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The ‘Optimal’ Tax Rate on Ultra-High Income?

Research & Commentary
July 19, 2011


Rich people-friendly lawmakers subscribe to a theory that considers any tax increase on the rich a reckless step down a slippery slope to economic disaster. Two top economists have just published a new paper that takes on that theory.

Our nation’s capital remains awash with powerful people who believe that civilization as we know it will take a terrible tumble if we dare raise taxes on the richest among us. For these powerful people, outside keeping taxes low on high incomes, nothing else really matters — not even, as the debt limit battle demonstrates, the full faith and credit of the U.S. government.

History, of course, lends no support whatsoever to the claim that disaster awaits any nation that taxes its rich at significant levels. The United States, in the years after World War II, taxed top-bracket income at rates that never dropped below 70 percent — double today’s top marginal rate — and survived quite nicely.

Powerful people committed to not taxing the rich simply ignore this history. They rely on theoretical constructs instead. Taxing the rich, they assert, will undermine incentives to work and save and, down the road, leave everybody, rich and poor alike, worse off.

This theoretical claim has lots of fans in academia. A small army of analysts have fashioned quite nice little careers developing intricate mathematical models that they say affirm the folly of subjecting rich people to high taxes.

Economists Peter Diamond of MIT and Emmanuel Saez of the University of California at Berkeley, two leading global experts on taxation and high incomes, have never enlisted in this army. And now they’ve explained why — in a just-released new paper that goes mano a mano with the rich people-friendly mathematical model crowd.

Their goal in this new paper: to present “the case for tax progressivity based on recent results in optimal tax theory.” Their conclusion: The federal government ought to be taxing income at the top at much higher rates than the federal government does now.

The top federal income tax rate on income in the highest tax bracket currently sits at 35 percent. The optimal rate, Diamond and Saez suggest in The Case for a Progressive Tax: From Basic Research to Policy Recommendations, would go all the way up to 76 percent.

Diamond, a Nobel Prize winner, and Saez, a 2010 MacArthur “genius” fellow, haven’t written this new paper for the mathematically faint of heart. Their many equations and charts can make for tough sledding. But the two researchers do pause to offer a variety of easily digestible statistical nuggets along the way.

One example: In 2007, Diamond and Saez point out, the average federal tax rate on the nation’s highest-earning 1 percent averaged 22.4 percent. If the rate had been about double that — say 43.5 percent — the top 1 percenter share of our national after-tax income in 2007 would still have been twice as high as the top 1 percent’s after-tax income share back in 1970.

We’ve come a long way, in the wrong direction, in the four decades since 1970. The top marginal tax rate on our richest has been halved, from 70 to 35 percent, and our rich have become phenomenally richer. Getting that top tax rate back up, Diamond and Saez remind us, makes as much sense in theory as in real life.

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