The income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. is one of the more contentious areas in tax policy. The highest tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. , currently at 39.6 percent, has been subject to much debate. This is understandable, since it raises a substantial amount of tax revenue but also significantly disincentivizes individuals to work an extra hour. Moreover, the lowest income tax bracket is also often the focal point of discussion, in that it most affects individuals that are in the lowest income stratum of society.
We modeled changes to each of these tax rates using the Taxes and Growth model, in order to gauge and contrast how each of these changes affects the economy and tax revenues. In this post, we examine the effects of incrementally lowering the lowest tax bracket to zero and the effects of incrementally increasing the top tax bracket up to 59.6 percent.
Table 1 below shows the results of eliminating the lowest income tax bracket, through 2 percentage point incremental tax rate reductions. The lowest income tax bracket has an upper bound of $8,025 and assesses a 10 percent tax on income below that amount. Thus, all changes are with respect to the baseline case of a 10 percent tax rate.
Table 1: The Effects of a 2 Percentage Point Incremental Tax Rate Change in the Lowest Tax Bracket
|
Changes to the Lowest Income Bracket (10% baseline) |
Reduction in the Tax Bracket to: |
||||
|
Economic and Revenue Effects |
0% |
2% |
4% |
6% |
8% |
|
GDP |
0.27% |
0.21% |
0.16% |
0.11% |
0.06% |
|
Private Business Stocks |
0.49% |
0.39% |
0.30% |
0.21% |
0.11% |
|
Hours Worked |
0.21% |
0.17% |
0.13% |
0.09% |
0.05% |
|
Static Revenue Change ($ Billions) |
-$114.55 |
-$92.19 |
-$69.54 |
-$46.63 |
-$23.46 |
|
Dynamic Revenue Change ($ Billions) |
-$104.78 |
-$84.39 |
-$63.57 |
-$42.52 |
-$21.26 |
As illustrated by Table 1, reducing the lowest income tax bracket to zero percent leads to an increase in GDP of 0.27 percent, a 0.49 percent growth in private business stocks, and a 0.21 percent rise in hours worked. Tax revenues, as a result of eliminating the lowest income tax bracket, significantly decline on both a static and dynamic basis. The static revenue change is equal to approximately negative $115 billion, while the dynamic revenue change is about negative $105 billion.
GDP, private business stocks, and hours worked rise as a result of the tax cut’s increased incentive to work. The approximate $10 billion difference between the static estimate and the dynamic estimate reflects a limited economic expansion, where growth only marginally compensates for the loss in tax revenues on a static basis.
Next, Table 2, as displayed below, explores the economic and revenue effects of increasing the top income tax bracket. This is modeled by incrementally raising the current 39.6 percent top income tax rate by 5 percentage points at a time, up to 59.60 percent.
Table 2: The Effects of a 5 Percentage Point Incremental Tax Rate Change in the Top Income Tax Bracket
|
Changes to the Top Income Tax Bracket (39.6 % baseline) |
Increase in the Tax Bracket to: |
|||
|
Economic and Revenue Effects |
44.60% |
49.60% |
54.60% |
59.60% |
|
GDP |
-0.48% |
-0.98% |
-1.49% |
-2.01% |
|
Private Business Stocks |
-1.10% |
-2.23% |
-3.40% |
-4.57% |
|
Hours Worked |
-0.26% |
-0.52% |
-0.80% |
-1.07% |
|
Static Revenue Change ($ Billions) |
$34.40 |
$69.02 |
$103.75 |
$138.53 |
|
Dynamic Revenue Change ($ Billions) |
$16.57 |
$32.20 |
$46.69 |
$60.75 |
As shown in Table 2, an increase in the top income tax rate to 59.60 percent (similar to countries like Denmark and France) results in a 2.01 percent decline in GDP, a 4.57 percent slump in private business stocks, and a 1.07 percent decrease in hours worked.
A tax increase to a top rate of 59.60 percent leads to a gain in static and dynamic revenues of around $139 billion and $61 billion, respectively. The discrepancy between the static and dynamic revenue estimate is due to the increasing disincentive to work. This difference between revenues estimated on a static basis versus a dynamic basis increases as the tax rate moves higher. At the 44.60 percent level, the dynamic revenue estimate comprises approximately 48 percent of the static revenue estimate, while at the 59.60 percent level, the dynamic revenue estimate constitutes 43 percent of the static revenue approximation.
An important aspect in comparing tax rate changes to different tax brackets relates to marginal and inframarginal considerations.
Lowering the tax rate on the current 10 percent bracket results in a windfall or increase in after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. but does not create an increased incentive to work for a large number of people. This is because many of those individuals are in a higher tax bracket—for example in the 25 percent bracket—on their last dollar of earned income. Thus, such a tax rate decrease has a relatively limited impact on the motivation to generate additional economic output, as illustrated by Table 1.
In contrast, the top marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. will always constitute the marginal tax rate for persons in the highest income tax bracket. As a result, the incentive to work for all individuals in that tax bracket will be decreased as the top marginal tax rate increases.
Furthermore, another reason as to why increasing the top marginal tax rate results in such pronounced negative economic effects is because this rate often affects pass-through businesses.
While a decrease in the lowest income tax bracket does spur economic growth, the positive real economic effects are marginal and lead to substantial revenue losses on both a static and dynamic basis. In contrast, tax rate changes in the top income tax bracket have larger real economic impacts and a larger gap between static and dynamic estimates.
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