David Grusky believes that taxing the rich won’t do much to solve extreme income inequality in the United States, because it does nothing to correct the real culprit—the growing gap in pre-tax income. We disagree.
Our research on eighteen OECD countries shows that, between 1975 and 2008, there was indeed a strong correlation between reductions in top tax rates and increases in top 1 percent pre-tax income shares. For example, the United States in this period experienced a 35 percentage point reduction in its top income tax rate and a very large ten percentage point increase in its top 1 percent pre-tax income share. By contrast, France and Germany saw very little change in their top tax rates and their top 1 percent income shares during the same period. Hence, the evolution of top tax rates is a good predictor of changes in pre-tax income concentration.
There are three explanations for the strong response of top pre-tax incomes to top tax rates. They have very different policy implications and thus should—and can—be tested.
First, higher top tax rates may discourage work effort and business creation among the most talented—the so-called supply-side effect. In this scenario, lower top tax rates would lead to more economic activity by the rich and hence more economic growth. We found that in a purely supply-side model, the revenue-maximizing top tax rate would be 57 percent. This implies that the United States still has some leeway to increase taxes on the rich, but that the upper limit has already been reached in many European countries.
Second, higher top tax rates can increase tax avoidance. In that scenario, increasing top rates in a tax system riddled with loopholes and tax-avoidance opportunities is not productive either. However, a better policy would be to first close loopholes so as to eliminate most tax avoidance opportunities and only then increase top tax rates. With sufficient political will and international cooperation to enforce taxes, it is possible to eliminate most tax avoidance opportunities, which are well known and documented. With a broad tax base offering no significant avoidance opportunities, only real supply-side responses would limit how high the top tax rate can be set before becoming counter-productive.
Third, top earners, especially managers of complex organizations, might be able to affect their own pay by bargaining harder or influencing compensation committees. Naturally, the incentives for such rent-seeking are much stronger when top tax rates are low. In this scenario, cuts in top tax rates not only increase top income shares, but the increases in top 1 percent incomes come at the expenseof the remaining 99 percent. In other words, top rate cuts stimulate rent-seeking at the top but not overall economic growth.
The top tax rate could be as high as 83 percent without harming economic growth.
To tell these various scenarios apart, we need to analyze to what extent top tax rate cuts lead to higher economic growth. We found that, since the 1970s, there has been no correlation between cuts in top tax rates and average annual real GDP-per-capita growth. Countries that made large cuts in top tax rates, such as the United Kingdom and the United States, have not grown significantly faster than countries that did not, such as Germany and Denmark. Hence, a substantial fraction of the response of pre-tax top incomes to top tax may in fact be due to increased rent-seeking at the top rather than increased productive effort.
The bottom line is that rich countries have all grown at roughly the same rate over the past 30 years, in spite of huge variations in tax policies. Using a model in which the response of top earners to top tax rate cuts is due in part to increased rent-seeking behavior and in part to increased productive work, we find that the top tax rate could be as high as 83 percent—as opposed to 57 percent in the pure supply-side model—without harming economic growth.
What should the top income tax rate be in the United States? That will depend whether the public believes that top pay reflects productivity or whether top pay arises from rent-seeking. The latter seems unfair, both in itself and because with higher income concentration top earners have more economic resources to influence social beliefs (through think tanks and media) and policies (through lobbying), thereby creating some reverse causality between income inequality, perceptions, and policies.
This article first appeared on www.VoxEU.org. Adapted with permission of the authors.