The Economic Impact of Raising Taxes on High-Income Households

I've been waiting for this.

It's the long-awaited, reader-friendly review by Chye-Ching Huang of the economic theory, evidence, and literature on the relationships -- or lack thereof -- between taxes on high-income households and their impact on growth, jobs, investment, and entrepreneurship.

CCH takes you -- pretty gently, I'd say -- through the facts of the case in some detail, but I've pasted in the key bullets below (see text for endnotes). A lot of this reminded me of this post on small vs. large responder theories of how people respond to tax changes (hint: "small" usually wins).

A lot if it also reminded me of this: you know all those arguments we're always having about supply-side, trickle-down economics? Like every day in the Congress, on the campaign trail, and on cable TV? Well, scholars have actually looked at this stuff and come up with consistent and compelling answers. So, if we can just find our way back to The-Land-Where-Facts-Matter, we might be able to make some smart choices around tax policies.

Taxable income and revenue. Opponents of raising the taxes that high-income households face often point to findings that high-income taxpayers respond to tax-rate increases by reporting less income to the Internal Revenue Service (IRS) as evidence that high marginal tax rates impose significant costs on the economy. However, an important study by tax economists Joel Slemrod and Alan Auerbach found that such reductions in reported income largely reflect timing and other tax avoidance strategies that taxpayers adopt to minimize their taxable income, not changes in real work, savings, and investment behavior. While such strategies entail some economic costs, these costs are relatively modest. Moreover, policymakers can limit high-income taxpayers' ability to respond to increases in tax rates by engaging in tax avoidance activity -- and also enhance the efficiency of the tax code -- by broadening the tax base, as discussed below.

Work and labor supply. The evidence shows that changes in tax rates that fall within the ranges that policymakers are debating have little impact on high-income individuals' decisions regarding how much to work. As Leonard Burman, former head of the Urban-Brookings Tax Policy Center (TPC), recently testified, "Overall, evidence suggests [high-income Americans'] labor supply is insensitive to tax rates."[2]

A marginal rate increase may encourage some taxpayers to work less because the after-tax return to work declines, but some will choose to work more, to maintain a level of after-tax income similar to what they had before the tax increase. The evidence suggests that these two opposing responses largely cancel each other out.

Saving and investment. Some claim that tax increases on high-income people -- in particular, increases in capital gains and dividend tax rates -- depress private saving rates and investment. But as Professor Joel Slemrod has written, "there is no evidence that links aggregate economic performance to capital gains tax rates."[3] Similarly, the Congressional Research Service (CRS) has reported that most economists find that reducing capital gains tax rates would have only a small -- and possibly negative -- impact on saving and investment.[4]

Although tax increases on high-income individuals might reduce their saving, if the revenue generated is devoted to deficit reduction, the resulting increase in public saving is likely to more than offset any reduction in private saving. CRS concludes, "Capital gains tax rate increases appear to increase public saving and may have little or no effect on private saving. Consequently, capital gains tax increases likely have a positive overall impact on national saving and investment."[5]

Small business. The evidence does not support the claim that raising top marginal income tax rates has a heavy impact on small business owners: a recent Treasury analysis finds that only 2.5 percent of small business owners fall into the top two income tax brackets and that these owners receive less than one-third of small business income. Moreover, even those small business owners who would be affected by tax increases on high-income households are unlikely to respond by reducing hiring or new investment. As Tax Policy Center co-director William Gale has noted:[6]

"[T]he effective tax rate on small business income is likely to be zero or negative, regardless of small changes in the marginal tax rates. This is for three reasons. First, small businesses can expense (immediately deduct in full) the cost of investment. This alone brings the effective tax rate on new investment to zero, regardless of the statutory rate. Second, if they can finance the investment with debt, the interest payments would be tax-deductible, making the effective tax rate negative. Third, they can deduct wage payments in full, so the marginal tax rate should have minimal impact on hiring."

In addition, a review of the research finds little evidence for the common assertion that small businesses are responsible for the majority of job creation in the United States or that tax breaks for small businesses generally -- as distinguished from start-up ventures -- are effective at stimulating jobs or growth in Gross Domestic Product (GDP).

Entrepreneurship. CRS finds that "An extensive empirical literature on [the relationship between income tax rate increases and business formation] is mixed, but largely suggests that higher tax rates are more likely to encourage, rather than discourage, self-employment."[7] One reason is that taxes may reduce earnings volatility, with the government bearing some of the risk of a new venture -- by allowing tax deductions for losses -- and receiving some of the returns. Further, there is little evidence that the current preferential tax rates for capital gains and dividends substantially stimulate investment in new ventures.

Growth and jobs. History shows that higher taxes are compatible with economic growth and job creation: job creation and GDP growth were significantly stronger following the Clinton tax increases than following the Bush tax cuts. Further, the Congressional Budget office (CBO) concludes that letting the Bush-era tax cuts expire on schedule would strengthen long-term economic growth, on balance, if policymakers used the revenue saved to reduce deficits. In other words, any negative impact on economic growth from increasing taxes on high-income people would be more than offset by the positive effects of using the resulting revenue gain to reduce the budget deficit. Tax increases can also be used to fund, or to forestall cuts in, productive public investments in areas that support growth such as public education, basic research, and infrastructure.

This post originally appeared at Jared Bernstein's On The Economy blog.