Tax trap and top 1% income earners

People do not work to pay taxes; they work to earn after-tax income

BRUSSELS:

People do not work to pay taxes. People work to earn an after-tax income. What that after-tax income is in each case, and how it is related to reported income and work efforts, is often far from obvious.

Tax rates or retention rates are conceptually quite different. Grasping the difference is the key to understanding the ways in which taxes change economic behaviour and outcomes.

When tax rates are high, small changes in those rates result in large changes in personal incentives to report income. When tax rates are low, small changes in those rates result in small changes in personal incentives to report income.

High top tax rates disproportionately reduce incentives for the highest-income earners. When it comes to tax revenues, the higher a tax rate, the more likely that an increase in that tax rate will reduce tax revenues.

Conversely, the lower a tax rate, the more likely that an increase in that tax rate will increase tax revenues. High tax rates on the highest-income earners not only hurt the economy but are also likely counterproductive to raising tax revenues.

Total tax revenues for any one year paid by the top 1% of income reporters are a product of three inputs. These are, first, the average tax rate paid by the top 1%; second, the average reported income of the top 1%; and third, the number of filers in the top 1%.

Breaking down total revenues into three inputs offers easy access into seeing how raising (or lowering) the top rate on the rich results in total tax revenues paid by this same group. In general, three conclusions apply:

First, raising the top tax rate should, all things being equal, increase the average tax rate on the top 1%. Second, raising the top tax rate should reduce the average income reported by the top 1% of income earners, all else remaining the same.

Average tax rates and average incomes both respond to changes in the top tax rate but in opposite directions. There is a direct conflict between the two primary forces determining total tax revenues.

Third, raising the top tax rate, unless specified otherwise, should reduce the number of tax filers who are subject to the rate.

The highest tax rate may be very high, but average tax rates on the rich are always much lower. (The average tax rate is taxes paid divided by income).

The top tax rate elicits behavioural responses as to how much taxable income people report. The average tax rate, along with total taxable income, generates tax revenues.

There are many reasons for average tax rates following a similar but smoother pattern compared with that of top tax rates: not all income of the top 1% of income earners is taxed at the top rate. Not all forms of income accruing to high earners are taxed at the same rates.

The more progressive the tax code, the more the average and the top rate vary. And to the extent high top tax rates discourage earning income by the top 1%, this reduces the ratio of average tax rates to top tax rates.

Several observations can be drawn from this. The first is that average tax rates for the top 1% are always lower than the top, the "marginal" tax rate. Second, the two series generally follow the same pattern. Third, movements of the average rate are more muted than those of the top tax rate. And finally, the gap between the top tax rate and the average tax rate narrows dramatically as the top tax rate falls.

There is a remarkably close relationship between the top 1%'s incentive to report taxable income and the average amount of taxable income that the top 1% actually reports. The correlation is tight.

The top 1% are highly sensitive to tax rates. The more you tax them, the less they report in pre-tax income.

The correlation of average tax revenues (namely, the average tax rate multiplied by detrended average real income) of the top 1% and the top tax rate is astoundingly close. High top tax rates are tightly associated with lower average tax revenues – as are lower top tax rates with higher average tax revenues.

The crux of the matter is that if top tax rates are raised on pre-tax reported incomes of top income reporters, those people will report less income and pay less taxes.

There are many ways for the top 1% to reduce pre-tax reported income. These include evading, sheltering, avoiding, shifting income to lower tax categories, working less, moving to lower tax environments, bartering, etc.

Regardless of how they do it, high-income earners have found ways to lower their pre-tax reported incomes when top tax rates have been high.

Top income tax rates and top income tax returns data show the validity of the Laffer Curve (the theoretical relationship between tax rates and tax revenues). We all need to add this remarkable fact into our understanding of academic macroeconomics.

THE WRITER IS A PHILANTHROPIST AND AN ECONOMIST BASED IN BELGIUM