Tax Analysts®Tax Analysts®

My Subscriptions:

Featured News

February 22, 2012
What Is the Revenue-Maximizing Tax Rate?

Full Text Published by Tax Analysts®

By Bruce Bartlett

Bruce Bartlett is a former Treasury deputy assistant secretary for economic policy. His new book, The Benefit and the Burden: Tax Reform -- Why We Need It and What It Will Take, has been published by Simon & Schuster.

In this article, Bartlett explains that President Obama's endorsement of the "Buffett rule" to raise taxes on those with high incomes and Republican efforts to require dynamic scoring for tax bills will lead to a debate on what tax rate maximizes federal revenues. This is an issue that has been debated since the 1970s. Recent academic research shows that the top U.S. rate could rise substantially from its current level of 35 percent before the increase would have such disincentive effects that revenues would start to fall.

Bruce Bartlett (Goodman/Van Riper) With the economy recovering and increasing attention being paid to the budget deficit, Republicans are finding it harder and harder to gain political traction on tax cuts. Although they continue to maintain that spending can easily be cut enough to finance even a big tax cut, they are quietly preparing an alternative strategy. They are moving to force the Joint Committee on Taxation and the Congressional Budget Office to adopt dynamic scoring, which would incorporate macroeconomic growth effects into revenue estimates. Republicans have long believed that incorporating those effects would greatly reduce the budgetary cost of tax cuts and make them easier to enact.1

Dynamic scoring got started with the so-called Laffer curve, supposedly drawn on a napkin in 1974 by University of Chicago business Professor Arthur Laffer for Donald Rumsfeld and Dick Cheney, both members of President Ford's staff.2 The curve was popularized by Wall Street Journal editorial writer Jude Wanniski, who first described it in a 1975 article.3 He went on to develop it at greater length in his 1979 book, The Way the World Works.

At its core, the Laffer curve is unobjectionable. It shows simply that neither a 0 percent tax rate nor a 100 percent tax rate raises revenue; somewhere in between is a rate that maximizes revenue. The trick is to empirically estimate the revenue-maximizing rate based on the existing tax regime and economic conditions. It turns out that even supply-side economists have seldom found examples of tax rates that were so high that a rate cut would increase revenue.

In the 1970s Harvard economist Martin Feldstein and others argued that a cut in the capital gains rate would raise net revenue. However, that was mainly a short-term unlocking effect. A Treasury Department study later concluded that the cuts in the capital gains rate in 1978 and 1981 reduced long-term capital gains revenue and did not materially increase economic growth.4

When asked about the impact on revenues of an across-the-board rate cut, as proposed in the 1978 Kemp-Roth bill and later by President Reagan, Laffer declined to estimate whether that would raise revenue even though tax rates were substantially higher than they are now, with a top rate of 70 percent. The most Laffer would say was that the Kemp-Roth tax cut would self-finance by reducing spending for things like unemployment compensation as economic growth increased, raising private saving, reducing the value of tax shelters, and creating higher revenues at state and local levels.5

In 1978 economists Norman Ture and Michael Evans incorporated supply-side economics into their detailed revenue forecasts, and both concluded that the Kemp-Roth bill would never pay for itself. Ture estimated substantial revenues losses, net of feedback, even 10 years after enactment, when revenues would still be $53 billion (in 1977 dollars) below baseline.6 Evans's figures were very similar, showing a $61 billion deficit increase in 1987.7

Contrary to popular belief, the Reagan administration never incorporated Laffer curve effects into its revenue estimates for the 1981 tax cut. All published estimates conformed to standard Treasury revenue-estimating methods and were almost identical to independent estimates done by the CBO.8

Treasury tried to empirically estimate the Laffer curve in 1984. It concluded that most tax cuts lose revenue. Rate cuts for those in the top bracket had the potential to raise revenue, but only in the long term. In the short term, revenues would fall. As Treasury explained:


    Discussions of the Laffer Curve often presume that there is a single aggregate tax rate elasticity that applies to a nation. Thus they argue over whether a tax cut will increase or decrease revenues. In reality there is not a single tax rate and tax elasticity. Rather, there is a series of tax rates and elasticities that pertain to different income classes. Our estimates suggest that the income tax base is not very responsive to tax rate changes in the income categories occupied by most Americans. In this sense, they are highly consistent with estimates by other researchers indicating that aggregate tax elasticity is quite small.9

