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Yes, There Is No Good Reason Not to Raise Marginal Tax Rates from Their Current Values

Christina Romer:

Marginal Tax Rates and Wishful Thinking: If the incentive effects are small, however, the situation is very different. Cutting taxes would still raise output for a while by putting more money in people’s pockets, and so increasing their spending — a temporary demand-side effect. But lower marginal rates wouldn’t greatly raise output over the long haul through the supply side. History shows that marginal federal income tax rates have varied widely…. If you can find a consistent relationship between these fluctuations and sustained economic performance, you’re more creative than I am. Growth was indeed slower in the 1970s than in the ’60s, and tax rates were higher in the ’70s. But growth was stronger in the 1990s than in the 2000s, despite noticeably higher rates in the ’90s….

A useful summary measure of such changes’ supply-side effects is the sensitivity of reported income to marginal rates. If people work and invest more in response to tax cuts, their reported income will rise when marginal rates fall. True supply-siders believe that this sensitivity is well over a value of 1, implying that cuts in marginal rates raise reported income enough that government tax revenues nevertheless rise. But a critical review of several natural-experiment studies concluded that the best available estimates of this sensitivity range from 0.12 to 0.40…. David Romer and I found that changes in marginal rates in the 1920s and ’30s had even smaller effects…. The rate shifts in that era make those after World War II look tame, and varied greatly across income groups…. We found that an increase in marginal rates on an income group leads to a decrease in its reported taxable income relative to other groups…. But the estimated impact is very small — almost at the bottom of the postwar studies’ range….

I can’t say marginal rates don’t matter at all…. But the strong conclusion from available evidence is that their effects are small. This means policy makers should spend a lot less time worrying about the incentive effects of marginal rates and a lot more worrying about other tax issues….

[I]ncome inequality has surged in recent decades. Raising marginal rates on the wealthy is a straightforward, effective way to counter this trend, while helping to solve our looming deficit problem. Given the strong evidence that the incentive effects of marginal rates are small, opponents of such a move will need a new argument. Invoking the myth of terrible supply-side consequences just won’t cut it.

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