Taxing Times

What is the optimal top tax rate?

A couple of MIT professors studied what top marginal income tax rate would generate the highest revenues to the government. This is important, because optimal tax rates are a hot-button political issue. They compared tax rates, pre and post-tax income, and tax collections in 1970 and 2007, and they found—surprise—that tax collections were higher in 1970 than they were in 2007.

Right now the top marginal tax rate is about 42%, combining the top Federal rate with Medicare taxes and average top State income taxes. By running a lot of mathematical equations, they come up with an optimal top rate of 73%. They call this optimal because they suggest it would maximize tax collections from the top 1% of income-earners which the government could use for other things. That is, the utility lost by these taxpayers would be less than the utility gained by everyone else.

It doesn’t take a Nobel Prize in economics to see that this is nuts. If the government taxes 75% of my marginal labor, it is rational for me to use 75% of my marginally available time to find ways to avoid paying taxes. Legal tax-avoidance structures—charitable trusts and annuities, municipal finance, special deductions—may be desirable for me, but the time and effort I put into using them is time and effort lost to the economy. This loss hurts everyone.

There are many differences between the economy of 1970 and 2007. I don’t think many folks want to go back there. Suggesting that sky-high marginal tax rates would raise more revenue misses the point: people adapt. Unrealistic proposals don’t help.

Douglas R. Tengdin, CFA
Chief Investment Officer
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