Taxapalooza

As I understand the current tax debate, Team Obama’s policy argument is largely based upon a 2011 Journal of Economic Perspectives paper by Peter Diamond and Emmanuel Saez entitled “The Case for a Progressive Tax: From Basic Research to Policy Recommendations” (available from http://www.aeaweb.org/articles.php?doi=10.1257%2Fjep.25.4.165). It all comes down to a rather technical discussion concerning the reliability of econometric estimates of the elasticity of taxable income (ETI), which refers to the sensitivity or responsiveness of taxable income to changes in marginal tax rates.  If taxable income is indeed not all that sensitive to increases in marginal tax rates (Diamond and Saez claim an estimate for ETI = 0.25 in their paper), then you can obtain (as Diamond and Saez do) so-called “socially optimal” tax rates of 73%-83% on the top 1% which would raise tax revenues while having a neutral effect on overall economic growth. On the other hand, if ETI is higher than .25, then the Diamond-Saez marginal tax rate recommendations could have the exact opposite effect – i.e., they could potentially cause substantial losses in tax revenue while reducing economic growth.

Compared with other public finance academic studies, the Diamond-Saez ETI of 0.25 represents a “lowball” estimate. In fact, other studies indicate ETI estimates ranging from 0.62 (from a 2004 paper by Saez) to 1.99 (from a 2000 public finance book edited by Michigan economist Joel Slemrod). Selecting the midpoint of this range (1.3), the application of the Diamond-Saez methodology would then imply a substantially different policy recommendation – in that case, the so-called “socially optimal” tax rates would be more like be 33.9% for all taxes, and below 27% for the federal income tax.

Also the AEI’s James Pethokoukis just posted an article at the AEIdeas “New study shows why heavily taxing the rich won’t work” which summarizes a new AEI paper by Aparna Mathur, Sita Slavov, and Michael Strain which casts further doubts concerning whether “…the [Diamond-Saez] model can be used prudently as the basis for the real-world public policy problem of determining the socially optimal top marginal income tax rate.”

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