Wednesday, April 14, 2010

Two directions on tax reform

Demolishing AEI president Arthur Brooks's claim in today's WSJ that Americans do not favor progressive taxation, Jonathan Chait cites a public opinion snippet that raises a fundamental question about tax reform (my emphasis):

The Quinnipiac University poll found that 60 percent of Americans among both major political parties think raising income taxes on households making more than $250,000 should be a main tenet of the government's efforts to tame the deficit. More than 70 percent, including a majority of Republicans, say those making more than $1 million should pay more.

The question is: leaving aside the precise optimal level for the top marginal income tax rate, why is the highest bracket fixed at a mere $250k in family income?  Matt Yglesias and Nate Silver batted this question around in March '09. Silver:
 What the discussion over the top marginal tax rate ignores, however (and what Ygelsias picks up upon) is that this rate has been assessed at very different thresholds of income. In 1940, for example, the top marginal tax rate was 81.1 percent -- but this rate only kicked in once you made $5,000,000 or more in income, which is equivalent to about $75,000,000 in today's dollars.

But today, the threshold where the top tax bracket kicks in isn't $75 million, or $5 million, or even $1 million ... it's a mere $357,700. The progressivity of the tax code stops there....

The question, of course, is why there isn't a millionaires tax bracket now ... or even a multi-millionaires tax bracket. I haven't run the numbers, but I'm guessing that if you established a new tax bracket at, say, 40.5 percent, that started at incomes of $1,000,000 or more, this would bring in as much revenue to the government as restoring the $250K tax bracket (which is really $360K now given indexing to inflation) to 39.6 percent, as it was under Clinton. 

On the other side of the coin, the report of a committee on taxation and budgeting organized by the National Research Council and the National Academy of Public Administration, Choosing Our Nation's Fiscal Future (headed by Reagan-era CBO head Rudolph Penner), claims that raising marginal tax rates reduces tax efficiency -- presumably because high rates generate pressure for new targeted tax breaks and loopholes as well as sophisticated forms of evasion:

The economic distortions in the tax code are magnified when marginal tax rates are high or differ among otherwise similar economic options. The economic waste (“deadweight loss”) to economic performance from the current tax code is directly related to marginal tax rates. As marginal rates rise, these efficiency losses rise more than proportionally, roughly as the square of marginal tax rates. Because of this distortion, tax reform efforts in the past, such as the bipartisan Tax Reform Act of 1986, focused on reducing marginal tax rates.

I assume that the same criticism would apply to adding new tax brackets as to raising the rates in existing brackets.  Indeed, the report's broadest recommendation is to reduce both the number of brackets and marginal rates while also eliminating large targeted tax breaks  such as the mortgage deduction, the employer health care deduction, even pension savings deductions). Simplifying the code enables more revenue to be yielded at lower rates. It means foregoing all the behavior incentives loaded into the tax code, for better and/or worse.

1 comment:

  1. The is a very excellent article in Time about the psychology of the income tax. Tax day itself seems like a monumental day for everyone, with big numbers involved. We seem to all want government services (whether we admit it or not), but clearly we are not drawing in the needed revenue to cover all their costs.
    Perhaps a fee-based or a value-added tax would help us be more honest with ourselves as a society?

    By the way, don't be turned off by the title of the article... It's a misnomer.