I have to answer QC’s call, so a little lesson is in order I think.
Why does it matter if the highest income bracket sees a tax rate of 39.5% versus 35%? What is the big deal if people who make more money than we’d ever dream of make 4.5% less than they would before? A lot more than you’d imagine.
Taxes create incentives, and incentives are the key to economic behavior. Incentives are more powerful when they aren’t pigeonholed, like when Democrats talk about “incentives” for green jobs or owning hybrid cars or whatever their pet project is that month; no, incentives are at their best when they are individually motivated and made in a way that is “to each his own.”
To think a bit harder about this, we have to think about how people who make the kind of money that the upper income bracket makes decisions and how more taxes impacts them. The word that applies to both is margin. High income taxes are taxes at the margin, and upper income people make decisions at the margin.
Marginal tax rates are just that, meaning that if you go from making 150,000 dollars a year to making 150,001 a year your taxes don’t jump from one bracket to the next. Instead, for every dollar you make over 150,000 you’ll pay the higher tax rate of 39.6% while your old income is still subject to the lower bracket (and so on and so forth down the income scale). Thus the taxes are indeed more progressive, if there was a hard tax rate increase from one bracket to the next, than people would spend a large amount of time trying earn just less than the next highest rate and incentives would be even more impacted, but that’s just silly to think about.
So if the effect on incentives are stunted a bit by being marginal, than where does the harm come in? Well, to answer that we have to establish a well known economic maxim: wages are equal to the marginal productivity of labor. Your compensation from the firm that you work for is directly tied to your contribution to that company. Otherwise, you’ll take your skills somewhere else for higher compensation. If a lot of people can do your job, than your compensation will be lower, since you are easily replaced. Since most of us are more likely to work a job that most everyone can do, we get very little flexibility when if comes to how often we work or when we work, but that changes when your skills are more specialized and rare.
People who make the top marginal tax rate are often more able to dictate the amount of hours they work and the amount of money they make. So if we have a doctor and a lawyer married together and the lawyer makes 200k and the doctor make 150k, than the doctor will choose to work less since they are not the primary income earner and they must file jointly. This is because every dollar that doctor earns will be taxed on amounts higher than if they weren’t married at all. The fact that every dollar the doctor earns will only come back at 60 cents will factor into the decision of whether to work or not. The economic capacity of the economy falls by the amount equal to the doctors decision not to work, so if the doctor decides to work a four day work week or see ten less patients a month or whatever.
If you factor in state taxes, the effect is even stronger. When those rates go from 35% to 39.5% to 45% or whatever we’re heading for, than the addition of state taxes will inflict further pain upon that decision. So while I may be paying 40% to the federal government for every dollar over 200k, I may owe an additional 15% to the state, so now I am working more for the government than for my self or my family. I gain little in the way of working above that 200k, so I work my way up to around that level and I stop, my incentive to contribute to the economy above 200k has been effectively killed off. If I have a spouse who may want to go to work to earn some income, she’ll discover that her return on any income that she gets is only 45 cents on the dollar, and she’ll likely drop out of the workforce. These decisions effect everything, from whether an entrepreneur decides to expand or sell his business, a lawyer decides to take on more clients, a professor to publish more research, the possibilities are endless. Remember, you can’t just replace these individuals production since their contributions are extremely rare and take a long time to train.
Add another layer to this, investment. My friend is offering bonds in his new start up that I think will do pretty well, and say I make right at the top tax rate amount. He offers me a 7% a year five year bond. I decline, since I’ll be taxed at over half on the money I’ll be earning, and it’;s not worth it to me at that rate. He has to raise interest rates to 10% in order to entice my investment, making it a little more costly to receive financing for his business and reducing his chances of success. Since I’m one the highest income level, I’ll choose instead to consume more rather than invest in the future productivity of the economy. Since riskier investments have a higher rate of return, I’m more inclined to take on lower risk. This reduces the likelihood of entrepreneurs succeeding, and drives actually increases the barriers of entry into the higher income class, reducing class mobility.
This is the distortion that high taxes can wreak upon an economy. The number of people who do productive work above a certain point is higher the lower the tax rate is. That means that increasing the highest marginal tax rate from 20 to 25% may not reduce much but going from 40 to 45% may change a whole lot. This is the same principle applied in all of economics, as return decreases than so goes the quantity of labor supplied.
Now, debating marginal tax rates is actually more open to debate among reasonable individuals than much of what the Obama administration is doing. Reasonable people can disagree about whether the top rate should rest at 35% or 39.5% and that it makes little difference to their overall outlook on the economy. For example, I’ll take a U.S. economy with strong property rights and rule of law over a country that has a lower tax rate but a stifling bureaucracy that hinders entry into the market. However, everything being equal, lower tax rates should produce higher economic growth. History has played this out over and over again, Alan Reynolds has a wonderful overview of this. A key passage from that same article:
The marginal tax on added earnings matters because it is easier to earn less than to earn more. To increase income, people have to study more, accept added risks and responsibilities, relocate, work late or take work home, tackle the dangers of starting a new business or investing in one, and so on. People earn more by producing more and better goods and services. If the tax system punishes added income, it must also punish added output—that is, economic growth.
