Diamond and Saez: High Tax Rates Won't Slow Growth

We're not close to the top of the Laffer Curve. Raising tax rates is part of a sensible deficit reduction strategy.

By PETER DIAMOND AND EMMANUEL SAEZ WSJ

The share of pre-tax income accruing to the top 1% of earners in the U.S. has more than doubled to about 20% in 2010 from less than 10% in the 1970s. At the same time, the average federal income tax rate on top earners has declined significantly. Given the large current and projected deficits, should the top 1% be taxed more? Because U.S. income concentration is now so high, the potential tax revenue at stake is large.

But will taxable incomes of the top 1% respond to a tax increase by declining so much that revenue rises very little or even drops? In other words, are we already near or beyond the peak of the famous Laffer Curve, the revenue-maximizing tax rate?

The Laffer Curve is used to illustrate the concept of taxable income "elasticity,"—i.e., that taxable income will change in response to a change in the rate of taxation. Top earners can, of course, move taxable income between years to subject them to lower tax rates, for example, by changing the timing of charitable donations and realized capital gains. And some can convert earned income into capital gains, and avoid higher taxes in other ways. But existing studies do not show much change in actual work being done.

According to our analysis of current tax rates and their elasticity, the revenue-maximizing top federal marginal income tax rate would be in or near the range of 50%-70% (taking into account that individuals face additional taxes from Medicare and state and local taxes). Thus we conclude that raising the top tax rate is very likely to result in revenue increases at least until we reach the 50% rate that held during the first Reagan administration, and possibly until the 70% rate of the 1970s. To reduce tax avoidance opportunities, tax rates on capital gains and dividends should increase along with the basic rate. Closing loopholes and stepping up enforcement would further limit tax avoidance and evasion.

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