Are There Any Problems With A 70% Marginal Income Tax Rate?

Last weekend new “it” Congressperson Alexandria Ocasio-Cortez got herself interviewed by the 60 Minutes television show, and used the occasion to pitch some of her policy ideas. I wasn’t planning to use the valuable space of this blog to respond to such a thing, but then my daughters started reporting that reaction to the AOC interview had been lighting up their Facebook and Instagram feeds, with numerous comments on the order of “Wow! Finally there’s a politician who really inspires me!” Really?

The particular statement of Ms. AOC that seems to have most “inspired” these young people was her proposal to raise federal marginal income tax rates back up to 70% or so on the highest earners. In her interview, AOC noted that rates at that level had prevailed in this country in the years after World War II:

You look at our tax rates back in the ’60s and when you have a progressive tax rate system. Your tax rate, you know, let’s say, from zero to $75,000 may be ten percent or 15 percent, et cetera. But once you get to, like, the tippy tops— on your 10 millionth dollar— sometimes you see tax rates as high as 60 or 70 percent. That doesn’t mean all $10 million are taxed at an extremely high rate, but it means that as you climb up this ladder you should be contributing more.

But might such high tax rates have some adverse economic consequences? As if on cue, Official Manhattan Contrarian Worst Economics Writer Paul Krugman chimed in with a column in the New York Times on January 5. The gist of Krugman’s piece is that historical data prove that the U.S. economy did just as well with top marginal tax rates in the 70 - 90% range as it does today.

The controversy of the moment involves AOC’s advocacy of a tax rate of 70-80 percent on very high incomes, which is obviously crazy, right? I mean, who thinks that makes sense? . . . What we see [from the data] is that America used to have very high tax rates on the rich — higher even than those AOC is proposing — and did just fine. Since then tax rates have come way down, and if anything the economy has done less well.

QED! But is Krugman leaving anything out? I asked that question to my daughters, and they didn’t know. And why would they? — this all happened well before they were born.

The big thing that Krugman leaves out is tax shelters and exemptions of every variety and description. The stated highest marginal tax rates were in fact 90 - 91% in the 1950s through 1964 (the year of the so-called Kennedy tax cut), then 70% until the tax reform of 1983, and 50% until the tax reform of 1986, when the top rate went down to 28%. But almost nobody actually paid any meaningful amount of tax at those 70% and 90% rates, because there existed an endless variety of tax shelters and exemptions that made the highest rates easily avoidable by nearly everyone who otherwise would have had to pay them. Here were two of the biggest:

• Standard tax shelters. The basic idea was to reduce income this year and roll it over into future years. Ultimately you would roll it over all the way until you retired and then, if you played your cards right, dribble it out to yourself in amounts under the highest brackets. Two big categories were limited partnerships to finance movies and commercial real estate. You would invest, say, $50,000 this year in a partnership buying an office building. The partnership would then take non-cash depreciation deductions each year, generally as much in each year as your initial investment, and you could use those to reduce your taxable income from other sources. Your hope and expectation was that you could eventually sell the building for a profit — to be offset by non-cash deductions thrown off by other tax shelter investments that you would buy along the way. These types of structures no longer worked after the tax reforms of the 80s.

• Tax free bonds to finance private projects. Before the 1986 tax act, municipalities universally used municipal bonds to finance new factories, stores, shopping centers and the like (sports stadiums anyone?) within their borders. Hey, it “created jobs”! The bonds were only payable out of the revenues of the projects, and thus were riskier and paid higher interest rates than standard general obligation municipal bonds. All free from federal income tax, of course. Again, almost all of this was wiped out by the tax reforms of the 1980s.

There were also plenty of more exotic schemes if you had larger amounts of income to suppress.

So how many people actually paid the top rates during these decades? The answer is clearly “almost no one,” but I’ve spent some time looking for IRS data on that subject, without much success. However, I have found this seminar on tax policy put on by the George W. Bush Presidential Center in 2012. At the seminar, a guy named Lawrence Lindsey, who had been the head of the National Economic Council when W was President, and had also been a governor of the Fed (and therefore likely in a position to know) had this to say (page 46 at the link):

if you go back and look at the income tax data from 1960, as a place to start, the top rate was 91 percent. There were eight — eight Americans who paid the 91 percent tax rate.

