Blog post

Taxing the 1%

Publishing date
20 December 2011

What’s at stake: While the movement of the “99 percent” is receding, some of the issues it raised continue to be highly discussed in academic and policy circles. In particular, a crucial public policy question is whether governments should tax high earners more. While in previous election cycles, the narrative on inequality and the crisis was not completely set out, detailed proposals on how to tax the 1% have, this time, already been laid out. President Obama made, for example, clear that this issue was going to be a “defining issue” of the 2012 presidential election. This could also have implications in other advanced economies where tax policy, in a context of difficult fiscal outlooks ought to become a more debated political issue.

The Saez and al. proposals

In a Journal of Economic Perspectives article, Peter Diamond and Emmanuel Saez note that although facing an average federal income tax rate of 22.4%, the top percentile of the income distribution paid 40% of total federal individual income taxes in 2007. Taxation of very high earners is therefore a central aspect of the tax policy debate not only for equity reasons but also for revenue raising. Setting aside behavioral response for a moment, the authors argue that increasing this rate to 43.4% would be sufficient to raise revenue by 3 percentage points of GDP. Remarkably, it would still leave the after-tax income share of the top percentile more than twice as high as in 1970.

Note that this definition of optimal taxation is quite different from that of Mirrlees for whom the optimal tax is the one that maximizes economic output (ie. The one that effectively minimizes the tax wedge and the disincentives to work associated with taxation). Mirrlees and Vickrey received in the Nobel prize for this work which led them to the conclusion that the marginal tax rate should actually be quite low given the marginal productivity of high income earners.

In the article, Peter Diamond and Emmanuel Saez compute that the optimal marginal tax rate – the tax rate that maximizes revenue raising – for the top percentile is around 70% in the United States. The authors explore the path from basic research results in optimal tax theory and seek to maximize the Laffer curve of fiscal revenues for a given marginal tax rate. By taking into account limits on resources and behavioral responses to taxation, and using data on elasticity responses to taxation, the authors argue that very high earners should be subject to high and rising marginal tax rates on earnings.

In a closely connected paper, using the large database constructed with Anthony Atkinson on high incomes, Thomas Piketty, Emmanuel Saez and Stefanie Stantcheva argue that the common story to explain the rise of inequality at the high end of the income spectrum (the infamous 1%) is wrong: it cannot be technology or globalization, because all countries have been affected by these phenomena, but only English speaking countries have experienced a major rise in inequalities. The authors note that even if the strong correlation between the reductions in top tax rates and the increases in top 1% pre-tax income shares from 1975–79 to 2004–08 was entirely due to supply-side effects – where smaller top tax rates encouraged work effort and business creation among the most talented – the revenue-maximizing top tax rate would still be 57% (it would be 83% in a model that considers the response of top income earners is also due to increased rent seeking behavior). Up until the 1970s, policymakers and public opinion considered that at the very top of the income distribution, pay increases reflected mostly greed or other socially wasteful activities rather than productive work effort. This is why they were able to set marginal tax rates as high as 80% in the US and the UK. The Reagan/Thatcher revolution has succeeded in making such top tax rate levels unthinkable since then. But after decades of increasing income concentration that has brought about mediocre growth since the 1970s and a Great Recession triggered by financial sector excesses, a rethinking of the Reagan and Thatcher revolutions is perhaps underway. The United Kingdom has, for example, already increased its top income tax rate from 40% to 50% in 2010 in part to curb top pay excesses.

Reactions to the proposals

Scott Sumner argues Saez and Diamond’s argument is based on questionable assumptions. In particular, Diamond and Saez use the argument of tax avoidance in order to favor a higher taxation of capital, but then assume that loopholes should be closed to justify a high marginal tax rate on labor income. The traditional view is that the tax on capital should be zero, because a higher rate would impose higher taxes on future consumption than current consumption, and hence lead to a sub-optimal level of savings and investment.  In response, they point out that our current tax system often allows labor income being falsely reported as capital income. But, when they consider the appropriate tax rate, S-D have no problem waving a magic stick and assuming away all tax loopholes.  Notice how both assumptions favor higher MTRs on higher incomes.

Stephen Williamson
points at the dynamic effects of high taxation: lower expected earnings lead not only to lower effort (an effect taken into account by Diamond and Saez) but also to lower human capital accumulation in the first place. Not taking into account these long-term effects would stifle long-term growth.  He also criticized the proposition of Robert Frank, in Slate, who would rather see a progressive consumption tax than an income tax. His argument is that the ‘keeping-up-with-the-Joneses’ behavior (raising one’s consumption to keep his status compared with his neighbors) leads to negative externalities. Raising consumption taxes would in the end make everyone better off by reducing the race for a better status. There again, according to Williamson, it does little to take into account dynamic effects on the labor supply. Tyler Cowen uses results on CEO compensation to explain that they do add value for their shareholders, and that the incidence of higher taxation is little known.

