By James Kwak
Christina and David Romer’s new paper, “The Incentive Effects of Marginal Tax Rates: Evidence from the Interwar Era,” is available as an NBER working paper (if you are so lucky). Given the current debates about taxes, the paper is likely to garner some attention.
In the central section of the paper, Romer and Romer regress reported taxable income against the policy-induced change in marginal after-tax income share. The after-tax income share is the percentage of your gross income that is left after taxes; policy-induced changes are those caused by tax changes rather than be macroeconomic changes. They do this for the top 0.05% of the income distribution, broken down into ten sub-groups by income, because the income tax only affected the very rich during the interwar years.
Their headline finding is that “The estimated impact of a rise in the after-tax share is consistently positive, small, and precisely estimated” pp. 15–16). They find an elasticity of taxable income with respect to changes in the after-tax income share of 0.19.
Advocates of lower tax rates are sure to seize on this as evidence that higher tax rates depress incentives to work. But that’s hardly what the paper says. First of all, the Romers’ elasticity estimate is lower than earlier empirical estimates that are largely based on the postwar period. To put this in perspective, an elasticity of 0.19 implies that tax revenues would be maximized with a tax rate of 84 percent; that is, you could raise taxes up to 84 percent before people’s reduced incentives to make money would compensate for the higher tax rates.
Second, remember that this is a study of the super-rich: not the top 1%, but the top 0.05%. These are the people whom one would expect to have the highest income elasticity, precisely because they don’t need the marginal dollar. Elasticities tend to be lower for ordinary people because they need to cover their expenses.
Finally, the left-hand-side variable for the main regression is reported taxable income. Taxable income can change both because people are earning less income and because they are engaging in tax strategies to reduce their taxable income. As Emmanuel Saez, Joel Slemrod, and Seth H. Giertz conclude in “The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review” (pp. 49–50):
while there is compelling U.S. evidence of strong behavioral responses to taxation at the upper end of the distribution around the main tax reform episodes since 1980, in all cases those responses fall in the first two tiers of the Slemrod (1990, 1995) hierarchy—timing and avoidance. In contrast, there is no compelling evidence to date of real economic responses to tax rates (the bottom tier in Slemrod’s hierarchy) at the top of the income distribution.
In other words, recent U.S. history shows that when you raise taxes on the rich, they don’t stop trying to make money: they just pay their lawyers and accountants more to avoid paying taxes. The solution to that is a simpler tax code with fewer exclusions and deductions.
The Baseline Scenario 
Got to love that last paragraph.
What you are observing in your last paragraph is that if you raise tax rates but make loopholes available to avoid them, then the higher rates don’t produce an incentive effect (other than more intensive use of the loopholes). To which I say “Duh!”. Then you’re suggesting that this somehow proves that if we were to introduce higher rates that did bite (via eliminating the loopholes), those rates wouldn’t produce an incentive effect either. It would be unfair to the sophomores I know to describe the logic error here as ‘sophomoric’. The evidence as presented, properly understood, says nothing about the likely level of incentive-driven losses due to higher effective tax rates, so your proposal hardly merits being described as “the solution”.
This blog makes no common sense. Implying that raising the tax rate to 84% maximizes revenue because the payer will not be so disinfranchised as to quit working is not true. While they will still be working they will be paying less taxes by finding ways around the tax. In order to maximize revenue the rate needs to balanced to where the money is funneled to the government and not to lawyers and bankers; at a rate that the .05% actually earn an income versus alternate methods of payment. Unless of course, your goal is simply to redistribute the wealth. Then by all means raise the rate to 84% so that the lawyers have more money to spend. I just thought that the liberal agenda believed that the government was the most efficient method of redistribution. If that were the case, then why was the net worth of the top 1% the highest in the 70’s prior to the lowering of the tax rate for the top bracket. Also not that the income earned by the top 1% was at its lowest while they were taxed the highest and has steadily risen since the mid 80’s. The lowering of the tax rate below 50% not only maximized revenue. It also maximized the redistribution of wealth.
I believe things are better understood once you put your feelings aside and finally admit that the laws we have today are a joke. So if you derive your income from any part of the gvt, then that part of your whole life is being/ has been, supported by a joker. Lets give the joker a name, say Uncle Sam, and we all know that Uncle Sam wants you. He doubles down on everything, all the time, just waiting for the one win to put him over the top, and begin the process all over again. But the longer that win takes, the more frustrated and desperate he grows. Don’t let Uncle Sam double down on you, remember, that’s what he lives, and dies, for.
Its a bit of a lenghty read, but when tracking abusive Uncle Sams, it worth it.
http://www.counterpunch.org/2012/02/06/wall-streets-secret-spy-center-run-for-the-1-by-nypd/
“Second, remember that this is a study of the super-rich: not the top 1%, but the top 0.05%. These are the people whom one would expect to have the highest income elasticity, precisely because they don’t need the marginal dollar.” This makes sense, but the 84% number doesn’t, especially without deductions. It actually would work against incentives for capital formation.
James. this is very badly worded and therefore confusing:
“To put this in perspective, an elasticity of 0.19 implies that tax revenues would be maximized with a tax rate of 84 percent; that is, you could raise taxes up to 84 percent before people’s reduced incentives to make money would compensate for the higher tax rates.”
Are you saying that the marginal tax rate on the upper 0.05% could be raised TO 84%, or BY 84% from its present levels? Your closing phrase contradicts your opening phrase. The difference would be 84% vs. 70% marginal tax rate. Still high, but significantly different.
Other than that, I’m not sure if this says anything about the job-making behavior of the ultrarich, which is one of the arguments offered by the proponents of low taxation.
