There are two contradictory forces and one inefficiency at work when income tax rates are changed:
- First, there is the familiar Laffer Curve effect which effectively says as you increase taxes on labor people substitute untaxed leisure. I.e. you get less of what you tax. That is fairly uncontroversial as a theoretical construct, but there is little agreement on how large the effect is. It can be called the substitution effect.
- Second, there is a countervailing effect called the income effect. If people need a certain amount of money to live then arguably raising tax rates (thus reducing their consumable income) could lead them to work more to get the same amount of money.
- Third, the inefficiency is that at high rates people may do economically inefficient things to avoid the taxes (hold on to things to avoid capital gains taxes, use non-qualified deferred comp, put more in retirement plans than they would otherwise, set up a C corp. and retain the earnings in that entity, etc.) those are considered inefficient because it isn’t what people would choose to do absent the high taxes so there is a reduction in utility.
All of these effects will hit different people and items differently. Here are a few of the main ones:
- Low-income workers – the income effect will probably dominate so raising taxes on the relatively poor or lower middle class is a very good way to raise revenue (I am not necessarily recommending it, I’m just sayin’…). They can’t afford to work less, and have few options for avoiding the tax aside from taking cash jobs off-the-books.
- High-income workers – in theory the substitution effect should dominate, but it doesn’t appear to (with one exception I’ll get to next). That may simply be that we haven’t had rates high enough to trigger it. The rates necessary to make raising taxes unproductive (Laffer Curve maximum) might be as high as 60-70% though you still would create drag on the economy even below those rates. In other words, if taxes are raised 10% and that causes a 5% reduction in hours worked for the group, tax revenue is increased but GDP will be lower so the economy isn’t doing as well overall. High-income workers also have more flexibility to take income as perks or in different forms, delay recognition, move out of the country, etc. so the third item (inefficiency) from above is important here as well.
- High-income worker married to a low-income worker – the data does show that the lower paid spouse does tend to opt out of the paid labor force with higher taxes. For example, a lower income spouse might stay home at higher rates. That is bad for tax receipts, but also bad for lower-income workers if in staying home tasks are no longer outsourced. In other words, he or she might cook more rather than the family eating out, clean more rather than hire a maid, mow the lawn more rather than hire a lawn service, wash and iron clothes more reducing the need for dry-cleaning services, and watch the kids more reducing the need for daycare. Thus, by raising taxes on “the rich” it could reduce government revenue while simultaneously reducing the income of waitresses, cooks, maids, gardeners, drycleaners, childcare workers, etc. – none of whom are likely to be “rich.” For example, suppose the marginal tax rate on our taxpayer was 50% but it is raised to some higher amount while these other lower-income workers are in the 25% bracket the entire time. The lower-paid spouse did make $40,000 which after tax was $20,000 which was all spent paying for these additional services. The government got $20,000 plus $5,000 from the other folks. By staying home and doing all these things “in house,” spendable income (on other things) is exactly the same – there is no loss of standard of living (though of course the stay-at-home spouse may disagree) – but the government is out $25,000, and low paid workers out $15,000.
- Recognition of capital gains taxes is frequently very discretionary and thus even modest increases in this rate probably triggers more of a Laffer Curve effect. It is hard to see how there would be any income effect at all.
So what is the conclusion? Assuming Congress is rational (so already this is silly conjecture) there should be a trend to:
- Raising taxes on lower incomes.
- Keep capital gains taxes low (and though I didn’t touch on it here, dividends as well because an unpaid dividend becomes a capital gain eventually, and we don’t need further incentives for debt in the capital structure of companies).
- Change the code to treat each person individually rather than as a household (i.e. you may be married, but each spouse still files an individual return). This has the advantage of not treating unmarried couples differently and allows the lower-income spouse to have a low marginal rate and thus stay in the workforce.
- Raise taxes on higher incomes modestly. There is probably room before the Laffer Curve maxes out – particularly if the previous bullet is implemented.