Nancy Folbre
points that a recent essay in The Wall Street Journal asserts that the high volatility of income at the top makes it impractical to rely on taxing it. But these concerns are overstated, the author agues, and can be easily addressed by rainy-day funds that set some revenues aside as a buffer against variation. The Tax Policy Center argues that restoring pre-1982 effective rates wouldn’t require implementing pre-1982 statutory rates. Raising the top statutory rates is one way to increase effective rates, but it’s not the only (or best) way. For instance, more modest rate increases could be supplemented by scaling back tax preferences that disproportionately benefit high-income taxpayers (like the mortgage interest deduction) and very high-income taxpayers (like the preferential rate on capital gains).

Taxing job creators

Paul Krugman argues that one important idea from Diamond and Saez is that the optimal tax rate on top earners should be the rate that maximizes the revenue collected from these top earners — full stop. Right now, the rhetoric is, however, that high-income individuals are “job creators” who must be cherished for the good they do. Brad DeLong points that the idea that the rich and powerful deserves our deference is an old one that goes back to Adam Smith not in his most famous work, The Wealth of Nations, but in his far less discussed book The Theory of Moral Sentiments. On the one hand, we don’t wish to disrupt the perfect felicity of the lifestyles of the rich and famous (to which we aspire); on the other hand, we don’t wish to add to the burdens of those who have spent their most precious possession – their time and energy – pursuing baubles. These two arguments are not consistent, but that does not matter. They both have a purchase on our thinking.

Adam Ozimek
disagrees with DeLong and Krugman and In this sense, suddenly kicked out the top argues that many high skilled, high paid workers work at moving the productivity frontier forward, and thus increasing the marginal productivity of other workers. 10% of high IQ people (or 10% most productive people, or 10% most creative people, or whatever) in the U.S would in all likelihood reduce the total output of the remaining 90% would go down. Hence affecting their incentives (throught taxation) in a way that distract these people from working, reduces our ability to push or reach or production frontier.

Inequality and elections: “This is the defining issue of our time” (Obama, Dec 2011)

Robert Reich argues that the President’s speech in Osawatomie, Kansas — where Teddy Roosevelt gave his “New Nationalism” speech in 1910 — is the most important economic speech of his presidency in terms of connecting the dots, laying out the reasons behind our economic and political crises, and asserting a willingness to take on the powerful and the privileged that have gamed the system to their advantage. For those familiar with our prior issue of the Blogs review on inequality, this extract should certainly ring a bell: “For most Americans, the basic bargain that made this country great has eroded. Long before the recession hit, hard work stopped paying off for too many people. Fewer and fewer of the folks who contributed to the success of our economy actually benefitted from that success. Those at the very top grew wealthier from their incomes and investments than ever before. But everyone else struggled with costs that were growing and paychecks that weren’t - and too many families found themselves racking up more and more debt just to keep up.”

Eduardo Porter
writes in the Sunday Review of the New-York Times that today, America is an outlier among industrial nations. Inequality in America has soared over the last 30 years, approaching and even surpassing that in many poor countries. Its distribution of income looks closer to that of Argentina than, say, Germany. For more, on the general topic of inequality, we recommend the latest interview from Five Books by Daron Acemoglu.

Clive Crook
argues that Obama is right that tax revenues need to rise, but wrong to focus so tightly on top marginal income-tax rates. In terms of the politics, a center-left party advocating higher taxes on "the rich" ought to define that term a bit more narrowly than what one Democratic party spokesman recently called the ultra-rich: a household income of $250,000. True, less than 3 per cent of households make that much at any one time - but a police officer married to a civil servant could sneak into this category. Income varies during one's lifetime, so a far larger number have crossed the line, or will do, or hope to, during their peak earning years.

Nancy Folbre
notes that American voters have the power to increase tax revenues from millionaires and have recently done so in eight states: California, Connecticut, Hawaii, Maryland, New Jersey, New York, Oregon and Wisconsin. A detailed study of the New Jersey case, published in the National Tax Journal by Cristobal Young and Charles Varner, found little effect on millionaires’ migration from the state.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.

About the authors

  • Jérémie Cohen-Setton

    Jérémie Cohen-Setton is a Research Fellow at the Peterson Institute for International Economics. Jérémie received his PhD in Economics from U.C. Berkeley and worked previously with Goldman Sachs Global Economic Research, HM Treasury, and Bruegel. At Bruegel, he was Research Assistant to Director Jean Pisani-Ferry and President Mario Monti. He also shaped and developed the Bruegel Economic Blogs Review.

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