One of the political-economic legacies of the late 1970’s and early 1980’s was a belief in supply-side theories of tax cuts as an “engine of growth”. Republicans have claimed this as a legacy from Ronald Reagan. In fact, however, the cutting of top marginal income tax rates was started by Jimmy Carter. Under Carter’s administration the top marginal tax rate (MTR) was reduced from 70% to 50%. Under the first of the Reagan cuts, the top MTR was cut further to 38%, and then later to 33%. The claim had been (and still is by some) that reducing the MTR’s improves the incentives to work resulting in more people working harder & longer & making more income (thus more GDP). The inverse has also been argued as a reason why MTR’s can never be increased, particularly on upper-income brackets.
This logic, carried to an extreme under the Bush II administration brought us the first attempts to fight two major (in $ terms) wars and finance them with tax cuts instead of taxes. It hasn’t worked. Part of the reason is because such supply-siders ignore part of the logic and theory of why people work. Yes, higher tax rates reduce my incentive to work longer because they reduce the take-home pay rate I get for longer hours. But the lower income also motivates me to work longer and harder to maintain the same absolute dollar income. Theory is indeterminant about which effect dominates. However, experience is not indeterminant. MTR’s as incentive mechanisms are very weak.
Trickle-down theorists are quick to object that higher taxes would cause top earners to work less and take fewer risks, thereby stifling economic growth. In their familiar rhetorical flourish, they insist that a more progressive tax system would kill the geese that lay the golden eggs. On close examination, however, this claim is supported neither by economic theory nor by empirical evidence.
The surface plausibility of trickle-down theory owes much to the fact that it appears to follow from the time-honored belief that people respond to incentives. Because higher taxes on top earners reduce the reward for effort, it seems reasonable that they would induce people to work less, as trickle-down theorists claim. As every economics textbook makes clear, however, a decline in after-tax wages also exerts a second, opposing effect. By making people feel poorer, it provides them with an incentive to recoup their income loss by working harder than before. Economic theory says nothing about which of these offsetting effects may dominate.
If economic theory is unkind to trickle-down proponents, the lessons of experience are downright brutal. If lower real wages induce people to work shorter hours, then the opposite should be true when real wages increase. According to trickle-down theory, then, the cumulative effect of the last century’s sharp rise in real wages should have been a significant increase in hours worked. In fact, however, the workweek is much shorter now than in 1900.
One implication is that the U.S. could raise MTR’s on upper income taxpayers without slowing growth. In particular, a top candidate should be hedge fund managers and other Wall St. traders that use loopholes introduced in 2001 to pay a lower tax rate than on their high six and seven-figure incomes than someone earning $60,000 pays on theirs. This could go a long way to paying for universal healthcare, reducing the long-term structural deficit, and even paying for those wars Washington just can’t seem to let go of.