How Much Do Income Taxes Affect Our Behavior?

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During the 1980 Republican Presidential primary, Ronald Reagan promulgated the idea that by lowering taxes on the rich, the government could actually increase the federal government’s revenue. George H.W. Bush famously derided that idea as “Voodoo Economics.” After all, how could lowering tax rates actually increase revenue?

The idea isn’t as far-fetched as it might seem at first blush. To illustrate, think about tax rates in the extreme. If the government took 100% of your income, surely many people would simply not work. Perhaps nobody would work. And if the government lowered the 100% tax rate to, say, 80%, it seems very likely that at least some more people would work and the government would take in more revenue.

On the other hand, if the government starts with very low tax rates, lowering them further probably wouldn’t increase the incentive to work much, if at all.

(MORE: The Corporate Tax Rate Is Lowest in Decades; Is Business Paying Its Fair Share?)

Given the logic of these scenarios, there must be an inflection point between these two extremes where the federal government would be shooting itself in the foot by raising rates any further. Predictably, those on the political right estimate this rate to be much lower than do those the left. And the recent proposal by the Obama administration to raise marginal rates on top earners has once again brought this discussion to the forefront: Last fall, Bill O’Reilly threated to quit his popular television show if his taxes were raised; and just last week, Staten Island Republican representative Michael Grimm questioned Fed Chairman Ben Bernanke on the effects of raising taxes on capital gains, insinuating that Great Britain’s raising its capital gains tax actually caused tax receipts to go down.

(MORE: Why Lower Corporate Taxes Won’t Create More Jobs)

But a working paper issued in February by the National Bureau of Economic Research and co-written by the former chair of President Obama’s Council of Economic Advisors, Christina Romer, and her husband David, suggests that tax rates have a much lower effect on investing and labor decisions than previously thought. In fact, the paper argues that revenue-maximizing tax rate is as high as 84%.

The paper also finds that taxes generally have less effect on behavior than previously thought. What separates this study from others of its kind is that it looks at tax rates in the period between the two world wars, as opposed to more recent times. The advantage of this approach is that there were many changes in the marginal tax rates during this time, giving researchers many opportunities to study how those changes effect citizen behavior. In addition, the income tax regime during this period was much more progressive than it is now. For instance, for most of the period studied, the top 1/200th of one percent of earners bore between 30 and 40 percent of the total federal income tax burden.

As Baseline Scenario blogger James Kwak argues, these are the folks who would most likely change their behavior based on tax rates. They have enough money to stop working if they wanted to, but the evidence suggests that this is not what people do. Kwak argues that the real danger is not that the wealthy will stop working, but that they’ll pour more and more resources into shielding their income from taxes, and that a simplified tax code is should therefore be a priority.

(MORE: Obama’s Job Creation Tax Credit: Cool Idea, Bad Policy)

Of course there are other considerations besides revenue maximization to take into account when deciding upon marginal tax rates. Fairness is one. Conservatives don’t usually like to explicitly raise the fairness argument because once fairness is a consideration, it opens up the door for all kinds of wealth redistribution. But when it comes to taxes, fairness can be a compelling argument to make even for those who wish to lower taxes on the rich.

A recent poll conducted by The Hill illustrates this point perfectly. The poll shows that 3/4 of the American electorate believe that the top marginal tax rate should be lower than it actually is. That flies in the face of a much-cited Pew poll that showed that 66% of Americans thought that taxes should be raised on the highest earners. The difference between these two polls comes down to how the questions were worded. The Hill poll asks respondents what the ‘most appropriate’ rate is for those earning above $250,000 a year, while the The Pew poll simply asked whether taxes on the rich should be raised. According to The Hill:

 “One possible explanation is voters may not know how much the nation’s top earners are already being taxed. The poll did not ask voters to identify current tax rates before saying what rate they favored.”

So it seems Americans recoil from tax rates much higher than 30%, regardless of how rich those paying the tax are. Of course, the disconnect between what Americans demand from their government and what they think is fair that the government demand of them is not new.  What the Romer study does show us is that the government’s taxing and spending affect our professional and investing decisions much less than we thought.

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