In January, as part of a deal to avert the fiscal cliff, Congress increased marginal tax rates on higher-income earners to Clinton-era levels while preserving existing Bush-era rates for most taxpayers.
By boosting rates for the rich, Congress is banking on the notion that tax increases will deliver much-needed revenue for the government without unduly damaging the economy. The bet is that high earners will keep working despite Uncle Sam's taking a bigger bite out of their income. In the short run, this might well be true. But the longer run is much more complicated.
President Barack Obama started the fiscal cliff negotiations by proposing to raise taxes on couples making more than $250,000 and singles making more than $200,000—roughly the top 2 percent of taxpayers. The president has long maintained that he just wants the rich to pay their "fair share," a formulation famously supported by billionaire investor Warren Buffett. Never mind that the federal tax code is more progressive than most and that millionaires already pay an effective tax rate that's nearly three to four times the rate paid by the middle class.
In a November New York Times op-ed piece, Buffett once again called for increasing marginal rates on taxpayers making $500,000 or more, plus a minimum tax on high incomes: 30 percent on taxable income between $1 million and $10 million, and 35 percent on incomes above $10 million. According to Buffett, such tax policies would safely raise revenue from rich people who are unlikely to change their behavior. He writes "So let's forget about the rich and ultrarich going on strike and stuffing their ample funds under their mattresses if—gasp—capital gains rates and ordinary income rates are increased. The ultrarich, including me, will forever pursue investment opportunities."
High-income earners' response to changes in taxes is an issue that academics have studied extensively. In 2000 University of Michigan economist Joel Slemrod published Does Atlas Shrug?: The Economic Consequences of Taxing the Rich (Harvard University Press), a book in which he challenged the free market belief that raising taxes on the rich would lead them to secede from the work force, as famously described in Ayn Rand's novel Atlas Shrugged.
Since then, economists have tried to refine their understanding of the magnitude of the aggregate labor supply changes— one of the ways people can adjust their behavior in response to higher tax rates. But they have not yet reached a consensus. On one hand, the literature has revealed that in the short run the supply of labor is relatively unresponsive to changes in after-tax earnings. Full-time employees—especially primary earners, who have historically been men—don't really seem to react much when their taxes go up. They work the same hours at the same jobs even when they get to keep less of their earnings.
This may be because those male breadwinners don't have many options. They still have to earn a living to take care of their families and probably can't shift their income from taxable wages to less-taxed forms such as capital gains. Under these conditions, it is conceivable that the economy would continue to grow and tax revenue would go up even when rates are raised.
On the other hand, you have the work of economists such as Nobel Prize winner Edward Prescott. Using aggregate labor supply data, such as the differences in hours worked among countries with different levels of taxes, Prescott finds that people work more hours when marginal income tax rates are lower, in particular when they are just starting out and when they are nearing retirement. This effect is particularly pronounced in the presence of a generous welfare state that provides benefits for lost revenue. His findings were released in a now-famous paper published in 2004 by the Minneapolis Federal Reserve entitled "Why Do Americans Work So Much More Than Europeans?"
Gender also seems to matter. Studies have shown that women, and secondary earners more generally, are much more responsive to changes in income tax rates. A 2011 paper published in the Journal of Economic Literature by University of South Wales economist Michael Keane shows that females respond more to higher tax rates on household earnings because they, unlike most men, are willing to leave the labor force entirely rather than simply adjusting their hours.
Even if higher taxes don't discourage the efforts of those who are wealthy today, they decrease the incentive for individuals to become wealthy in the future through entrepreneurship, human capital accumulation, and career choices.
Economists Aparna Mathur, Silva Slavov, and Michael Strain at the American Enterprise Institute give a few examples of such behavioral effects in an article published in Tax Notes in November 2012 called "Should the Top Marginal Income Tax Rate Be 73 Percent?" They write: "Imagine a high school student who graduates in a world where the top marginal income tax rate is more than 70 percent. He may decide not to pursue his dream of becoming a college-educated engineer because the government will take a large share of the returns to his college investment—that is, much of the extra money he will earn because he is a college-educated engineer will be seized by the government, so he may conclude that going to college isn't worth it. He is worse off because of the high top income tax rate. And so is society, because we now have one less engineer."
The authors offer more examples, such as a medical student who decides to become a pediatrician rather than a heart surgeon and an entrepreneur who decides not to expand his business. These examples jibe with a much talked about 2012 article in the Journal of Economic Literature by Keane and Princeton University economist Richard Rogerson. Keane and Rogerson conclude that factors such as investments in education, occupational choice, and business creation and development are more important when thinking about the long-run effects of high marginal rates than most economists had previously realized.
By calling for radically increased taxes on the wealthy, Warren Buffett and his fellow "patriotic millionaires" are creating an environment in which it will be much, much harder to become the next Warren Buffett. Increasing taxes on the wealthiest earners may raise some revenue for the government in the short run, but the long-term costs may be substantial.
Working fewer hours is not the only weapon big earners have against increased taxes. For instance, Mathur, Slavov, and Strain note that people can avoid taxes by shifting "income into non-taxable forms such as employer-sponsored health insurance and other untaxed fringe benefits, or they can engage in tax evasion by underreporting income." While economists have not reached a consensus on the responsiveness of income to the marginal rates for high-income earners, there is some support for the idea that this behavioral effect may be important and therefore costly to the economy.
The most overlooked cost of raising taxes on the wealthy is that it allows lawmakers to ignore necessary reforms of expensive programs such as Social Security and Medicare. Even at the higher Clinton-era tax rates, there aren't enough rich people to pay for our current and future spending. Assuming no change to spending patterns, Slemrod and Leonard Burman report in their 2012 book Taxes in America (Oxford University Press) that rates would have to reach 91 percent on top earners to pay our current bills. At those punishing rates, we can kiss economic growth goodbye and say hello to massive tax evasion and much higher taxes for the rest of us.