...President Barack Obama has proposed that most of the tax cuts for households with incomes above roughly $200,000 for singles and $250,000 for married couples (the "high-income rate reductions") be allowed to expire as scheduled, although he would partially extend the 2003 dividend tax cut. At the same time, he has called for the permanent extension of the Bush tax cuts for taxpayers with incomes below those thresholds (the "middle-class tax cuts"), with no spending cuts or tax increases to offset the associated revenue loss.[2]
From the standpoint of long-run economic growth, this proposal represents the worst of both worlds. As explained below, the high-income rate reductions provide much greater incentive for investment and other economic activity, relative to revenue loss, than the middle-class tax cuts. The expiration of the former and extension of the latter therefore combine much of the disincentive effects of full expiration with much of the deficit increase of full extension."
President Obama recently claimed that the expiration of the high-income rate reductions would merely restore marginal tax rates "back to what they were under President Clinton."[4] Whether or not this claim is a compelling argument for expiration, it is a correct description of 2011 and 2012 tax rates, as can be seen from the figure. But it is not correct for later years. Under the March 2010 health care law, the top Medicare payroll tax rate on wages and self-employment income will rise from 2.9 to 3.8 percent, starting in 2013. Also, a new 3.8 percent tax on ordinary investment income, capital gains, and dividends, called the Unearned Income Medicare Contribution (UIMC), will take effect in 2013.[5] As shown in the figure, the expiration of the high-income rate reductions (including the dividend tax cut) will leave the tax rates on all of the income categories above the Clinton levels.
The Harm from High Marginal Tax Rates
As I explained in two previous Outlooks, high marginal tax rates are harmful because they pose a disincentive to earning taxable income.[6] Because the marginal tax rate is the additional tax liability that arises from earning an additional dollar of income, it directly governs the incentive to earn that additional dollar.
The fact that taxpayers can alter their taxable income implies that income taxation is distortionary, meaning that it imposes an economic burden beyond the actual tax payments. For example, suppose that a taxpayer would earn $1,000 of income if her tax liability did not depend upon income, but chooses to earn only $800 when 40 percent of additional income must be paid in tax. The revenue raised by the tax is $320 (40 percent of $800), but this tax payment is not the taxpayer's only loss because she also bypasses the opportunity to earn the additional $200. The sacrifices that would be required to earn the last $200 were worth making when she kept the full $200, but not worth making when she keeps only $120 of the extra income. If these sacrifices would have been worth making for $160, for example, then the taxpayer has a $40 loss in addition to the $320 tax payment. That $40 loss reflects the distortion inflicted by the tax. The distortion depends upon the marginal tax rate, the fraction of each additional dollar of income that is absorbed by tax. Moreover, the distortion rises disproportionately with the marginal tax rate, roughly quadrupling when the marginal tax rate doubles.
Although marginal-tax-rate increases are distortionary at any income level, rate increases at the top income levels generally create the largest distortions per dollar of revenue. That partly reflects the fact that the rates at the top income levels are already high, so further increases are more damaging. But it also reflects the fact that rate increases at the top raise revenue from only some of the affected taxpayers' income. For example, consider a proposal to increase taxes by 5 percent of the income above $250,000 (which approximates the expiration of the high-income rate reductions for a married couple with ordinary income). The resulting revenue is less than 5 percent of the affected taxpayers' incomes because the tax applies only to the income above the $250,000 threshold; for a $400,000 couple, for example, the 5-percentage-point tax increase applies only to the last $150,000 of income, and the revenue is only $7,500. Because the disincentive effects depend upon the marginal tax rate applied to the last dollar, though, they are as severe as if the couple had to pay an extra 5 percent on their entire income (except that the disincentive will not prompt the couple to reduce their income below $250,000).
The opposite pattern holds for tax hikes in the bottom bracket, which actually leave marginal rates unchanged for most of the taxpayers from whom additional revenue is collected. For example, suppose that the 10 percent bracket, which will apply to the first $17,000 of a couple's taxable income in 2011 if extended, reverted to 15 percent. Taxpayers in that bracket would face a 5-percentage-point increase in ¬disincentives and would pay an additional 5 percent of taxable income. At the same time, all couples in higher brackets would also pay an additional $850 in tax because the first $17,000 of their income would be taxed at 15 rather than 10 percent. These higher-bracket taxpayers would not, however, face any additional disincentives because there would be no change in their marginal last-dollar tax rates.
The size of the distortions depends upon the extent to which taxpayers can reduce their taxable income in response to higher marginal tax rates. Even if taxpayers do not greatly reduce their work effort, they may significantly reduce their taxable income in many other ways, such as by shifting their earnings into tax-free fringe benefits or spending more on tax-deductible items. Statistical studies have generally found that taxable income displays significant sensitivity to marginal tax rates, particularly at high income levels.[7] This greater sensitivity at the top provides a third reason to avoid rate hikes at those income levels, in addition to the fact that those rates are already relatively high and the fact that rate increases at the top raise revenue from only part of the affected taxpayers' incomes.
Penalizing Investment
Although the factors above offer a powerful case against rate hikes at the top, the case is dramatically strengthened by the impact on saving and investment. Because the income tax applies to capital income as well as labor income, an increase in income-tax rates reduces the incentive to save and invest. The rate hikes at the top would have important effects in this regard.
It is widely recognized that individual income tax is imposed on the income of "pass-through" firms--sole proprietorships, partnerships, limited-liability companies taxed as partnerships, and S corporations. For tax purposes, these firms' profits are passed through to the owners' individual tax returns. It is often forgotten, though, that individual income tax is also imposed on the income of C corporations. Although these firms pay a separate corporate income tax, their investors also pay individual income tax. If a C corporation issues new stock to finance an investment, the resulting profits are either paid out as dividends on which stockholders are taxed or reinvested to generate capital gains on which stockholders are taxed when they sell their stock. If the corporation reinvests past profits to finance an investment, the reinvestment generates capital gains on which stock-holders are taxed when they sell their stock. Also, if any firm--a C corporation or a pass-through--borrows to finance an investment, the lenders are taxed on the interest income.
Of course, the expiration of the high-income rate reductions would boost marginal tax rates only on the savings of high-income households. The savings of this small group, however, account for a large volume of investment. Internal Revenue Service data for 2007 reveal that households with incomes above $200,000 received 47 percent of the taxable interest income, 60 percent of the dividends, and a staggering 84 percent of the net capital gains reported on tax returns.[8] Although a few of these taxpayers (married couples with incomes between $200,000 and $250,000 and taxpayers on the alternative minimum tax) would not be affected by the higher rates, this still leaves a significant amount of income that would be affected. The share of pass-through business income going to the affected group is also large. Taxpayers subject to the higher rates will receive 44 percent of the sole proprietorship income reported on 2011 tax returns, according to Urban-Brookings Tax Policy Center estimates,[9] and will receive 50 percent of total pass-through and related income reported on tax returns, according to Joint Committee on Taxation estimates.[10]...
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