate to 60% produces no income-shifting, doesn't decrease capital formation, and doesn't encourage anyone to lessen their work effort.   While the literature on the income elasticity of taxation is varied, no one thinks the effect is zero--and one thing that people often don't understand is that the higher the tax rate already is, the harder it is to raise it further.    

This is counterintuitive because when we're talking about policy, we tend to look at tax increases as a fraction of total taxable income, or as a fraction of the current tax rate.  To see what I mean, think about two cases:  one where the tax rate is going from 5% to 10%, and one where it is going from 50% to 55%.    

If you look at this as a percentage of total income, these two tax increases are the same.  

If you look at it as a percentage of the tax rate, then the first increase is much larger: it is doubling your taxes!  While the second increase is only upping them by 10%.  

But in terms of behavior, the percentage increase in the rate, or the percentage decrease in total income, is much less important than a third figure: the percentage decrease in your after-tax dollar.  Most people think less about their nominal annual salary than about how much they bring home in each paycheck. And if you look at it this way, the second tax increase is much, much larger than the first.  

Taking your tax rate from 5% to 10% decreases your after tax income by 5.26%.  But by the time your tax rate is 50%, you're only keeping half of your income.  So increasing the tax rate by 5% decreases your after-tax income by 10%: you used to take home 50 cents out of every dollar, but now you only take home 45 cents.  

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If you were surprised that Gerard Depardieu decided to leave France rather than pay the new 70% top rate, think of it this way: the rate increase was only 30%, but it was going to cut his income in half. Yes, that would still leave him with more money than you and I live on.  But people don't think this way: if the government came and took half your after-tax income away, that would still leave you with more money than a middle-class family in Bangalore lives on, and you would still be hopping mad, not to mention panicking about how the mortgage was going to get paid.  Even if they only took half of your marginal after-tax income away--an extra 50% of every dollar you made over $40,000 say--you would be pretty upset, because you've probably already earmarked uses for those dollars.

With the people in the highest-income states already pushing a 50% marginal rate under current law (and also, under what I take to be the negotiation outcome desired by most of the Democratic Party), every 10% tax hike is a 20% decrease in the after-tax value of extra work.  And of course, if the tax rate goes to 60%, a 10% increase takes 25% of after tax income--which is why not even the Nordics have gone there.

So we're pretty quickly going to have to start exploring tax increases on people who make less than $250,000 a year . . . or exploring serious spending cuts.  Or looking to limit deductions (including yes, the sacred deductions for charitable deductions and state and local income taxes, and the tax-free status of municipal bonds).  

Probably, we are going to have to do all three.  The era of "Don't tax you--don't tax me--tax that fellow behind the tree!" is coming to a close, not because we're any more in touch with reality than we were five years ago, but because pretty soon, reality is going to get in touch with us.