Yesterday’s Wall Street Journal op-ed by Peter Diamond and Emmanuel Saez received quite a reaction. Diamond and Saez advocate raising the top marginal tax rates on the rich to between 50-70%. Their recommendation is based on a 2011 paper they published in the Journal of Economic Perspectives (PDF) where they advocated 1) Raising marginal tax rates on the very rich, 2) Subsidizing earnings (phasing out at a high rate) for low earners, and 3) Taxing capital. Their paper was widely discussed when it was published, and it is serving as a justification for many on the left to raise taxes on high-income earners. It’s their first recommendation that I would like to address.
There are several key limitations with the authors’ methodology used to conclude that raising marginal tax rates is optimal social policy. Two I’ll mention here are the dynamic effects of raising marginal tax rates in the medium and long term, and the volatility that comes with higher rates on a small portion of the population.
First, and this is the most important issue with the paper, Profs. Diamond and Saez are unable to produce estimates of the effect higher marginal tax rates have on economic growth or tax revenues in the medium or long term. (I’d note that Scott Sumner highlighted the following excerpt months ago. Still, it should be front and center of the criticism of their recommendation.) From their paper:
It is conceivable that a more progressive tax system could reduce incentives to accumulate human capital in the first place. The logic of the equity-efficiency trade-off would still carry through, but the elasticity e should reflect not only short-run labor supply responses but also long-run responses through education and career choices. While there is a sizable multiperiod optimal tax literature using life-cycle models and generating insights, we unfortunately have little compelling empirical evidence to assess whether taxes affect earnings through those long-run channels.
Translated: We don’t know what will happen in a few years as a result of this change.