TOPICS > Economy

Taxes: How High Is Too High?

January 11, 2012 at 12:00 AM EDT
Economics correspondent Paul Solman explores the question of just how high U.S. tax rates should or shouldn't be and examines the relationship between economic activity and tax rates. It's part of his ongoing reporting series, Making Sen$e of financial news.

GWEN IFILL: Taxes are already a major issue in the Republican presidential primary. And they have been at the center of budget battles throughout the past year.

NewsHour economics correspondent Paul Solman explores the question of just how high tax rates should or shouldn’t be.

It’s part of his ongoing reporting Making Sense of financial news.

REP. ERIC CANTOR, R-Va., House Majority Leader: We, as Republicans are, not going to support tax increases.

REP. JOHN BOEHNER, R-Ohio, Speaker of the House: Everything is on the table, except raising taxes on the American people.

PAUL SOLMAN: The debate over taxing the well-to-do — on one side, the Republicans in Congress, all but 13 of whom have signed a pledge, never raise taxes, certainly not now, and certainly not on the rich. On the other side, President Obama, leading most Democrats with a pledge of his own, tax the rich more, above all, those who make more than a million dollars a year.

What do you do when you raise the taxes on the rich? They employ less people than they otherwise would have employed. Those people will have less income taxes. They will have less payroll tax. There will be less sales tax, less property taxes.Arthur Laffer

PRESIDENT BARACK OBAMA: And I know that many of our wealthiest citizens would agree to contribute a little more if it meant reducing the deficit and strengthening the economy that made their success possible.

PAUL SOLMAN: To get back to the basic economics of this debate, we thought we’d start with the man as responsible as anyone for bringing taxes on top earners down from 70 percent in 1980 to 35 percent today: Ronald Reagan’s controversial economist, Arthur Laffer.

ARTHUR LAFFER, former White House economic adviser: And, you know, I’m being pinned as being some right-wing nut. You know, all I want to make very clear is, taxes do matter.

PAUL SOLMAN: His life threatened, his California home vandalized, Laffer dropped out of the public eye for years, moved here to Nashville, Tennessee. But though he’s an avid collector of fossils, he’s no dinosaur, and was more than willing to sketch the skeleton of perhaps his favorite specimen, first conjured back in 1974.

ARTHUR LAFFER: First, you have two axes.

PAUL SOLMAN: Laffer doodled his original Laffer Curve on a napkin for, among others, Dick Cheney and Donald Rumsfeld of the Ford administration. Tax revenues are on the horizontal axis, tax rates on the vertical.

ARTHUR LAFFER: Total tax rates at 100 percent up here. Now, obviously at 100 percent tax rate, if you make nothing for doing the activity, you won’t do it, and there will be no revenue.

PAUL SOLMAN: That’s because, according to Laffer, if the government taxes away all income, people will stop working entirely.

ARTHUR LAFFER: No one will work and there will be zero revenues. And, obviously, at zero percent tax rates, everyone will work like mad, but you still won’t get any revenue.

PAUL SOLMAN: In between, a smooth curve representing Laffer’s pretty simple idea: Somewhere above zero percent and below 100 percent, there is a tax rate where government will collect the most revenue in any given year.

Now, the Laffer Curve applies to everyone, but the top so-called marginal rate is only relevant to the rich. It’s now 35 percent on all taxable income in excess of about $380,000 a year.

Does that 35 percent rate maximize total tax revenue for the government? We will get to the question in a bit. But Arthur Laffer certainly doesn’t believe the tax rates should be any higher.

ARTHUR LAFFER: If you raise tax rates, you collect more money per dollar of income, but then you have the economic effect, which, if you raise tax rates, you reduce the incentives for people to do the activity, and you get lower income.

PAUL SOLMAN: But because a low top rate encourages the rich to work harder and earn more, says Laffer, they’ll invest more, create more jobs and increase total tax revenues in the long run.

And thus, the key policy question that has driven the tax debate ever since Arthur Laffer first put pen to napkin: What is the optimal top tax rate for the good of the economy as a whole? Laffer’s position has never wavered: Set the tax rate well below the point of maximum short-term revenues.

ARTHUR LAFFER: What do you do when you raise the taxes on the rich? They employ less people than they otherwise would have employed. Those people will have less income taxes. They will have less payroll tax. There will be less sales tax, less property taxes.

PAUL SOLMAN: But we don’t actually know that. That’s the inference you’re drawing.

