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If Taxes Must be Raised, Raise Average Tax Rates

e21 | 12/06/2012

In the debate on how best to resolve the so-called “fiscal cliff” of $600 billion of pending tax increases and spending cuts scheduled for January 1, 2013, President Obama is not only insisting on more tax revenue; he is demanding that this revenue be raised in the most economically counterproductive manner possible. The President demands that a deal must include increases in marginal tax rates “on the top 2%” of earners. By raising marginal tax rates, the President’s proposal would discourage additional work, savings, and investment and slow economic growth. This strategy is senseless when the same revenue can be raised in an economically neutral fashion. Yet, the President’s strange obsession with increases in marginal rates – which borders on bloodlust – seems to guarantee that Congress will either walk off the “cliff,” or agree to slow growth in an already depressed economy.

It is important to note at the outset that this is NOT a debate about whether or not to raise tax rates. The President mistakenly argues that Congress is trying to prevent “rates” on high-income households from increasing. But any policy change that increases the amount of taxes owed on a given amount of income is a tax rate increase. For example, if a household pays $100,000 of federal income taxes on $500,000 of ordinary income with $100,000 of itemized deductions from state and local taxes and mortgage interest, its effective tax rate is 20%. If the tax code is changed so as to eliminate the deductibility of mortgage interest and state and local taxes, this household’s tax bill would increase to $135,000, increasing its effective average tax rate to 27%. By increasing the amount of income exposed to taxes by $100,000, the household’s tax rate would increase by 7 percentage points (35%) without compromising the after-tax value of an additional dollar of income.

The after-tax value of an additional dollar of gross income is what matters from an economic perspective. The economic literature is quite clear that increases in marginal tax rates cause households to reduce their supply of investment and labor and result in a smaller economy. The adjustment to higher marginal rates is generally borne through three channels: (1) second earners drop out of the workforce or reduce hours, often due to the increase in the relative cost of child care services; (2) a reduction in the market production of services that could be performed at home, which depresses the demand for the services of housekeepers, mechanics, contractors, painters, and other service providers; and (3) an increase in tax-preferred investments, like municipal debt, rather than more economically productive investments.

Higher marginal rates reduce the after-tax return to an additional hour of work. This means marginal tax rate increases can reduce the after-tax value of a second income below the pre-tax cost of child care. For example, with a 44% marginal tax rate, a second earner has to earn $90,000 of gross income to generate $50,000 in after-tax dollars. The cost of consumption expenditures is tied ultimately to the number of hours worked required to finance a given outlay. For this reason, changes in after-tax rates of return on labor can also dramatically alter the relative attractiveness of do-it-yourself projects. An increase in marginal tax rates from 35% to 44% (the 39.6% top rate plus the 3.8% Affordable Care Act surcharge) increases the effective price of domestic services like painting, house cleaning, and child care by 16%. Increases in prices lead to reductions in demand.

Arguments in favor of marginal tax increases tend to rely on strawmen. Some like to imagine a discontinuous reaction function where a 4 percentage point increase in marginal rates causes high income workers to suddenly quit their jobs. This kind of hyperbole ignores the real issue of deadweight costs. Should policymakers not care that a 4 percentage point increase causes even one second earner to drop out of the workforce, or encourages an additional dollar of tax-preferred consumption on housing or health care? Efforts to exaggerate the claims made by opponents of marginal tax rate increases are designed to undermine credibility and avoid the real issues.

More perplexing is the suggestion from some quarters that revenue gained from a limitation on deductions would somehow be less certain than an increase in tax rates. The idea is that if a household is motivated by taxes to take out a bigger mortgage, or opt for more expensive employer-sponsored health insurance (a tax exclusion), then reducing those tax benefits would result in less tax-favored activity, which would mean less revenue than previously supposed. The President has even argued that limitations on deductions could cause charitable organizations to collapse. So the President believes that taxes have no effect on hours worked or dollars invested but charitable contributions are perfectly elastic with respect to marginal tax rates?

This argument has it exactly backwards. Marginal tax rate increases are “riskier” from a revenue perspective because they encourage taxpayers to make greater use of these same deductions to reduce taxable income. When the cost of shifts in consumption is included in estimates of the distortions introduced by tax rate increases, the revenue gains associated wih marginal rate increases tend to be relatively small. The Clinton tax increases of 1993 raised only one-third of the revenue that would have been expected had taxpayers not responded by changing behavior by working fewer hours, increasing nontaxable fringe benefits like employer-sponsored health insurance, and substituting tax-free municipal debt for dividend-paying stocks in investment portfolios.

These are just the most obvious strategies; with the help of $600 per hour tax attorneys, accountants, and the rest of the tax-planning establishment, higher income taxpayers can pursue strategies to reduce taxable income substantially with no material change to their actual incomes or wealth. One would anticipate that “progressives” focused on narrowing income inequality would prefer reductions in tax expenditures to higher marginal rates precisely because of the myriad tax avoidance strategies tax expenditures create for households with the means (and incentives) to exploit them. Higher rates increase the economic value of the tax-planning services that high-income attorneys and accountants provide to other high income professionals.

If a policy choice has been made to increase the tax revenue collected from high income households, Congress should implement this choice in the least costly way possible. Limitations on deductions offer a mechanism to raise a given amount of revenue in a way that does not discourage an additional hour of work or increase the relative cost of consumption expenditures. It would be extremely unfortunate if Congress were to eschew this obvious solution to the fiscal cliff impasse in favor of marginal rate increases designed to deliver a “scalp” the President can hoist for his progressive supporters.