Optimal tax theory – could it be more interesting than it sounds?

What should the maximum rate of tax be? I must admit that I would have guessed that anything above about 40% might be a disincentive to generate more income. I also thought that most economists would probably say something similar. So I was rather surprised to learn that some very eminent economists suggest that much higher rates are ‘optimal’. Peter Diamond (winner of the Nobel Memorial Prize for Economic Science in 2010) and Emmanuel Saez (winner of the John Bates Clark medal for economics in 2009) consider optimal tax theory where the objective is to maximize social welfare constrained by the response of individuals to paying or avoiding tax. Their findings are summarized in the Abstract of their 2011 paper

First, very high earners should be subject to high and rising marginal tax rates on earnings. Second, low-income families should be encouraged to work with earnings subsidies, which should then be phased-out with high implicit marginal tax rates. Third, capital income should be taxed.

They suggest that the marginal tax rate should rise to over 70% for incomes in excess of around half a million US dollars (if I have understood their numbers correctly), and similarly for capital gains. Some of this tax should then be redistributed to those on low incomes to encourage them into work. This maximum tax rate is not so far out of line with the proposals of the French socialist Presidential candidate Francois Hollande who has talked about a 75% tax for incomes above one million euros. But higher taxes are not generally that popular (see for example some of the comments to this BEC news report on M. Hollande’s ideas or this Wall Street journal article on Diamond and Saez). A common response is that higher taxes destroy growth, punish success and are easily avoided by moving overseas leading to a brain drain. So how could it be that such ‘high’ taxes are ‘optimal’? First the rich, well at least those that really create wealth, can still avoid paying the high rate by reinvesting in their business and investment is good for growth. Second the higher incomes generated at the lower end also generate more economic activity leading to higher incomes for the rich too. Recent historical data supports these ideas as reported by the Wall Street journal. Since 1945 there is a correlation between higher growth and higher taxes. What happens in France on Sunday and what happens next will be fasciniating to watch!


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