Marginal Benefits

Twenty years ago, cutting marginal income tax rates was a good idea. Today, it makes no sense at all.

The White House holds as an article of faith that cutting marginal tax rates will encourage investment, personal saving, and hard work (not to mention motherhood, sunshine, and minty breath). Indeed, slashing marginal income tax rates—served with a side order of dividend tax cuts—is essentially the Bush administration’s entire domestic policy.

Of course, there is a long, bipartisan history of reducing marginal tax rates to stimulate growth. John F. Kennedy did it in the 1960s, and Ronald Reagan did it in the 1980s.

But when Kennedy came into office, income tax rates rose to 59 percent at $50,000 and to 75 percent at $75,000. The top rate—affecting incomes over $500,000—was 91 percent! JFK reduced the top rate to 70 percent and sliced rates at $50,000 and $75,000 to 50 percent and 62 percent, respectively. Reagan, for his part, in 1981 and 1986, effectively reduced the top marginal tax rate from 70 percent in 1980 to 28 percent and collapsed 15 brackets into four.

We can all agree that a 91 percent top tax rate, or a 70 percent tax rate, might inhibit investment and working overtime for those extra bucks. But does reducing the top rate from 39 percent to 35 percent have any significant effects? What if our tax system—in which rates (until last week) stepped from 10 percent at the bottom to 38.6 percent at the top—is already so flat that it renders changes in the marginal rates irrelevant? “Once you’re below the 40 percent range, people aren’t that sensitive,” says Lawrence Katz, an economics professor at Harvard who worked in the Clinton administration. “And once you’re well above 50 percent people are sensitive.”

You don’t have to take it from a former Clintonite. Austan Goolsbee, a sharp young economist at the University of Chicago Business School (hardly a left-wing redoubt), has studiedthe many changes in marginal rates on the highest earners in the 20th century and examined their impact on income. The data, he writes in this paper, “indicate that the responsiveness of high-income people seems to be relatively modest in almost all times except the 1980s.”

What’s more, recent history seems to argue against a link between tweaking top marginal tax rates and income growth. The marginal tax increases on high earners by President George H.W. Bush (1990) and President Clinton (1993) didn’t hamper economic or income growth. And the marginal tax reductions of the past few years haven’t lit a fire under the economy.

Ah, but what about the halcyon 1980s? Didn’t reported income (and hence federal taxes collected) rise even as income tax rates were slashed? And wouldn’t that experience seem to vindicate devotees of the Laffer Curve?

To the vast majority of professional academic economists—not the economists manqués who inhabit intellectual biospheres such as the Wall Street Journal editorial page and certain time slots on CNBC—the debate over the Laffer Curve is long since settled. Most people get their income from their jobs, where taxes are withheld. Reducing marginal tax rates by a few points won’t magically cause people to start working 50 hours a week instead of 40 hours; and raising them won’t induce those same people to cut back their hours.Indeed, for all the attention paid to rates, Americans as economic creatures simply aren’t that responsive to the current regime of marginal rates. If they were, you’d expect to see incomes clustering at points where there’s an abrupt change in tax rates, as people strive to keep their income just below the next jump in marginal rates. But this paper by University of California at Berkeley economist Emmanuel Saez doesn’t find much bunching.

Furthermore, Goolsbee argues that the data from the ‘80s are an aberration because the tax cuts coincided with a long-term secular trend—dating back to the late ‘70s—of income inequality. In other words, the rich would have been getting richer, reporting more income, and paying more taxes, even without the tax cuts.

More damaging to the supply-siders is the record of the last 13 years. Remember, in 1990, Bush, under pressure from a Democratic Congress, raised the top rate from 28 percent to 31 percent. In 1993, Clinton created two new upper brackets, one at 36 percent, and the other at 39.6 percent. Confronted with such higher rates, did rich people suddenly start working less, or reporting less income? Did poorer people stop trying to get rich? Did the lucky ducks who paid lower marginal rates catch up to the better off? No, no, and no. Income inequality increased in the ‘90s, and the wealthy’s share of national income (and share of income tax paid) grew sharply. Meanwhile, since Bush started reducing marginal tax rates in 2001, national income growth has been relatively stagnant, and tax revenues have plummeted—especially tax revenues paid by the wealthy.

The last 13 years have been frustrating times for the supply-side wing of the Republican party. First, they were betrayed by their own president in 1990. Then, neither their hysterical warnings of doom in 1993 nor their enthusiastic predictions of boom in 2001 came to pass. The seven fat years of the ‘80s, when their theories were put into practice, are receding into memory. The irony is that Republicans may have been so successful at flattening out the tax code in the ‘80s that today’s further rate reductions (and the one Bush wants next year, and the year after …) won’t help their cause.