Given the frenzied shouting that is going to accompany the current calls for tax reform we need to remind ourselves of one rather important thing – the Reagan tax reforms worked.
By this I don't mean that Art Laffer is always and everywhere right, that tax cuts pay for themselves, not that that's what he actually said anyway. Rather, they succeeded in bringing our tax rates roughly to where any further increases will not do much to increase government revenue, and they forced much of the compensation that high-earners were receiving in the form of untaxed perks back into being reported and taxed as personal income.
What Laffer and his Curve did actually say is that it is possible for tax rates to be so high that lowering them will change people's behavior enough to increase revenue. NYC seems to have reached that point, for example, with its tobacco taxation, gross revenue declined after the last rise. Just about any level of financial transactions tax goes over that peak revenue raising rate. Whether the American Federal income tax rate is above that at the moment, well, around and about that maximal rate is probably the right answer.
The best research we've got into this is from Peter Diamond and Emmanuel Saez – one with a Nobel, the other tipped as an odds-on certainty for his own. Some naughty people like to say this paper shows that a 76 percent top rate gains the most revenue – but that is for a system with no "allowances," methods of deferring, delaying tax or even methods of structuring so a different tax applies. Capital gains instead of income tax for example, leaving the money in a company instead of taking a dividend, IRAs and basically the entire tax structure other than just the income tax itself. In our own actually existing system the top revenue raising rate becomes 54 percent. Which is about where we are.
For what is being talked about is taxes upon income, not income tax. Social Security contributions max out but Medicare ones don't. Yes, we do, as the paper makes clear, need to add what is nominally paid by the employer. Then there are state and sometimes city income taxes. And so it could be that New Yorkers are above the curve peak at a 39.6 percent federal top rate, whereas those living in Washington State with no income tax are still below it.
The Reagan reforms, with subsequent minor adjustments, seem to have got us to roughly the right place for maximizing revenue. There's simply no point in a major income tax rate rise just because we're not going to get much more, if any, money from doing so.
It is true, though, that recorded income inequality has soared since then as David Leonhardt is complaining here. That's also a success of those very Reagan reforms -- to change the definition of income to make sure high earners were actually reporting it as personal income, as opposed to the old system, which incentivized a bevy corporate perks for high earners, the costs of which were taxed at a much lower rate than individual income. The Reagan reforms removed those perverse incentives, so that all the stuff they were getting, untaxed, is now counted as income and is taxed. To do that their pay structure has changed and that is indeed the reason for at least some of the rise in inequality, the fact that we deliberately engineered it.
Income inequality was higher in the past than we record it as being. More of high earners' compensation wasn't being recorded as income, nor being taxed as personal income. Those 90 and 70 percent top income tax rates were actually incentivizing people to take compensation in those non-taxable forms. We've now eradicated, to a great extent, that, but this does then mean that the reaction to tax rates going back up isn't going to be the same. We're also, to the best of our current knowledge, around the peak revenue raising rate anyway.
It really is true that the Reagan tax reforms worked in these senses, perhaps the most important in terms of fairness being that we now tax all of CEO income as we didn't then. And 40 to 50 percent of everything could well be more than 70 percent of only the cash they used to receive.
Tim Worstall (@worstall) is a contributor to the Washington Examiner's Beltway Confidential blog. He is a senior fellow at the Adam Smith Institute.
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