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Optimal tax rate for top one per cent may be as high as 83%

Paper suggests cutting taxes may divert attention to wasteful bargaining

By Alex Hern Published 28 May 2012 17:21

Pictured: Laffer. No, wait, laughers. Photograph: Getty Images

Via Daniel Elton, a new(ish) paper (pdf) by economists Thomas Piketty, Emmanuel Saez and Stefanie Stantcheva makes the case for the optimal tax rate of the richest one per cent could be as high as 83 per cent.

The authors look at three possible ways in which top incomes respond to marginal tax rates.

The first is the "supply side" channel cited by Arthur Laffer when he developed his concept of the Laffer curve. Under this channel, marginal tax rates that are too high result in people doing less work than they otherwise would. Lower tax rates thus respond to more economic activity, and greater growth and higher tax revenue. Laffer's work was used by the Reagan administration to justify cutting the top rate in the US, from 70 per cent down to 28 per cent.

The second is the "tax avoidance" channel. This is the model cited by the Chancellor when he made the decision to cut the tax rate for top earners in Britain from 50 per cent to 45 per cent. The argument is that high tax rates increase tax avoidance, but the authors argue – in common with many of the Chancellors critics – that tax avoidance can be dealt with directly, writing that:

A better policy would be to first close loopholes so as to eliminate most tax avoidance opportunities and only then increase top tax rates.

The third is the "compensation bargaining" channel. The authors argue that:

While standard economic models assume that pay reflects productivity, there are strong reasons to be sceptical, especially at the top of the income distribution where the actual economic contribution of managers working in complex organisations is particularly difficult to measure.

As a result, top workers have ample opportunity to set their own pay, through bargaining harder or influencing compensation committees. The incentives for this economically wasteful activity are higher the lower tax rates are. Just as with the supply side model, tax cuts increase the wealth of the richest in society, but unlike that model they do not also increase growth; rather, the extra money for the rich comes from those poorer than them.

The authors, using their estimates of the elasticity of the various channels (that is, the magnitude of the effect), then calculate what the optimum rates would be. Under the first model, they find it to be roughly 57 per cent – 5 per cent higher than the top British tax rate is until the cut takes effect (National Insurance for top earners is 2per cent). Assessing the second model (Osborne's preferred argument), they find that the optimal tax rate would be 62 per cent, but argue that if the correct anti-avoidance and simplification measures were put in place, it would be 71 per cent.

The third model, however, outputs an optimal rate of 83 per cent. The authors still assume a minor supply-side effect, making up 40 per cent of the total elasticity, which is why it isn't higher. That is, they still assume that high tax rates will encourage the rich to work less, but they also assume that they will encourage the rich to put more of their effort into actual work, and less of it into "compensation bargaining".

How to decide between models one and three (the authors assume that once anti-avoidance measures are put in place, model two is the same as model one)? The former predicts that lower tax leads to more work, the latter that it merely leads to higher pay. As a result, tax cuts should be correlated with higher growth. Are they? Well, no:

As a result, the bargaining model can at least be said to be as realistic as the supply-side model; and if that's the case, the optimal top tax rate for most nations is likely to be far in excess of where it is set now.

For more, see the authors in the Boston Review, VoxEU, or their original paper (pdf).

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7 comments

Mon, 2012-06-04 21:48 — Eddy S (not verified)

First simplify taxes so that we do not armies of tax accountants and lawyers, one thing we have to admit is that the layers and layers of tax complexity actually increase tax avoidance although it is always introduced with good intentions. The problem know one knows how to do this there are too many special interests. The tories have actually increased complexity with child benefit (even though it does not make sesnse for richer people to have child benefits). What we get are timid changes we hardly make an impact on tax complexity.

Tue, 2012-05-29 11:48 — Supernaut (not verified)

One of the issues here is the lumping together of the 1% - and it's worth remembering that 1% is still quite a large number. Not all of these people are financiers and the mega-rich; you'll get everyone from senior civil servants through to former bricklayers who have built their own firms - and these firms aren't necessarily monoliths like MacAlpine. Not everyone works in a sector that is a capital flight risk who can decamp to Dubai; and many of them are entrepreneurs who DO work hard and whose hard work DOES create jobs. They will also, more than likely, get paid in a very different manner to those who work in finance - taking their money from their business (under different tax rules) than someone who gets paid a (big) salary and (bigger) bonus. It's welcome that policy makers are looking at these sort of things in the round and its positive that the NS is giving this coverage (even if it does just identify 'the rich' as a homogenous group) - but there needs to be a better understanding of what wealth creation really means and that there is a genuine difference between spurious 'trickle down' economics and allowing real entrepreneurs to grow their businesses and create jobs.

Mon, 2012-05-28 22:10 — therealguyfaux (not verified)

Of course, we are begging the question, aren't we, about what level of governmental services are to be provided; if the state would be less intrusive in its presence, then its share of tax revenue should decrease as a result. Of course, this cannot happen whilst the state has to pay the debt service on all its previous borrowing; what will need to happen is that the higher tax rates, should they eventuate, should be earmarked to paying down the debt, at whatever cost to the governmental services. No-one will agree to produce more, or close loopholes, nor will there be any let-up in the attempt to secure as much compensation as possible, no matter what the tax structure would be, if no-one sees any point in maintaining or enlarging a status quo that has got us to this stage in the proceedings. There is no magic money tree; the revenue has got to come from taxes, which nobody who does now pay will want to pay absent some sort of austerity. Paying more for less sounds counterintuitive but it is the only way the debt can be overcome. A corporate bankruptcy of a United States Chapter 11 variety, in which business goes on as usual without a receiver, but there is no new credit absent the debtor's ability to pay it currently, on pain of some sort of liquidation to pay off all debt, current and historical, may become necessary; and just as in a personal bankruptcy short of liquidation, every available pound must pay off the debt and if that requires that you economise till it hurts, and then economise some more, that is what will need to happen. To allow any new revenue to go to any new social spending or indeed any expanded current social spending is merely to give money to a drunken sailor. Here's the ultimate compensation bargain-- you get more tax revenue if you can prove you can pay off the debt; any veering from this course and the tax rates come back down. Won't do it? Then you are sowing the wind, and you won't like the whirlwind you're going to reap.

Mon, 2012-05-28 21:01 — sense (not verified)

Complete Tosh. If the top 1% know how to earn the money, they know how to hide it. With jealousy of leftists scums all we can get it is another Soviet Union.

Mon, 2012-05-28 20:29 — mbrecker (not verified)

Lower tax rates consistently result in the top 1% NOT investing, creating new jobs and helping expand the economy. Zuckerberg and Facebook? No. "Allegedly" many were involved in insider trading. The prevailing attitude is "all the real market players do it. So what's the bid deal"?

If the govt. raises taxes and the top 1% leave, will there be a massive run on the banks? Possibly. As for the 1%, they'd use their inside sources and expensive tax attorneys to protect themselves abroad.

If you're a US citizen abroad, more are just renouncing their citizenships instead of paying dual tax. How mnay of the UK 1% would do the same thing? From what I see, many want the nice weather of France, Spain or Australia AND the convenience of the NHS. A double standard?

A question for all Tories who say do away with the NHS. If it's an "entitlement", why wasn't it abolished years ago? The reason is because not even your hero Thatcher would be that daft.

Someone should ask Blair why a war criminal is making millions and has maybe the most complicated tax protection in the UK.

Mon, 2012-05-28 20:07 — SHINSE167 (not verified)

- moving to Dubai or Singapore
Designate Dubai and Singapore illegal tax havens and put sanctions on them.
- stopping working a fewer weeks
Did you read the article?