Corporate executives say that the top rates on income taxes have to be kept low in order to give them an incentive to invest and create jobs. But when you stop and think about it, the incentive is the exact opposite. The lower the top income tax rate, the more incentive there is to take money out of the business. The higher the top income tax rate, the more incentive there is to put money back into the business, since reinvested profits aren’t taxed.
This is obvious now that I think about it, but I didn’t see it until an economist named Mike Kimel pointed it out. His study of the historical data indicates that the optimal top federal income tax rate is 65 percent. Here’s how he thinks this works.
… … There is a notion that raising tax rates will reduce people’s willingness to work… which is only true above certain thresholds. (That threshold, of course, varies per individual.) As anyone who has ever had a business will tell you (when they’re not busy demanding tax reductions), you don’t pay taxes on income from the business if you turn around and reinvest that income. (An accountant would talk to you about decreasing your tax liability by increasing expenses which amounts to the same thing.) You only pay taxes on that income you take that income out, presumably for consumption purposes.
So to simplify, consider an example. Is a successful businessperson more likely to take money out of the business if his/her tax rate is 70 percent or if it’s 25 percent? In general, a person is more likely to take that money at 25%, as there’s less of a penalty. At 70 percent tax rates, there is more of an incentive to reinvest in the business, creating more growth in the business in subsequent years, and more economic growth thereafter. Seventy percent tax rates are more likely to generate faster economic growth than 25 percent tax rates precisely because people are self-interested and the higher tax rates induce people to continue investing in things they do well.
(Of course, tax rates can get too high. At 95 percent, people will reinvest almost every dime, even if they have exhausted every good investment opportunity they have. Thus, to avoid taxes they’ll be making lousy investments which in turn slow economic growth.)
In addition to the things Kimel mentioned, the risk-reward tradeoff on investment by rich people is much the same no matter what the marginal rate. Higher rates decrease risks as well as returns. You get to keep less of your marginal profit, but you get a more valuable tax deduction if you have a loss.
Now I don’t think that marginal tax rates are the main reason for high or low economic growth. Businesses expand when there are paying customers for their products, not otherwise. But it is a historical fact that, in the United States, business growth since the Great Depression has been greatest when the top tax rate has been highest. And it also is a historical fact that since the Reagan revolution in taxes, there has been an increase in corporate executives and financiers who get rich not by creating value, but by transferring wealth from enterprises into their own pockets.
I also find it hard to believe that marginal tax rates affect the behavior of financiers and executives who don’t even know what their tax rates are.
Jamie Dimon, the CEO of JPMorgan Chase, is railing against bashing the rich.
Dimon was responding to a question at an investor conference about the hostile political environment towards banks.
“Acting like everyone who’s been successful is bad and that everyone who is rich is bad — I just don’t get it,” said Dimon at the [Dec. 7] conference, which was organized by Goldman Sachs. … …
“Most of us wage earners are paying 39.6 percent in taxes and add in another 12 percent in New York state and city taxes and we’re paying 50 percent of our income in taxes,” Dimon said in defense of his fellow Wall Street bankers.
Jamie Dimon has not paid a 39.6 percent top rate since the Clinton administration. Under the George W. Bush administration, his top tax rate went to 35 percent, which is where it is today. And of course that top rate applies only on income over and above $250,000, and only on what his accountants can’t figure out how to exclude from taxation.
Click on The Kimel Curve and the Laffer Curve and Peter Diamond, Emmanuel Saez, Paul Krugman and Me: Looking at Optimal Tax Rates for Mike Kimel’s posts on his Presimetrics web log.
Click on The top marginal income tax should be about 65 percent which Mike Kimel cross-posted to the Angry Bear web log. Presimetrics and Angry Bear are both a bit technical, but they provide good information.
Click on The Case for a Progressive Tax PDF for a paper by Peter Diamond, who won a Nobel economics prize, and Emmanuel Saez arguing that the optimum marginal rate, including federal, state and local taxes, ought to be about 73 percent. This was too technical for me to be able to follow, but I include the link for those who are interested.
Click on Taxing Job Creators for Paul Krugman’s view.
Click on GOP Objects to ‘Millionaires Surtax’; Millionaires We Found? Not So Much for National Public Radio’s report on its fruitless effort to find millionaires willing to say that a proposed tax increase would affect their business decisions.
I don’t think Kimel has given a watertight proof that higher marginal tax rates spur economic growth. Maybe they do and maybe they don’t. Maybe they don’t matter much one way or the other. What he has done is to disprove the argument that we don’t dare raise the top tax rate because that would stifle economic growth.
Tags: Marginal tax rates