By Edward Conard • Wall Street Journal
Newly elected Rep. Alexandria Ocasio-Cortez spent her first few weeks on Capitol Hill calling for a 70% top marginal income-tax rate, and suddenly the debate over optimal rates has reopened. To support her charge, some liberals are citing a 2011 study by economists Peter Diamond and Emmanuel Saez, which advocates for confiscatory upper-range tax rates. But a quick look at their analysis reveals grave caveats that only an advocate of higher taxes could possibly overlook.
Messrs. Diamond and Saez admit that taxes can have detrimental…
Newly elected Rep. Alexandria Ocasio-Cortez spent her first few weeks on Capitol Hill calling for a 70% top marginal income-tax rate, and suddenly the debate over optimal rates has reopened. To support her charge, some liberals are citing a 2011 study by economists Peter Diamond and Emmanuel Saez, which advocates for confiscatory upper-range tax rates. But a quick look at their analysis reveals grave caveats that only an advocate of higher taxes could possibly overlook.
Messrs. Diamond and Saez admit that taxes can have detrimental long-term effects on growth. Yet they ignore the long-term effects of marginal tax rates on growth. Their analysis assumes there is no effect on growth when the government taxes, redistributes and consumes income that Americans otherwise would have invested.
The authors grant that new taxes on high earnings would decrease work effort, but they don’t account for the reduced supply of talent reducing investment opportunities over time. They similarly assume confiscatory tax rates won’t diminish workers’ willingness to endure tough training and often tedious work in fields essential to growth, such as computer programming, accounting and engineering.
Most important, Messrs. Diamond and Saez ignore how inhibiting investment, risk-taking, training and work effort slows the rate at which the economy builds productivity-compounding institutions. Companies like Google accelerate innovation by exposing American workers to cutting-edge ideas and opportunities.
This exposure, together with communities of experts like Silicon Valley that facilitate the commercialization of innovation and cultural norms that encourage entrepreneurial success, magnifies the productivity of America’s talent. Punitive taxes would slow the creation of these institutions by disincentivizing the behaviors that create them.
It doesn’t take much imagination to see how society benefits more in the long run from higher growth than from larger annual tax levies. Even many liberal economists agree that for every dollar investors earn on average, they create $5 of value for the rest of the economy, chiefly for their customers and workers.
So why would an “optimal” tax policy maximize taxes collected on the $1 of earnings rather than maximizing the value of investment to others? One study last year that did account for taxes’ long-term effect on growth found that the optimal top marginal tax rate would be between 30% and 35%. At best, a 70% marginal tax rate would maximize federal revenue in the short term before eventually slowing the growth of America and the rest of the world.
The stifling effect of reducing the value of success is clear when comparing the U.S. and European economies. With greater payoffs for success, it’s no surprise America’s most talented workers work longer hours and take more entrepreneurial risks than their counterparts in other high-wage economies. Since the commercialization of the internet in the early 1990s, American innovation has significantly outpaced Western Europe. Today the value of privately held American startups priced above $1 billion—so-called unicorns—is seven times the figure in Europe.
Another discouraging aspect of Ms. Ocasio-Cortez’s tax plan is that, even putting aside its long-term costs, its short-term upside isn’t significant. The Tax Foundation finds that a 70% tax rate on incomes over $10 million would increase federal revenue by less than $30 billion a year over the coming decade—a pittance compared with the more than $800 billion deficits expected this year.
The same study found that revenue would actually decrease if the new top rate were extended to capital gains as some of its backers are advocating. In truth, America runs enormous deficits because, unlike Europe, it doesn’t tax the middle class for the full cost of the government services they consume.
The only way to cover the cost of burgeoning debt without growth-crushing taxes is to encourage faster economic growth. High-skilled immigration is America’s only viable option. Today innovation, and the skilled workers who produce it, drives growth.
The country could potentially double its long-run growth rate by using immigration to double the six million ultrahigh-skilled workers who represent the top 5% of its full-time workforce. It could do this by redirecting the million green cards a year it currently issues to all immigrants exclusively to the world’s most talented workers—workers who pay far more in taxes than the value of the government services they consume. That would go a long way toward solving the problem. But those immigrants won’t come to America if the government confiscates their hard-earned success.