“…when you raise taxes on the rich, they don’t stop trying to make money…” Along with trying to find ways to avoid the higher taxes, they also realize incentives to reinvest in the enterprise that makes their income to begin with. Adjusting marginal rates seems elementary as a Skinnerian approach to discourage greed.
Click to access saez-slemrod-giertzJEL10round2.pdf
Oregeno, I think he beats to the sound of a different drummer. I mean nobody wants to get conned BY a confidence man.
U.S. history shows that when you raise taxes on the middle and lower classes, the economy goes into recession or worse. FDR made this boneheaded move in 1937. The solution is a simpler tax code that lets the Bush tax cuts expire only for incomes over $100k.
@owen owens: Maybe this will help you figure out who is spying on whom in NYC: http://en.wikipedia.org/wiki/Demographics_of_New_York_City
I’m still running for President of the USA so that the CIA/NYPD/AIPAC/IRS/Shamans/etc. etc. etc. can scour my tax returns as a CLUE for how *they* helped slam the *middle class* under das boot of the GLOBAL war lords and drug lords and slave lords through tax policies. We all have the paperwork…
So WHY even collect *taxes* anymore from SLAVES – seems like just a sadistic exercise of the top top top so-high-up their brain is oxygen deprived “Tisch” girlzs….
Even in the ruthless Roman Empire, the reverse was possible, SLAVES were able to work their way to freedom – the banksters have implemented the OPPOSITE now – *middle class* labors itself into global slavery…
Trust me, they’re all MAJOR a–holes in NYC – Jem Hadar for the Dominion…you know who they HATE the most….? The few people who never got hooked on drugs/booze/sex – they have the biggest lust to tear down the good people…..
A simpler tax code with less loopholes makes sense to me. Both sides of the political divide would probably say they agree. Some could be dropped immediately and some could be phased out over time. Each tax break will be a political nightmare to eliminate.
@Annie:
James, thanks so much for confirming my intuitive belief, or, rather, thanks to Christine and David. After all, the top 0.05%, without knowing exactly, must be at least those who have incomes above $10 million annually. It makes perfect sense to assume that, owing to the essential meaningless of the “marginal” dollar to their motivation as to marginal tax rates would be extremely inelastic. After all, at 84%, they are still netting over $1.5 million. And, of course, this is without accounting for any other means of tax avoidance (of which there are many). I must say that the idea of not increasing taxes on the “job creators” has always been a thoroughly bogus argument, since we know that the real job creators are small and new enterprises, and that only a miniscule minority of those fall into a high tax bracket (i.e. a million and above). I would also be interested in seeing you and Simon opine on the latest proposed change in corporate tax rates offered up recently by Romney (and other candidates) and the Obama administration. Based upon the fact that very few corporations presently pay significant taxes (and a majority none at all), it seems ot me that most of this is just rhetoric, and that the larger issue of the determination of the taxable income of corporations based upon the present structure of the tax code is a far more important issue.
Furthermore, the real issue isn’t rates, but the complexity and idiocy of our present tax code as it applies to both individuals and business enterprises (the Sub-S issue is a great example), since the code is massively beneficial to no one but the highest income individuals (capital gains rates, tax subsidies, etc.) and corporations (loss carry backs, international earnings allocations,etc.). Sadly, my view is that the most logical arguments become meaningless in this wealth controlled, plutocraticly governed nation. Simon once compared us to a Third World nation, and that comparison is more valid than it was about three years ago when he first opined. Much like the situation in France and Tsarist Russia, pre-revolution (and other countries at various times in history), the vast income disparity between the American Ruling Class and the average citizen will eventually lead to revolution. At some point in the not too distant future, this will happen, and I think that the major causation will be the massive global depression which is welling up now, if we are honest about the troubles confronting major portions of the international community. It’s nice to discuss tax policy. Right now there are many other far more important issues. But, sooner or later, this discussion will be extremely important.
Why is it a bad thing to de-incentivize work among the well-to-do?
Heavy taxation only counts as unfair when it burdens those in the lower ranges of income who don’t have enough to survive. In pre-Revolutionary France, the nobility was exempt from most forms of taxation. It didn’t notably incentivize them to do much of anything…and it cost many of them their heads.
Debates over incentives and marginal utility in economics are silly, and reflect the pre-suppositions of the disputants. The real issue is not efficiency, but entitlement. And it needs to be solved, like any moral argument, through collective debate as expressed through voting preferences — not by appeal to false economic relationships.
I’m in political sympathy with the Romers, but I find the notion of taking one gross macroeconomic variable (“cause”) and another gmv (“effect”), and running a regression line thorough them, then declaring this to be proof of a state of mind (incentive!) to be misguided.
@jobernard, “…but I find the notion of taking one gross macroeconomic variable (“cause”) and another gmv (“effect”), and running a regression line thorough them, then declaring this to be proof of a state of mind (incentive!) to be misguided….”
LOL.
ya think? good one :-)
Can’t even get all *revolutionary* when what you are trying to *change* is, in actuality, so very “schtoopid”….
There is no rational explanation, is there? Nihilistic hatred isn’t rational…
here you go, owen owens, to go along with the demographics of NYC:
http://www.huffingtonpost.com/2012/02/28/wall-street-psychopaths_n_1307168.html
it’s *normal* for the Don to rabble rouse the whole ‘hood against the people who he was never able to skin through his *businesses*….the *good* people are the STUPID people….
as you will note, most comments on the blog disagree with the *data* – they have seen that the rabid raccoon population is greater than 1 in 10 – and Homeland Insecurity protects the rabid raccoons nest…?!
I think I can up that to 9/10 wall street boys, after a chat with me.