It really is very close to no one. Lindsey goes on to comment humorously on how even eight people could have been so dumb as to pay 1960’s 91% rate when it was completely avoidable: “You’ve got to sort of scratch your head and wonder about the gene pool that produced those eight . . . .” My suspicion is that these were people who had died suddenly during the tax year, before they had gotten their shelters for the year in place. But more seriously, Lindsey describes how the high tax rates drove investment into inefficient and unproductive uses, because those were the uses that would produce the tax exempt income or the non-cash deductions that would shelter income and avoid taxes:

[The high tax rates] were avoidable by doing something that was essentially non-economic. If your tax rate is 91 percent and you have an economically viable project that produces a 10 percent return and one that’s somehow tax exempt that produce a 2 percent return, with a 91 percent tax rate, you go for the 2 percent project. So there was a lot of that that went on.

More easily available is data on what is called the “effective tax rate” paid by people reporting income at certain levels. The “effective tax rate” is your total tax paid divided by your total income reported. An effective tax rate much lower than the marginal rate for a given bracket indicates that people reporting income at the high level have claimed deductions that greatly lower the amount on which they pay tax. This January 7 piece by Phillip Magness of AEI reports that in the period 1960 - 1970, when top marginal tax rates were 91% and then 70%, people with reported income in the ranges of $500,000 to $1 million, and of over $1 million, who would have had effective tax rates near the top marginal rate in the absence of deductions, instead had effective tax rates in the range of 40-45%. That figure compares to today’s top federal marginal tax rate of 37%. Higher, but not much higher. And I suspect that even the 40-45% figure far overstates the truth of how much high income people of the time were effectively paying, because many of the tax avoidance strategies at that time resulted in what would otherwise be income either not being realized at all, or not being reported as such.

None of this is mentioned in Krugman’s piece. Does he know about the elimination of tax avoidance strategies by the tax reforms of the 1980s? Of course he does. He just doesn’t want you to know. AOC likely has no clue.

So the real question is whether economic performance would be improved or degraded by reimposing a top marginal rate of 70-80%, but with today’s limitations on deductions and avoidance strategies. For the reasons discussed, data simply comparing past economic growth rates with top marginal tax rates year by year do not provide meaningful information. Here are a few things you might wish to take into account in thinking about the answer:

• On the international front, how does the economic success of low tax/low spend jurisdictions (Switzerland, Singapore) compare to that of high tax/high spend jurisdictions (Greece, Italy)?

• In the 1970s, New York City and State imposed a combined top marginal income tax rate of 19%, which was on top of the federal rate of 70%. New York City’s population shrank by about 800,000 people during that decade, while no-income-tax Connecticut boomed. From the late 70s through the 80s, New York State cut its top rate about in half. Growth resumed.

• Can we think of any examples of large cuts in high income tax rates being promptly followed by surges in economic growth? Here are some: U.S. during the 80s (Reagan tax cuts, above); UK during the 80s (Thatcher tax cuts); U.S. in 2018 (Trump tax cut). There are many more examples if you look internationally (e.g., Latvia).

In his piece linked above, Krugman has this statement that reveals the core of his world view:

[W]hen taxing the rich, all we should care about is how much revenue we raise. The optimal tax rate on people with very high incomes is the rate that raises the maximum possible revenue.

“Optimal” for what? The one and only goal here is that the government gets absolutely as much money as possible, I guess because only government spending is truly moral and all personal spending by people such as you is just greedy and icky. So you will get what the government in its munificence elects to leave you, if anything. Meanwhile, of course, the great fortunes (think Bezos, Zuckerberg, Gates, Bloomberg, Buffett) have been built almost entirely without paying any income tax at all during the accumulation, otherwise known as “unrealized capital gains.” Those just aren’t covered at all by this whole income tax system.

Something tells me that my daughters’ friends who are now “inspired” by the vision of AOC and Krugman will eventually discover that being a serf to the all-powerful government is not all it’s cracked up to be. I just hope that by the time they discover this, it is not too late for them.