President Biden entered office with an ambitious agenda. From expanded healthcare subsidies and increased social security benefits, to student loan forgiveness. This would be costly. As a candidate, Biden proposed a series of tax rate increases on high-income families to pay for some of his new programs. Under his plan, corporate income tax rates and top personal income rates would rise. Top earners would face new Social Security taxes, and millionaires would face much higher tax rates on capital gains and dividends. What would these tax rate hikes look like, and what would they do to the economy?
Part 1: What are the Corporate Income Tax Increases?
Until 2018, the US had the highest statutory corporate tax rate in the developed world. Even before accounting for new state taxes, the top rate was 35%. This was well above rates in Ireland (12.5%), Canada (15%), and the UK (19%). The Tax Cuts and Jobs Act of 2017 (TCJA) permanently lowered the top rate to 21%. The current administration wants to increase the rate to 28%, which is higher than most developed countries, but still 20% lower than the 2017 rate. There are some reasons for why there isn’t support for the old rate:
- At higher rates, corporations have more incentive to avoid the tax. They hire expensive tax lawyers to find clever ways to reduce their tax bills. They move their headquarters/profits to low-tax jurisdictions. A higher tax rate shifts a corporation’s focus from producing better products at lower costs to finding ways to reduce its tax liability. It affects what they produce, where they build it, and how they finance it. The end result is that consumers pay more but get less and the government takes in less tax revenue.
- The person who pays a tax is often not the same person who bears the cost of the tax. In the case of corporate taxes, economist John Cochrane explains that “as an accounting matter, every cent corporations pay comes from higher prices, lower wages, or lower payments to the shareholders. The question is which one.” Economist Michael Boskin argues that corporate tax is born increasingly by workers: “Corporate taxes, like others, are ultimately paid by people. In a static economy with no international trade, shareholders are likely to bear the costs. The US economy is neither static nor closed to trade, and so taxes tend to be borne by the least mobile factor of production. Capital is much more mobile globally than labor, and the part of the corporate tax that is well above that of our lowest tax competitors will eventually be borne by workers. In a growing economy, the diminished investment slows productivity growth and future wages.
Slower economic growth and lower wages are a high price to pay for a tax that yields surprisingly little revenue. It’s no wonder then that there isn’t much support for pushing the rate back up to its former level.
Part 2: What About Personal Income Taxes?
About half of all federal tax revenue comes from personal income taxes. These taxes are progressive, meaning that as your taxable income rises, the share of your taxed income rises too. Every dollar of taxable income is taxed at a particular rate, called a marginal tax rate. Currently, marginal tax rates on earned income range from 10% to 37%. President Biden wants to raise the top rate to 39.6%, the rate that existed prior to the TCJA.
The personal income tax code doesn’t just tax wage income. People also pay income tax on realized capital gains and dividend payments. Capital gains are the profits made form selling an asset for more than it was bought. The tax rates for investment depend on the gross income of the tax filer and how long the filer held the investment. If you sell an asset within a year after buying it, your tax rate is generally the same tax rate you pay on your taxes. If you held it for more than a year, you pay a lower tax rate. Biden’s plan calls for eliminating this lower tax rate for filers with incomes above $1 million. How big of a tax increase would this be? Currently, the top rate on long-term capital gains and qualified dividends is 23.8% Biden’s plan calls for this to rise to 43.4%.
These higher marginal tax rates would have significant effects on the economy. Watch this video for an explanation:
The marginal tax rate affects a person’s decision on whether to work more hours, hire more workers, or invest in new innovations or businesses. As the video explains, the “investments not made, schooling not pursued, or businesses not started all cumulatively add up to a lower quality of life for everyone.”
While high marginal tax rates discourage the behaviors that produce economic growth, many policy makers are willing to accept that outcome in order to make the tax system more progressive. They argue that high-income taxpayers can afford to pay more. But just because they can, doesn’t mean they will. As we saw with corporate income taxes, the higher the rate, the more incentives people have to avoid the tax. This will be done either through clever accounting or through changing their economic decisions.
Further, the US already has one of the most progressive income tax systems in the developed world. The progressive rates don’t necessarily yield substantially higher tax revenue. The tax code is filled with countless deductions that reduce a filer’s taxable income and tax credits that directly reduce a filer’s tax liability. Filers may cut their taxable income by deducting charitable contributions, the interest they pay on their mortgage, and taxes they pay to state and local governments. Families with children may reduce their tax bill by claiming the child tax credit. Businesses can claim credits for research and development or building low-income housing. The US tax code has long been filled with these types of tax breaks. Milton Friedman explains how these tax breaks interact with high tax rates:
Part 3: What About Payroll Taxes?
Social Security and parts of Medicare are financed through payroll taxes on wage and salary income. The 2.9% Medicare tax, split evenly between employee and employer, is assessed on all wage and salary income. The Social Security tax is more complicated. It assesses a 12.4% tax, split like Medicare, on earnings up to the so-called taxable maximum. This maximum is set at $142,800 in 2021. Earnings above the taxable maximum face no Social Security taxes. President Biden wants to assess the full Social Security tax on all earnings above $400K.
It might seem odd that top earners pay a lower share of their income in Social Security taxes than those with earnings below the taxable maximum. There is an interesting historical reason for this unique tax. Workers’ taxable Social Security earnings are used to determine how much they receive in benefits when they retire. In discussing Senator Warren’s Social Security plan, John Cogan explains how applying these taxes to earnings above the taxable maximum would alter the nature of the program:
“The cornerstone of FDR’s Social Security program is its “earned right” principle, under which benefits are earned through payroll-tax contributions. Although Congress has eroded this principle over the years, it remains part of the program’s core. Warren’s plan calls for additional taxes on wage earnings, capital gains, and dividends paid to those with high annual incomes. These incomes are $250K or more for individuals, and $400K or more for families. But in a major break from one of FDR’s main Social Security principles, the plan provides no additional benefits in return for the new taxes. Warren’s new tax plan would account for about a quarter of future revenues flowing into the Social Security system. Such a large revenue stream to fund unearned benefits, called “gratuities” in FDR’s era, would put Social Security on a road to becoming a welfare program.
Even beyond its effect on the Social Security program, adding the Social Security tax on earnings above $400K would represent a dramatic marginal tax rate increase. Currently, workers with incomes in the top personal income tax bracket face a marginal tax rate of roughly 40.8%. 37% of that is for personal income taxes and 3.8% for Medicare. Adding the 12.4% tax would raise the top marginal tax rate above 50%, and that is before accounting for state income taxes. Like other marginal tax rates, these high rates will affect decisions to work, ultimately hurting future economic growth.
High marginal tax rates damage the economy and will result in fewer economic opportunities for everyone. yet we need revenue to pay for essential government services, and much more to fund the reforms envisioned by the new administration. Is there a better way?
Fortunately, yes. A consumption tax such as a sales tax or value-added tax offers a far more efficient way to raise revenue. In Blueprint for America, Michael Boskin explains:
“There is considerable research showing that moving toward a broad-based, integrated progressive consumption tax would significantly increase real GDP and future wages. Replacing both the corporate and personal income taxes with a broad, revenue-neutral consumption or consumed income tax would produce even larger gains.”
A consumption tax would give workers, entrepreneurs, and innovators better incentives to work, invest, and create. The result would be an economy that delivers more economic opportunity while providing adequate revenue for the government.