Modeling Martin O’Malley’s Idea for Tax Increases

During Saturday’s CNN Democratic debate, Governor Martin O’Malley (D-MD) suggested creating a new tax bracket that would apply to income over $1,000,000, and taxing capital gains at ordinary marginal income tax rates. He claimed that these changes would provide sufficient revenue for the public investments he supports. Here is the relevant quote:

“If we were to raise the marginal rate to 45% for people earning more than a $1,000,000, and if we taxed capital gains essentially the same we do earnings from hard work, sweat, and toil, you could generate $800 billion over the next 10 years, and that would do so much good for affordable college, debt-free college, cutting youth unemployment, investing in our cities again…”

Governor O’Malley did not provide any additional details, but I think it would helpful to examine how a similar set of changes would impact government revenues. Using the Tax Foundation Taxes and Growth Model, I modeled the effects of adding a new bracket of 45% on income over $1,000,000 and taxing capital gains and dividends at ordinary income rates. I found that these changes would raise a considerable amount of revenue on a static basis, but substantially less on a dynamic basis.

On a static basis, these changes would raise roughly $2 trillion over the next decade. However, these tax hikes sharply raise the cost of capital, leading to a decline in GDP of 4.2%. Accounting for this reduction in economic growth, they would generate $865 billion over the next decade.

Distributionally, on a static basis these changes would reduce the after-tax incomes of the top 10% and top 1% of earners by 3.84% and 8.52% respectively. Other deciles would also see small reductions in their after-tax income, due to higher rates on investment income. On a dynamic basis, all income deciles would see reductions in their after-tax income as a consequence of the decline in GDP.

Governor O’Malley is not the only Democratic candidate who has called for increasing taxes on wealthy individuals to pay for additional government spending. I find that eliminating the preferential treatment for capital income and imposing a higher tax rate on millionaires would raise a significant amount of revenue, but impose substantial burdens on economic growth and reduce after-tax incomes for most taxpayers.