Tax analysts may get a chance to test out their latest theories. In a recent paper Christina and David Romer studied the effect of changes in tax rates on reported taxable income. They did this on taxpayers in the top 20th of the income distribution—the top .5%–studying the 20 years between 1919 and 1939. This period is interesting because top rates changed a lot.
To no one’s surprise they found that as taxes go up, reported income goes down. Higher taxes discourage work. But the elasticity—the effect of taxes on reported income—was surprisingly small: about 0.2. This implies that tax revenues would be maximized with a top marginal tax rate somewhere north of 80%. Wow.
To my way of thinking, this is nuts. Maybe people in the ‘20s and ‘30s didn’t have many ways to avoid taxes, but the super-rich sure do now. But there may be a test soon of this theory. In France the Socialist candidate for President, Francois Hollande—currently leading in the polls—has called for increasing the top marginal income tax rate from 40% to 75% on incomes over 1 million Euros per year.
Critics say that such a change would drive France’s high earners abroad, but Hollande is sticking to his proposal. If he’s elected and the revisions are enacted, France could provide a real-world test of this idea.
Maybe they’re right: maybe wealthy French taxpayers will be patriotic enough or distracted enough or whatever to just pay up. But I’m glad they’re running the test.
Douglas R. Tengdin, CFA
Chief Investment Officer
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