Let’s Not Kid Ourselves about 70 Percent Tax Rates

By Edward Conard, an American Enterprise Institute visiting scholar. Excerpt:

"During Saez’s exalted period from 1950 to 1980, for example, when high marginal tax rates ruled America, growth of total factor productivity — the portion of growth driven by innovation, which is the chief source of growth today — fell from nearly 3.5 percent per year in the decade prior to the 1950s to less than 0.5 percent per year by the 1970s. America reduced marginal tax rates during the 1980s, and total factor productivity growth doubled to about 0.75 percent per year. That hardly makes his case that lower marginal taxes, higher income inequality, and greater influence by successful investors over the government necessarily endanger democracy and threaten prosperity."

See also Marginal Tax Rate above 30% Likely Suboptimizes Social Welfare by Edward Conard. Excerpt:

"Stanford’s Charles Jones corrects glaring shortcomings in the Diamond/Saez’s optimal tax analysis to show why top marginal tax rates of 30% or less likely maximize social welfare in an innovation-driven economy. Jones concludes:

“Because ideas are nonrival, each person’s wage is an increasing function of the entire stock of ideas. A distortion that reduces the production of new ideas therefore impacts everyone’s income, not just the income of the inventor herself. These conditions lead to a new term in the Saez (2001) formula for the optimal top tax rate: by slowing the creation of the new ideas that drive aggregate GDP, top income taxation reduces everyone’s income, not just the income at the top. When the creation of ideas is the ultimate source of economic growth, this force sharply constrains both revenue-maximizing and welfare-maximizing top tax rates. For example, in a baseline calculation, the revenue-maximizing top tax rate that ignores the innovation spillover is 92%. In contrast, the rate that incorporates innovation and maximizes a utilitarian social welfare function is just 29%. Moreover, if ideas play an even more important role than assumed in this baseline, it is possible for the optimal top income tax rate to turn negative: the increase in everyone’s income associated with subsidizing innovation exceeds the gains associated with redistribution.”"

See also Taxing Top Incomes in a World of Ideas by Charles I. Jones of Stanford & NBER. Here is the abstract:

"This paper considers the taxation of top incomes when the fol lowing conditions apply: (i) new ideas drive economic growth, (ii) the reward f or creating a successful innovation is a top income, and (iii) innovation cannot be perfectly targeted by a separate research subsidy — think about the business method s of Walmart, the creation of Uber, or the “idea” of Amazon.com. These conditions lead to a new term in the Saez (2001) formula for the optimal top tax rate: by slowing the creation of the new ideas that drive aggregate GDP, top income taxation reduces everyone’s income, not just the income at the top. When the creation of ideas is the ultimate source of economic growth, this force sharply constrains both revenue-maximizing and welfare-maximizing top tax rates. For example, for extreme parameter values, maximizing the welfare of the middle class requires a negative top tax rate: the higher income that results from the subsidy to innovation more than makes up for the lost redistribution. More generally, the calibrated model suggests that incorporating ideas and economic growth cuts the optimal to p marginal tax rate substantially relative to the basic Saez calculation."

Evidence Indicates 75% of Business Pass-Through Income Is Owners’ Labor Income by Conrad.

"Contrary to Thomas Piketty’s far-fetched claim that “[human capital] is far less consequential than one might imagine,” a new NBER paper finds “top earners are predominantly working rich,” mainly “undiversified working-age owners of midmarket firms in skill-intensive industries,” who “derive most of their income from human capital, not physical or financial capital,” and that, “Less than 13% of people in the 99.9^th percentile derive most of their income from interest, rents, and other capital income.”

“Match[ing] 83% of top 1% individuals born in 1980-1982 to their parents,” and “classif[ing] an individual as self-made if her parents were not in the top 1%,” the researchers find, “More than three out of four of these top earners did not have top 1% parents.” They authors note, “This is a conservative classification, as many children of the top 1% do not work for their parents’ firms and do not receive especially large financial inheritances.”

To estimate the share of business income attributable to owners’ labor, the researchers measure the effects of owner deaths and retirements on firm profitably. They find a “-72:9% impact of top 1% owner-deaths [on profits] and a noisier -92:3% impact of top 0.1% owner-deaths.” Their “preferred owner-retirement percentage impact of -82:5% … is nearly identical to [their] owner-deaths estimate. 

 From this, they conclude, “Three-quarters of private business profit” is “human capital income.” They caution, “We may in fact understate the working-rich share of top owners because pass-through income is not the only form of “capital” income that includes disguised wages.” 

Superior firm profitability is a persistent and systematic characteristic of high earners. Firms owned by top 0.1% earners enjoy profitability ($14K per worker) that is over twice as large as the profitability ($5K per worker) of firms owned by individuals in the bottom half of the top decile. 

The authors note:

Our classification of three-quarters of pass-through income as labor income reverses the earlier finding in [Piketty, Saez and Zucman] that a minority (45%) of top 1% imputed national income is labor income. Even among million-dollar earners, 71% of fiscal income and 50% of imputed national income is labor income. In the top 0.1%, labor income shares fall to the still large numbers of 69% and 46%, respectively.

Turning to growth in the share of business income, the authors conclude:

Growth in entrepreneurial income is explained by both rising labor productivity and a rising share of value added accruing to owners. In contrast, after accounting for the growth due to organizational form changes, rising firm scale in the form of employment plays no role in the growth of top entrepreneurial income. From 2001 to 2014…63% of the growth in top 1% entrepreneurial income … comes from rising labor productivity, -24% comes from lower employment, and the remaining 61% comes from a growing owner share of value added.

The authors note:

If 0% of pass-through income is labor income…a minority of top-earners are wage earners. For example, among million-dollar earners … 46.8% are wage earners in the fiscal income definition and only 34.6% are wage earners in the imputed national income definition. That conclusion reverses when classifying 75% of pass-through income as labor income. For example, among million-dollar earners, 89.2% are working in the fiscal income definition and 69.8% are working in the imputed national income definition. Even among the top 0.1% in the imputed national income series, 59.3% are working. 

They explain their reasoning for using two estimates:

Fiscal income has the advantage of being directly observed on personal income tax returns, but has the disadvantage of understating top capital income because some components do not appear on personal tax returns. Imputed national income has the advantage that it sums to national income, but has the disadvantage of relying on imputation assumptions. Retained earnings ($649bn in 2014) are a substantial part of national income but do not appear on personal tax returns and thus are not in fiscal income. PSZ allocate the household share of aggregate retained earnings to individuals in proportion to the sum of the individual’s observed dividends and realized capital gains. However, published IRS reports indicate that at least 25% and as much as 75% of realized capital gains are not from the sale of C-corporate stock and are instead gains from real estate and other asset sales or carried interest. This fact can explain how total realized capital gains ($732B in 2014) vastly exceeds the total household share of retained earnings ($306B in 2014). Realized capital gains are much larger than dividends and much more concentrated among top earners. Hence, imputing retained earnings in proportion to each individual’s sum of dividends and 100% of realized capital gains may allocate too much retained earnings to top earners and not enough to lower earners. These competing considerations motivate the presentation of our findings in both series, likely (in our view) bounding the truth."