There’s been a lot of rhetoric since Obama announced on Monday a plan to cut the debt by $3.1 trillion over the next decade, a good portion of which would come from raising taxes on the wealthly. The President’s speech itself contained a good bit of hyperbole. The President said that America’s millionaires pay a lower tax rate than average Americans. That’s not true. According to latest IRS data from 20088, Americas who had income of a $1,000,000 or more that year paid an average tax rate of 23.3%. The average American sent Uncle Sam 13.6% of their paycheck to the federal government. If you made between $30,000 and $50,000, your tax rate was just 7.2%.
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But what is true, which is what I believe Obama was getting at, is that at the high-end of the income scale the tax rate curve does start to bend in the wrong direction. The people who earn $500,000 to $1,000,000 pay an average tax rate of 24%. That rate slips to about 18% for the 400 top earners in America, who made on average $270 million in 2008. The only way to really correct that is to raise the capital gains tax. Republicans and others who are critical of raising taxes counter that raising the capital gains taxes will hurt jobs. That seems to be not just hyperbole but outright wrong. Here’s why:
Obama says he took the idea that the rate curve is unfair from Warren Buffett, who recently said, despite making millions each year, he pays a lower tax rate than his secretary, or for that matter everyone else in his office. Obama would like to correct this. Buffett hasn’t released his tax returns. But the reason for his lower rate is most likely the corporate gains tax, which currently is at 15%. When more of your income comes from capital gains and not normal income, which is taxes at 35% for the highest earners, your overall tax rate can drop. Which is exactly what happened for the 400 top earnings in 2008, who made nearly 60% of their income from capital gains. The theory is that the lower tax rate causes people to invest more, and presumably earn less regular income, because they will pay a lower tax rate on investment income. By the same logic, a higher tax rate would lower investment, hurting the economy and costing jobs.
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The problem with that argument is changes to capital gains tax rate appear to have little or no affect on the amount of capital gains, and therefore investment, the richest Americans make. In 1997, the capital gains rate was lowered from 28% to 20%. It fell again under George W. Bush to 15%. That’s a pretty significant move. And yet, the amount the income Americans generate from capital gains is about the same as it was a decade and a half ago. In 1996, the top 1% of America earners got 59.7% of their income from ordinary income – salary and wages – according to the The World Top Incomes Database, which was put together by economics professors Facundo Alvaredo, Tony Atkinson, Thomas Piketty and Emmanuel Saez. Last year, the top earners got 55.7% of their income from salaries. Income from entrepreneurial activities, which would include investments that would yield capital gains, was relatively unchanged at 27% and 28%, respectively. Dividend income, which like capital gains is now taxed at 15%, did jump 2.4 percentage points. But that could be because of shift away from bonds and towards stock, not because of any jump in investment.
Why was this? People try to make as much money as possible despite the tax rate. And how you can do that has little to do with the relative tax rates, but the opportunities in front of you – meaning the composition of the economy. The economy in the U.S. these days does seem slightly more tilted toward investing, as opposed to traditional career paths, than it used to be, which is my guess for the small shift in the composition of top incomes. Nonetheless, the past decade and a half shows that capital gains rates in themselves don’t change investment much. And as a result, raising the rate is unlikely to cause investment to fall, or kill jobs. In fact, it will probably do the opposite. More tax revenue for the government will lower the debt, which should keep interest rates low, which tends to boost investment and produce more jobs, not less. It’s a win-win.