Higher Marginal Tax Rates Reduce Income Mobility, Especially at the Bottom

By Charles Hughes of Cato.

"Calls for higher tax rates often suffer from a myopic focus on the one percent, but these proposals largely fail to acknowledge that tax rates, and the incentives they create, influence work decisions for everyone.  Nowhere is narrow focus more evident than the tax proposals from the two rivals for the Democratic nomination. Bernie Sanders has proposed more than $19 trillion in new taxes over the next decade, and Hillary Clinton’s own plans only look modest by comparison. My colleague Alan Reynolds briefly alluded to a recent paper from Mario Alloza of University College London that examines the relationship between tax rates and income mobility. He finds that higher marginal tax rates reduced mobility over the period analyzed, particularly for people with low incomes or less education. These findings imply that proposals to significantly increase taxes could make it harder for people at the bottom of the income distribution to work their way up.

Alloza looks at panel data between 1967 and 1996 to examine whether tax rates affect the probability of staying in the same decile in the following two years. He examines different scenarios including pre-tax, post-tax and post-tax and transfer. Most of the paper focuses on federal taxes, but he also examines a case where state and payroll taxes are included as well. Increases in the marginal tax rate are associated with a reduction in short-run relative income mobility. Households are roughly 6 percent more likely to stay in the same income quintile when the marginal tax rate is increased by one percentage point. This mechanism holds for all of the different tax and transfer scenarios. Even accounting for the impact of transfers and benefits, higher rates curbed the upward mobility of people at the lower end of the income distribution. This suggests that the impact of tax rates on income mobility is not confined to redistribution effects, but the changes in labor market incentives.

These effects are even more pronounced for people with low-income or less than a college degree. Tax changes focused on compressing the income distribution by taking more from those at the top could also make it harder for these people at the bottom to climb the economic ladder. When Alloza restricts his sample to non-college households, he finds that a one percentage point increase in the marginal tax rate increases the probability of moving down to lower deciles by roughly one percent, increases the likelihood of remaining in the same decile by roughly the same amount, and reduces the probability of moving up to a higher income decile by almost one and a half percent. For households in the lowest income decile, an increase in the marginal tax rate reduces their probability of moving up to a higher decile by almost one and half percent in the post-tax and transfer scenario.  Higher marginal tax rates reduce the mobility for these groups in particular.

These results provide more evidence that taxes matter for all people when they make decisions about work. Higher tax rates limit income mobility by changing work incentives, particularly for people near the bottom of the income distribution. Public policy should not further reduce the scope of opportunity for these people, and increasing tax rates would likely do just that."