Could the U.S. Tax Its Way Out of Debt and Inequality?

Thursday August 21st, 2014   •   Posted by Craig Eyermann at 6:11am PDT   •  

6330049_S What would happen if prominent income-inequality theorists, such as economists Thomas Piketty, Emmanuel Saez and Peter Diamond, could get their way and hike the topmost marginal income tax rate in the United States to 80%? Would the nation enter into an enlightened state of economic nirvana as they claim? Or would things perhaps turn out badly? Or would anybody even notice a difference?

To find out, the nonpartisan Tax Foundation applied its integrated model of the U.S. tax system and the U.S. economy to analyze the impact of hiking the top U.S. income tax rates to approximately 55% on annual household incomes above $200,000 and to 80% for households with incomes above $500,000, as these leading income-inequality theorists have advocated. Here are the key findings of what the impact would be for the federal government’s tax collections and the U.S. economy:

  • If ordinary income were taxed at the top rates of 80 and 55 percent, our model estimates that after the economy adjusts, total output (GDP) would be 3.5 percent lower, wage rates would drop 1.6 percent, the capital stock would be 7.4 percent less, and there would be 2.1 million fewer jobs.
  • If capital gains and dividends were taxed at the new tax rates along with ordinary income, the economic damage would be much worse. GDP would plunge 18.1 percent (a loss of $3 trillion dollars annually in terms of today’s GDP), the capital stock would be 42.3 percent smaller than otherwise, wages would be 14.6 percent lower, 4.9 million jobs would be lost, and despite the higher tax rates, government revenue would actually fall.
  • Although Piketty’s proposed income tax increase may appear to target only upper-income taxpayers, all income groups would suffer from the economic fallout.
  • Our model estimates that the after-tax incomes of the poor and middle class would drop about 3 percent if the higher rates do not apply to capital gains and dividends and about 17 percent if they do.

In running their analysis, the Tax Foundation tried out two different scenarios, which differ in how income from investments such as the dividends and capital gains might be taxed. The first chart below shows what their Tax and Growth model indicates would be the result if there are no changes in the tax rates for dividends and capital gains, which are currently capped at a maximum rate of 23.4% to minimize the extent of double taxation with the corporate income tax.


In this chart, the capital stock indicates how much the private sector of the U.S. economy could be expected to shrink in response to just these large tax hikes: 7.4%. Meanwhile, the number of employed Americans could be expected to drop by 2.2% and GDP overall would decline by 3.5% below what it would otherwise be in without the income tax increases.

Since income-inequality theorists often cite the income earned through risky investments in the stock or real estate markets as being the primary source of income inequality, the Tax Foundation also considered the scenario where household income earned through dividends and capital gains would be taxed at the same rates as for ordinary income, elevating their top tax rate to the same 80% level even though the corporate income tax would still apply. The following chart reveals the likely outcome for the U.S. economy:


Here, we see that the private sector of the U.S. economy could reasonably be expected to contract by 42.3%, while the number of employed Americans would decline by 5% as the nation’s overall economy would shrink to be permanently 18.1% smaller than it would be without the massive tax hikes advocated by income-inequality theorists.

These negative impacts for the U.S. economy would also have negative impacts for the national debt. The Tax Foundation describes how the tax hikes that were going to be counted upon to rectify inequality would instead aggravate it because government spending would not be able to be sustained without entering into a national debt death spiral:

Because of the dramatic economic decline caused by the higher taxes, government revenue would be lower than otherwise. To avoid going farther into debt, the government would have to cut its spending. Many of the cuts would unavoidably fall on transfer programs for the poor and middle class because those programs are such a large share of the budget.

One estimate indicates that in 2004, the U.S. government’s transfer programs were responsible for elevating 15.5% of the U.S. population out of poverty, dropping the poverty rate from what would otherwise have been 29% to just 13.5% instead. The combination of a shrinking economy with such spending cuts would greatly increase the number of Americans at the bottom of the income-inequality spectrum, which would counteract any decrease in the level of income inequality meant to be achieved in such draconian tax schemes.

The bottom line: there is no real-world way that the U.S. government could tax its way out of debt and inequality.

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