How Much Tax Should The Rich Pay?

In today’s New York Times Warren Buffet made the case for higher taxes on very high income earners. It’s very much an anecdotal case, aimed at a generalist audience. People interested in a more technical analysis should consult the recent paper from Peter Diamond and Emannuel Saez (PDF) “The Case for a Progressive Tax: From Basic Research to Policy

When a tax system offers tax avoidance or evasion opportunities, the tax base in a given year is quite sensitive to tax rates, so that the elasticity e is large, and the optimal top tax rate is correspondingly low. Two important qualifications must be made. First, as mentioned above, many of the tax avoidance channels such as re-timing or income shifting produce changes in tax revenue in other periods or other tax bases—called “tax externalities”—and hence do not decrease the optimal tax rate. Saez, Slemrod, Giertz (2011) provide formulas showing how the optimal top tax rate should be modified in such cases. Second, and most important, the tax avoidance or evasion component of the elasticity e is not an immutable parameter and can be reduced through base broadening and tax enforcement (Slemrod and Kopczuk, 2002; Kopczuk, 2005). Thus, the distinction between real responses and tax avoidance responses is critical for tax policy. As an illustration using the different elasticity estimates of Gruber and Saez (2002) for high income earners mentioned above, the optimal top tax rate using the current taxable income base (and ignoring tax externalities) would be τ*=1/(1+1.5 x 0.57)=54 percent while the optimal top tax rate using a broader income base with no deductions would be τ=1/(1+1.5 x 0.17)=80 percent. Taking as fixed state and payroll tax rates, such rates correspond to top federal income tax rates equal to 48 and 76 percent, respectively. Although considerable uncertainty remains in the estimation of the long-run behavioral responses to top tax rates (Saez, Slemrod, Giertz, 2011), the elasticity e=0.57 is a conservative upper bound estimate of the distortion of top U.S. tax rates. Therefore, the case for higher rates at the top appears robust in the context of this model.

A couple of notes on this beyond the headline. The analysis quoted here does not apply to capital income. Later in the paper, Diamond & Saez argue against the view that capital income should be taxed at a zero percent rate but don’t challenge the view that a tax preference for capital income is justifiable. But the biggest takeaway that I’d like to see people take from this paper is that fans of progressive taxation should be fans of tax reform. As you see in the text, the optimal marginal tax rate for high income people soars if you first (or simultaneously) enact loophole-closing measures to broaden the tax base. In a tax code with many loopholes, higher rates is largely an incentive to exploit loopholes. Close the loopholes, and you can soak the rich with much more efficacy.