In 1985 economist Lawrence Lindsey attempted to compute the revenue-maximizing tax rate. Given the 1982 tax structure, which had a top rate of 50 percent, Lindsey concluded that reducing the top rate to 43 percent would raise revenue, but that reducing any other rates would lose revenue.10

Not much was heard about the revenue-maximizing top rate for some years because tax reductions were the order of the day. But as the need to raise revenue -- and perhaps legislate increases in the top tax rate, for both revenue and distributional reasons -- has become pressing, there is once again interest in the subject.

An important contribution to the discussion happened in 2009. N. Gregory Mankiw, chair of the Council of Economic Advisers under George W. Bush and widely considered to be among the most conservative U.S. economists, coauthored a paper that explored optimal tax theory and concluded that the optimal marginal tax rate is between 48 and 50 percent.11

Also in 2009, economists Mathias Trabandt and Harald Uhlig examined revenue-optimizing tax rates for the United States and Europe. They found that the United States is well below the revenue-maximizing top rate of 63 percent, that taxes on labor could be increased by 30 percent before labor supply dropped enough to reduce revenues from further increases, and that taxes on capital could be increased by 6 percent.12

A 2010 paper by economists Anthony Atkinson and Andrew Leigh looked at five different Anglo-Saxon countries and found similar tax elasticities among high-income taxpayers. They concluded that the revenue-maximizing top rate is at least 63 percent and may be as high as 83 percent.13

Most recently, economists Peter Diamond and Emmanuel Saez concluded in a 2011 paper that the revenue-maximizing top tax rate is 73 percent -- well above the current top rate of 42.5 percent.14

Informal surveys of top economists confirm that the top tax rate could increase substantially before the Laffer effect caused revenues to decline. One survey was taken by The Washington Post in 2010 and quoted University of Michigan economist Joel Slemrod as suggesting that the revenue-maximizing top rate is at least 60 percent:


    The idea that we are on the wrong side [of the Laffer curve] has almost no support among academics who have looked at this. Evidence doesn't suggest we're anywhere near the other end of the Laffer Curve.15

University of California, Berkeley, economist Brad DeLong and Dean Baker of the Center for Economic and Policy Research have said that the revenue-maximizing top rate is about 70 percent. Even conservative economic journalists Larry Kudlow of CNBC and Stephen Moore of the Wall Street Journal editorial page said that revenues would rise until the top rate hit at least 50 percent.16

    Revenue Loss From Tax Cuts for the Top 1 Percent of Taxpayers Since 1986
                             (billions of dollars)
 ______________________________________________________________________________

                                                 1986 Revenues
           Actual Effective                      Effective
 Year      Rate (percent)    Actual Revenues     Rate of 33.1%      Difference
 ______________________________________________________________________________

 1987           26.4              $91.6              $114.8           $23.2
 1988           24.0             $113.8              $156.9           $43.1
 1989           23.3             $109.2              $155.1           $45.9
 1990           23.2             $112.3              $160.1           $47.8
 1991           24.4             $111.3              $151.3           $40.0
 1992           25.0             $131.2              $173.5           $42.3
 1993           28.0             $145.8              $172.5           $26.7
 1994           28.2             $154.3              $181.1           $26.8
 1995           28.7             $178.0              $205.3           $27.3
 1996           28.9             $212.6              $244.0           $31.4
 1997           27.6             $241.2              $289.2           $48.0
 1998           27.1             $274.0              $334.4           $60.4
 1999           27.5             $317.4              $381.9           $64.5
 2000           27.4             $366.9              $442.9           $76.0
 2001           27.5             $300.9              $362.5           $61.6
 2002           27.2             $268.6              $326.6           $58.0
 2003           24.3             $256.3              $349.4           $93.1
 2004           23.5             $306.9              $432.8          $125.9
 2005           23.1             $368.1              $527.3          $159.2
 2006           22.8             $408.4              $593.7          $185.3
 2007           22.4             $450.9              $665.3          $214.4
 2008           23.3             $392.1              $558.4          $166.3
 2009           24.0             $318.0              $438.8          $120.8

 Total                         $5,629.8            $7,417.8        $1,788.0
 ______________________________________________________________________________

 Source: Author's calculations based on IRS data.