ARTHUR LAFFER: No one disputes that taxing something will get less of it. I mean, do you really think taxing tobacco makes people smoke more? Do you really think fines on speeders makes speeders speed more? I don’t think so.

PAUL SOLMAN: Case closed? Not quite.

DAVID CAY JOHNSTON, Reuters: I think Arthur Laffer has it exactly backwards.

PAUL SOLMAN: David Cay Johnston is an expert tax journalist, and a successful businessman as well.

DAVID CAY JOHNSTON: You know, I’m in the top 1 percent, and I’m trying to make every extra dollar I can, even though I’m at the top marginal tax rate.

I can’t imagine saying, no, I’m not going to take this opportunity to make more money because I’m going to have to pay 35 percent of it to the federal government. I mean, that’s — that’s nuts.

PAUL SOLMAN: A registered Republican, Johnston says a higher tax rate wouldn’t encourage most high-earners to slack off. In fact, it might have the opposite effect.

DAVID CAY JOHNSTON: If it’s important to people at that level to have the same after-tax income, what are they going to do? Well, they’re going to work harder, they’re going to work smarter, they’re going to figure out how to make even more money and make their business even more successful, so they can have more money.

And if they don’t do that, the difference in their after-tax income isn’t going to matter to them and it’s not going to matter to society, except we’ll have more tax revenue to fund the things society needs to be prosperous.

ARTHUR LAFFER: If it causes the economy to be worse, would you like to get more revenue from them and have the unemployment rate go up to 11 percent? Is that what you would like?

PAUL SOLMAN: Well, of course not, but is that what would happen?

Not necessarily, says Nobel laureate economist Peter Diamond, a tax expert. You may recall he was nominated by President Obama for the Federal Reserve Board, blocked by Senate Republicans.

PETER DIAMOND, Massachusetts Institute of Technology: If you want to shoot tax dollars in the direction of business creation, you have got to ask, who is it that’s having trouble getting financing? It’s not the high-earners. It’s further down the income distribution.

PAUL SOLMAN: So, if I understand you correctly, you’re turning this argument on its head in a way. And you’d say, if your objective is to create more jobs, you might want to lower the taxes on people who are further down the income ladder.

PETER DIAMOND: Those are the people having trouble starting businesses. The top 1 percent have wealth. They have high earnings. They have an ability to borrow. If they want to do a startup, they’re not going to be limited by the fact that they’re paying a slightly higher or somewhat higher tax on their earnings.

PAUL SOLMAN: Now, Diamond buys the basic concept of the Laffer Curve and agrees that tax rates should be kept below the point at which they start to discourage work.

PETER DIAMOND: You never want to go into that part of the curve.

PAUL SOLMAN: But since he disputes the premise that it’s the wealthy who need low taxes to create jobs, he sees little harm in raising their taxes when government really needs the revenue.

PETER DIAMOND: We have a lot of studies, based on the available data, on the relationship between tax rates and the amount of revenue you get. It’s very close to certain that the current 35 percent is almost surely below, and comfortably below, what would maximize the revenue. So, I’m very comfortable that the top marginal income tax rate, high 40s, 50s, on up, maybe even into the low 60s.

PAUL SOLMAN: So, according to the data, says Peter Diamond, the Laffer Curve might really look some thing like this. And where would Diamond himself put the top tax rate?

At about 49 percent, still comfortably below the point of maximum tax revenue — 49 percent or so would have positive economic effects, short-term and long, by financing government investment in infrastructure, in education, in research and development, says Diamond, all key components of economic growth.

In fact, Arthur Laffer is sympathetic.

ARTHUR LAFFER: But I don’t think we can determine which dollar goes where, that those dollars are going to go exactly on the margin to infrastructure. They might go to Afghanistan. They might even go to Iraq. They might go to welfare payments. They might go fraud corruption and abuse. We don’t know where those dollars go.

PAUL SOLMAN: But might the benefits of more tax revenue, more government spending exceed the costs of higher taxes on the wealthy?

ARTHUR LAFFER: Honestly, I have been wrong in my life. And we have new research coming on and all sorts of things happening.

But we have to make a call. I don’t think raising tax rates on the upper income groups, all right, makes sense in this economy at this time.

PAUL SOLMAN: By contrast, Peter Diamond and David Cay Johnston do.

And according to at least two dozen polls over the past year, so does a solid majority of randomly selected Americans, although it’s worth remembering they could be wrong, too.