Feldstein on Taxes, Efficiency and Economic Growth

May 19, 2006

Harvard economist and public-finance legend Martin Feldstein has published an excellent new primer through the NBER’s working papers series, “The Effect of Taxes on Efficiency and Growth.” Here’s an excerpt from the introduction:

The taxes collected by the federal, state and local governments now take one third of GDP. Marginal tax rates are even higher. And it is the marginal tax rates that determine the efficiency costs – i.e., the deadweight losses – of the tax system.

A typical wage earner now pays a combined marginal tax rate of about 45 percent on incremental pay – a 25 percent federal personal income tax rate, a 15.3 percent combined employer-employee payroll tax, and a state income tax of about 5 percent. State and local sales taxes often put the total over 50 percent. And that is for someone who earns as little as $40,000 a year.

Understanding the magnitude and nature of the deadweight losses – i.e., of the efficiency losses – is important for assessing the true cost of increased government spending and for shaping the appropriate structure of taxes.

The good news is that marginal tax rates are lower today than they were in the past and that the deadweight losses of the tax system are therefore correspondingly lower. Back in 1963, the highest marginal tax rate in the personal income tax was 93 percent. A taxpayer in the top bracket got to keep only 7 cents out of every extra dollar that he earned. (I used to work for one of those taxpayers: Ronald Reagan. And his memory of the adverse effects of such high tax rates is an important reason that we have much lower marginal tax rates today.)

Even as recently as 1980, the top income tax rate was 70 percent on interest and dividends and 50 percent on wages and other personal services income. Today the top federal marginal income tax rate is 35 percent, although the effective marginal tax rate rises to about 40 percent when the Medicare payroll tax and the phase-out of deductions are taken into account. In some high-income two earner families, one of the earners is still subject to the marginal payroll tax, raising this 40 percent marginal tax rate to more than 50 percent.

The tax rates on capital income have come down even more than the rates on personal services income. The corporate tax rate is down from 46 percent in 1980 to 35 percent now. The maximum tax rate on capital gains, which in 1980 could reach more than 40 percent as a result of tax add-ons and offsets, is now down to 15 percent, although that could revert to 25 percent if Congress does not renew the current rates. Similarly, the current 15 percent rate on dividend income will revert to the full marginal tax rate of 35-plus percent if Congress does not act.

It would be wrong to conclude from these reduced rates on dividends and capital gains that the tax on investment income is now low. The full tax on capital income includes not only the taxes paid by the individual investors but also the corporate income tax. When these taxes are combined, the result is still a tax that can do a great deal of economic harm.

Read the full paper—which is excellent throughout—here.


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