Tax rates and taxes paid

Those who call for a return to 90 percent tax rates should be aware that few people actually paid tax at those rates.

Progressives are calling for higher income tax rates on the rich. The top marginal tax rate — that’s the rate that applies to high income earners on most of their income — was above 90 percent during most of the 1950s. From 2003 to 2012 it was 35 percent, and is now 39.6 percent. Some see that as a lost opportunity. If we could return to the tax rates of the 1950s, they say, we could generate much more revenue for government.

The top marginal tax rate is the rate that applies to income. It’s not the same as what is actually paid. This fact is unknown or ignored by those who clamor for higher taxes on the rich.

The mistake the progressives make is equating tax rates with the tax actually paid. For many people, there is a direct relationship. For workers who earn a paycheck, there’s not much they can do to change the timing of their income, find tax shelters, or shift income to capital gains. When income tax rates rise, they have to pay more. But people with high incomes can use these and other strategies to reduce the taxes they pay. In fact, there is an entire industry of accountants and lawyers to help people reduce their tax. Often — particularly in the past — investments and transactions were made solely for the purpose of avoiding taxes, not for any other economic benefit.

But: High tax rates make the middle class feel better about paying their own taxes. With top tax rates of 90 percent, they may believe that the rich are paying a lot of tax. The middle class may take comfort in the fact that someone else is worse off. But that is based on the misconception that high tax rates mean rich people actually pay correspondingly higher tax.

Top tax rates and taxes actually paid

Figure 1. The top marginal income tax rate has varied widely, but since World War II, tax revenue collected as a percent of GDP is remarkably constant.
Figure 1. The top marginal income tax rate has varied widely, but since World War II, tax revenue collected as a percent of GDP is remarkably constant.
A series of charts illustrate the lack of a relationship between the top marginal income tax rate and the income taxes actually paid. (Click charts for larger versions.)

Figure 1 shows that that top marginal tax rate has varied widely. But since World War II, the taxes actually collected, expressed as a percentage of gross domestic product, has been fairly constant. In 1952 the top tax rate was 92.0 percent, and income taxes paid as a percent of GDP was 13.5 percent. In 2012 the top rate was 35.0 percent, and income taxes paid as a percent of GDP was 11.2 percent.

Figure 2. The top marginal income tax rate has varied widely, but the average federal tax rates paid by top earners has varied less.
Figure 2. The top marginal income tax rate has varied widely, but the average federal tax rates paid by top earners has varied less.
Figure 2 shows how the top marginal income tax rate has varied widely, but the average federal tax rates paid by top earners has varied less. Data for this series is available only back to 1979.

Figure 3. The top marginal income tax rate has varied widely and has mostly fallen, and the share of federal taxes paid by top income earners has risen.
Figure 3. The top marginal income tax rate has varied widely and has mostly fallen, and the share of federal taxes paid by top income earners has risen.
Figure 3 shows how the top marginal income tax rate has varied widely and has mostly fallen, and the share of federal taxes paid by top income earners has risen.

Sources of data for these charts are the Internal Revenue Service, Bureau of Economic Analysis, and Congressional Budget Office.

Hauser’s Law

In 2010 W. Kurt Hauser explained in The Wall Street Journal: “Even amoebas learn by trial and error, but some economists and politicians do not. The Obama administration’s budget projections claim that raising taxes on the top 2% of taxpayers, those individuals earning more than $200,000 and couples earning $250,000 or more, will increase revenues to the U.S. Treasury. The empirical evidence suggests otherwise. None of the personal income tax or capital gains tax increases enacted in the post-World War II period has raised the projected tax revenues. Over the past six decades, tax revenues as a percentage of GDP have averaged just under 19% regardless of the top marginal personal income tax rate. The top marginal rate has been as high as 92% (1952-53) and as low as 28% (1988-90). This observation was first reported in an op-ed I wrote for this newspaper in March 1993. A wit later dubbed this ‘Hauser’s Law.'”

Incentives matter, economists tell us. People react to changes in tax law. As tax rates rise, people seek to reduce their taxable income. A common strategy is to make investments in economically unproductive tax shelters. There is less incentive to work, to save and build up capital stocks, and invest. These are some of the reasons why tax rate hikes usually don’t generate the promised revenue.

The subtitle to Hauser’s article is “Tax revenues as a share of GDP have averaged just under 19%, whether tax rates are cut or raised. Better to cut rates and get 19% of a larger pie.” Figure 1 illustrates. The top line, the top marginal tax rate in effect for each year, varies widely. The other two lines show total taxes and federal income taxes as a percent of gross domestic product. Since World War II, these lines are fairly constant, even as the top marginal tax rate varies.

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