Happy April, part two

A Case for Lower Top Marginal Tax Rates

            There has been much discussion in the popular press in the last few years about economic growth and income inequality. Some economists and commentators have suggested that inequality is a barrier to economic growth (Plumer, 2013). In Kuznets’ canonical formulation, inequality rises as per-capita income rises from low levels, but begins to fall as per-capita income rises yet further (Figure 1) (Kuznets, 1955). The argument of those who believe inequality and growth are incompatible is both that the United States economy is on the “right-hand side” of the Kuznets Curve, and that there is a causal relationship that runs from inequality to growth. Evidence, however, suggests that reducing the marginal tax rates for the top three brackets (currently 33, 35, and 39.6 percent) would increase gross domestic product (GDP). The primary channel for this increase is the labor supply. Numerous studies indicate that reducing top rates would incentivize workers to work more and for non-participants to enter the labor force. For these reasons, I recommend a reduction in the top three marginal income tax rates.

            Barro and Redlick find that marginal tax rate increases negatively impact GDP significantly. They found a tax multiplier of approximately 1.1. While this value is unlikely to be robust for marginal rates significantly different from current rates, the 1.1 value is likely to hold for a decrease in rates as well. Barro and Redlick also argue that a decrease in aggregate taxes has a higher multiplier, and therefore a greater stimulative effect, than increases in government purchases, for which the multiplier is less than one (Barro & Redlick, 2011).

            The 1986 Tax Reform Act (TRA), which greatly reduced the top rates, provides a natural experiment that has been studied by many researchers. Evans and Kenward estimate that labor supply would increase by 3 percent, leading to a rise in output of 2 percent (Evans & Kenward, 1988). Though they attribute some of the increase in labor supply to the entrance of women into the labor force, a similar effect could be observed today in the reversal of the downward trend in labor-force participation, which has been falling since the mid 1990s, and falling precipitously since 2008 (Figure 2).

            Feldstein’s panel study of the TRA finds that individuals’ response to this reduction included increasing labor supply (Feldstein, 1995). This response to altered incentives will lead to an increase in GDP if aggregate supply can be approximated with a Cobb-Douglas production function (Bao Hong, 2008). Feldstein also points out that lower marginal rates encourage workers to take less of their compensation in the form of untaxed perquisites (Feldstein, 1995). This shift toward pecuniary compensation likely reduces deadweight loss, as workers can more directly satisfy their needs and desires with money wages than with non-wage benefits.

            Heim’s panel study of the 2001 and 2003 tax law changes, which also reduced marginal rates on higher earners, mirrors Feldstein’s findings. Heim found positive labor-supply effects, especially among those with incomes above $500,000 per year. Like Feldstein’s, Heim’s results imply that reversing the reductions would not likely increase revenue, because workers whose taxes return to higher levels are more likely to work less than to continue working the same amount (Heim, 2009). It is important to note that the period covered by Heim’s study, 1999-2005, included a recession and subsequent recovery. It is therefore possible that his findings are specifically relevant to current conditions. Further supporting the results of Feldstein and Heim, McDaniel finds, in a study of fifteen OECD countries over the period 1960-2004, that 80 percent of changes in hours worked is attributable to changes in tax rates, with the relationship between hours worked and tax rates always negative (McDaniel, 2011).

            Arnold, et al. find that replacing income tax revenue with revenue from consumption taxes is beneficial to economic growth. These consumption taxes could take the form of value-added taxes and targeted taxes aimed at reducing environmentally damaging consumption. They specifically cite sales tax reductions as growth-inhibiting. They find that reductions in the top rates would spur productivity growth and entrepreneurship. They specifically cite the progressivity of personal income taxes as a barrier to growth (Arnold, et al., 2011).

            At a time when labor-force participation is falling, it is sound policy to incentivize workers to remain in or enter the labor force. Many studies have shown the efficacy of lower marginal income tax rates in achieving this goal. Further, the effect is most prominent on the highest earners. For this reason, I advocate a reduction of the top three marginal income tax brackets.

Figures

Figure 1: Theoretical Kuznets Curve (as described in (Kuznets, 1955))

Figure 2: Labor Force Participation 1993-2014 (Federal Reserve Bank of St. Louis, 2014)

Works Cited

Arnold, J. M., Brys, B., Heady, C., Johansson, A., Schwellnus, C., & Vartia, L. (2011). Tax Policy for Economic Recovery and Growth. The Economic Journal, F59-F80.

Bao Hong, T. (2008, November 20). Cobb-Douglas Production Function. Retrieved February 2, 2014, from João Luís Morais Amador: http://docentes.fe.unl.pt/~jamador/Macro/cobb-douglas.pdf

Barro, R. J., & Redlick, C. J. (2011). Macroeconomic Effects From Government Purchases and Taxes. The Quarterly Journal of Economics, 51-102.

Evans, O., & Kenward, L. (1988). Macroeconomic Effects of Tax Reform in the United States. Staff Papers - International Monetary Fund, 141-165.

Federal Reserve Bank of St. Louis. (2014, February 2). Civilian Labor Force Participation Rate (CIVPART). Retrieved February 2, 2014, from Federal Reserve Economic Data: http://research.stlouisfed.org/fred2/series/CIVPART

Feldstein, M. (1995). The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act. Journal of Political Economy, 551-572.

Heim, B. T. (2009). The Effect of Recent Tax Changes on Taxable Income: Evidence from a New Panel of Tax Returns. Journal of Policy Analysis and Management, 147-163.

Kuznets, S. (1955). Economic Growth and Income Inequality. The American Economic Review, 1-30.

McDaniel, C. (2011). Forces Shaping Hours Worked in the OECD, 1960-2004. American Economic Journal: Macroeconomics, 27-52.

Plumer, B. (2013, December 5). Is inequality bad for economic growth? Retrieved from Wonkblog: http://www.washingtonpost.com/blogs/wonkblog/wp/2013/12/05/is-inequality-bad-for-economic-growth/