Writing in the Wall Street Journal, my Cato Institute colleague Alan Reynolds offers a simple economics lesson about pitfalls of class-warfare tax policy:
…the evidence is clear that when marginal tax rates go up, the amount of reported incomes goes down. Economists call that “the elasticity of taxable income” (ETI), and measure it by examining income tax returns before and after marginal tax rates claimed a bigger slice of income reported to the IRS. The evidence is surveyed in a May 2009 paper for the National Bureau of Economic Research by Emmanuel Saez of the University of California at Berkeley, Joel Slemrod of the University of Michigan, and Seth Giertz of the University of Nebraska. They review a number of studies and find that “for an elasticity estimate of 0.5 . . . the fraction of tax revenue lost from behavioral responses would be 43.1%.” That elasticity estimate of 0.5 would whittle the Obama team’s hoped-for $1.2 trillion down to $671 billion. As the authors note, however, “there is much evidence to suggest that the ETI is higher for high-income individuals.” The authors’ illustrative use of a 0.5 figure is a perfectly reasonable approximation for most purposes, but not for tax hikes aimed at the very rich. For incomes above $100,000, a 2008 study by MIT economist Jon Gruber and Mr. Saez found an ETI of 0.57. But for incomes above $350,000 (the top 1%), they estimated the ETI at 0.62. And for incomes above $500,000, Treasury Department economist Bradley Heim recently estimated the ETI at 1.2—which means higher tax rates on the super-rich yield less revenue than lower tax rates. If an accurate ETI estimate for the highest incomes is closer to 1.0 than 0.5, as such studies suggest, the administration’s intended tax hikes on high-income families will raise virtually no revenue at all. Yet the higher tax rates will harm economic growth through reduced labor effort, thwarted entrepreneurship, and diminished investments in physical and human capital. And that, in turn, means a smaller tax base and less revenue in the future.