I'm not sure how much we could raise the top rate before it would become counterproductive in terms of revenue. But I think it is revealing that as recently as 1986, during the Reagan administration, those in the top 1 percent of taxpayers, ranked by adjusted gross income, had an effective federal income tax rate of 33.1 percent when the top marginal rate was 50 percent. Their effective rate has been significantly lower every year since. Had they simply kept paying the same effective rate, the federal government would have reaped $1.8 trillion in aggregate additional revenue between 1987 and 2009, not counting interest.

Of course, it goes without saying that the optimal tax rate in terms of revenue is not necessarily the one that maximizes growth or is socially optimal. Personally, I would prefer not to have a top income tax rate exceeding 50 percent, because it is important psychologically and morally that people not be forced to give more than half of their income to the federal government. However, given the magnitude of our nation's fiscal problem, a rate higher than that may be inevitable unless the United States adopts a VAT, carbon tax, or other broad-based tax to supplement existing revenue sources.


FOOTNOTES

1 On February 2 the House passed H.R. 3582, the Pro-Growth Budgeting Act of 2012, Doc 2012-1555, 2012 TNT 17-22, which would force the JCT and CBO to do a dynamic score for major tax bills, but not for appropriations bills.

2 Arthur Laffer, "The Laffer Curve: Past, Present, and Future," Heritage Foundation Report No. 1765 (June 1, 2004).

3 Jude Wanniski, "The Mundell-Laffer Hypothesis -- A New View of the World Economy," The Public Interest (Spring 1975), at 49-50.

4 Treasury report to Congress on the capital gains tax reductions of 1978 (1985).

5 Bruce Bartlett, The New American Economy 113 (2009).

6 House Ways and Means Committee, "Tax Reductions: Economists' Comments on H.R. 8333 and S. 1860 (The Kemp-Roth Bills)" (1978), at 96.

7 House and Senate Budget committees, "Leading Economist's Views of Kemp-Roth" (1978), at 76.

8 Bartlett, "The 1981 Tax Cut After 30 Years: What Happened to Revenues?" Tax Notes, Aug. 8, 2011, p. 627, Doc 2011-16766, 2011 TNT 152-7.

9 James Gwartney and James Long, "Income Tax Avoidance and an Empirical Estimation of the Laffer Curve," Treasury's Office of Economic Policy (July 1984), at 22.

10 Lawrence Lindsey, "Estimating the Revenue Maximizing Top Personal Tax Rate," National Bureau of Economic Research Working Paper No. 1761 (Oct. 1985), at 18.

11 N. Gregory Mankiw et al., "Optimal Taxation in Theory and Practice," 23 J. of Econ. Persp. 147, 158 (Fall 2009).

12 Mathias Trabandt and Harald Uhlig, "How Far Are We From the Slippery Slope? The Laffer Curve Revisited," NBER Working Paper No. 15343 (Sept. 2009).

13 A.B. Atkinson and Andrew Leigh, "The Distribution of Top Incomes in Five Anglo-Saxon Countries Over the Twentieth Century," Institute for the Study of Labor (IZA) Working Paper No. 4937 (May 2010), at 29.

14 Peter Diamond and Emmanuel Saez, "The Case for a Progressive Tax: From Basic Research to Policy Recommendations," 25 J. of Econ. Persp. 165, 171 (Fall 2011).

15 Dylan Matthews, "Where Does the Laffer Curve Bend?" The Washington Post, Aug. 9, 2010.

16 Id.


END OF FOOTNOTES

About Tax Analysts

Tax Analysts is an influential provider of tax news and analysis for the global community. Over 150,000 tax professionals in law and accounting firms, corporations, and government agencies rely on Tax Analysts' federal, state, and international content daily. Key products include Tax Notes, Tax Notes Today, State Tax Notes, State Tax Today, Tax Notes International, and Worldwide Tax Daily. Founded in 1970 as a nonprofit organization, Tax Analysts has the industry's largest tax-dedicated correspondent staff, with more than 250 domestic and international correspondents. For more information, visit our home page.

For reprint permission or other information, contact communications@tax.org